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Notes 1

Principles of Auditing (University of Embu)

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INTRODUCTION.
Definition
An audit is the independent examination of and expression of an opinion on
the financial
statements of an economic entity by appointed auditor in pursuance of that
appointment and in compliance with any relevant statutory obligation.
The objective of an audit is to enable the auditor express an opinion whether
financial statements show a true and fair view of the company state of affairs
in accordance with an identified financial reporting framework.
Advantages of auditing
•• Dispute resolution. A partnership business with a complex profit sharing
agreement may
require an independent examination of those accounts to ensure accurate
assessment
and division of those profits.
•• Significant changes in ownership and structure can be easily effected if
past accounts
contain unqualified audit reports. E.g. in mergers.
•• Auditors have access to the corporate strategy of the company thus are
able to give
advice on gaining competitive advantage and on improvement of business
efficiency.
•• Borrowing of finances from third parties is enhanced with availability of
unqualified audit
report on the company’s financial statements.
•• Auditing protects the interests of the shareholders who are separated
from the
management of their savings invested in the company.
•• Auditing assists in prevention and detection of fraud and error in financial
statements
although this is not the primary objective of an audit.
Disadvantages of auditing
• Audit fees are normally high since auditors are highly qualified
professionals hence small
firms such as sole proprietorships may not afford their financial statements
to be audited.
• The audit exercise interrupts the clients’ operations because client staff
have to spend time in availing the required information to the auditors.
• Company secrets may leak to competitors since all company information is
accessible to
the auditors.
Distinction between Financial Accounting and Auditing
Financial accounting entails provision of information about a business or
company in form of financial statements which are then made public. These

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statements are generally prepared on an annual basis and used by

management and other interested parties to make decisions. The
information contained in these financial statements must give a true and fair
view of the state of affairs in the organization.

Auditing is a check carried out by an independent auditor to make sure that

what a company is saying about its financial statement is true. Auditing
therefore adds credibility to the financial statements by ensuring the
availability of accurate and reliable financial information.

Differences between Auditing and Financial Accounting

• Auditing is an independent examination of company accounts and
expression of an opinion whether they contain a true and fair view of
company’s state of affairs. Financial Accounting is the recording, classifying
and summarizing events of an economic entity in order to assist
management in decision making.
• While auditing is conducted once in a financial period and usually at the
end, financial
accounting is a continuous process throughout the financial period of a
company.
• Auditing is governed by ISA while Financial Accounting is guided by GAAPs.

Similarities between Auditing and Financial Accounting

• Both auditing and accounting are statutory requirements i.e. that
companies must maintain proper books of accounts at that their financial
statement must be audited

Users of Audited Financial Statements

• Present and potential investors. These risk capital providers and their
advisors are concerned with the risk that is inherent in their investment.
They need information to help them determine whether they should buy
more shares, hold on to the shares they have or sell the shares they have.
• Employees. These and their representative groups such as trade unions are
interested in
information about the stability and profitability of their employers. They are
also interested
in information which enable them assess the ability of the company to
provide adequate
remuneration, retirement benefits and employment opportunities.
• Lenders. These are interested in information that enables them determine
whether their
loans and interests arising from the loans will be paid back when due.
• Suppliers and other trade creditors. These users are interested in
information that enables

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them determine whether the amounts owing to them will be paid when due.
Their interest in the company is of shorter period than lenders while they are
dependent upon the continuation of the company as a major customer.
• Customers. These have interest in information about the continuance of
the company
especially when they have long term involvement and or are dependent as
the company.
• Government. The main interest of the government is allocation of
resources. It also requires information in order to regulate the activities of
the enterprise, determine taxation policies and obtain national income
statistics.
• Public. A company affects public in a variety of ways. A company may
make substantial
contribution to the local economy by employing people and obtaining
supplies locally.
Financial statements assist the public in information on trends and recent
developments of
the company in the economy.
Types of Audits
Audits can be classified into two broadways.
1. According to terms of engagement i.e. nature of work done.
2. According to the approach to the work to be done/ timing.

According to nature of work done

A. Statutory audits
These are carried out as per the requirements of various statutes e.g.
Companies Act Cap 486 requires that all public limited companies to have
their financial statements subjected to an independent audit. The objective
of the audit is to enable the auditor express an opinion whether the financial
statements have a true and fair view of the company’s state of affairs. The
rights and duties of the auditor are laid down in the relevant statute. The
powers of appointment of the auditors are vested on the shoulders.

B. Private audits
These are not governed by statutes. They are performed by independent
auditors because the owners, members or interested parties require them
carried out. Private audits are carried out for organizations such as non-
governmental organizations, partnerships and clubs and among others.
Appointment of auditors is carried out as a private contract between the
auditor and the relevant shareholder. The scope and objective of the work as
well as rights and duties of the auditor are determined by the agreed terms
between the auditor and the client. The auditor is not liable to third parties.

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According to approach of the work to be done

A. Continuous audits
This is an approach whereby an audit is carried out throughout the financial
period usually
at predetermined intervals. This approach is ideal for large organizations
with tight reporting deadlines e.g. multinational banks. The approach
ensures accounts are kept up to date, errors and frauds are discovered in
early stages and better audit reports are developed since more time is
taken.
However, this approach is expensive considering amount of time taken, has
frequent interruptions of client work and auditors’ independence may be
affected by their continuous presence at clients’ premises.
B. Interim audits
This is an audit carried out halfway through the financial period. It usually
precedes the final audit and is a preparation for the final audit. It is ideal for
dynamic businesses, cheaper compared to continuous audits and enhances
keeping of up to date records.
C. Final audits
These are usually done at the end of the year as either a continuation of the
interim audit for large and medium size companies or as a single audit for
small companies at end of financial
period.
1 0 AUDITING AND ASSURANCE
STUDYTEXT

CONTINUOUS OF AUDIT:
It is also called Running audit. A continuous audit is one in which the audit
staff in engaged continuously in checking the accounts of the client during
the current financial year. It is of great help to relatively bigger concern. It is
not much use of small concern assists accounts can be audited at the end of
the financial year without much loss of time. A continuous audit is applicable
in the following cases.
(a) Where the volume of the transaction of very large.
(b) Where the management require the view of financial position of their
concern monthly or quarterly.
(C) Where not satisfactory system of internal check is in position and

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(d) Where it is desired to present the account just after the close of the
financial year, as in the case of the bank.
Advantages of continuous audit:
1. Efficient: The auditor of his staff gets sufficient time for the audit work.
The account books are properly inspected and checked in detail. The
auditing work would never be done in a hurry. Therefore, the audit will be
more efficient and detailed.
2. Quick discovery of errors: Errors and frauds can be discovered easily
and quickly as the auditor checks the accounts as regular intervals. As the
auditor visit his clients, say after a month or two or so, the number of
transactions will be small and hence the errors will be detected easily and
quickly.
3. Relief to auditor: In a continuous audit, the several visit paid by the
auditor to the client office enable his work to proceed easily and smoothly. It
also boots his confidence in his capacity to handle his work with efficiency
and effectiveness.
4. Knowledge of Technical details: Since the auditor remains more in
touch with the business, he is in position to know the technical and hence it
can be great help to his clients by making valuable suggestions.
5. Moral check: In continuous audit, the auditor may also pay surprises visit
to the client office. This exercises undoubtedly a great moral check on the
staff of the client who are over confident because of the ever present
apprehension of an impending visit by the auditor.
6. Interim dividend: Where the director of a company wishes to declare an
interim dividend continuous audit will help in the preparation of the interim
accounts without much delay.
7. Keep the client staff accounts up-to date: As the auditor visits the
client at regular intervals, the clerks will be very regular in keeping the
accounts up-to date.
Disadvantage of continuous audit
In spite of several advantages of continuous audit, there are certain
disadvantages of such an audit that are as under
1. Dislocation of work: Auditor frequent visit dislocate the work of the
client staff. The efficiency of the client staff may be affected.
2. Alternation of figures: The record of the transaction may be altered
fraudulently after they have been audited.

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3. Queries may remain outstanding: The audit clear may lose the thread
of his work and the queries remain outstanding, as there might be long
interval between the two visits.
4. Expensive: Continuous audit is very costly due to heat audit fees and
other incidental expenses connected with the audit staff.
5. Unhealthy relationship: Unhealthy relationship is developed between
the audit staff and the staff of the client due to the frequent visit of at the
audit staff.
PERIODICAL AUDIT:
This is also known as final audit or annual audit. The audit is very useful to
small concerns. It is understood as an audit that is carried out often at the
close of the accounting year. Most of the companies have audited their
accounts under this system. Nevertheless, in the case of large concerns, it
takes more time to complete the audit and hence presentation of accounts
to the shareholder is delayed. The shareholders are usually very anxious for
it dividends which cannot be declared until the final accounts have become
prepared and audited.
Advantages of periodical audit
The following are some of the main advantages of periodical audit
1. Economical Period: Periodical audit is economical and suitable
particularly small sized business units.
2. Smooth flow of work: The work of the audit proceeds in uninterrupted
manner and there are no intervals in the case of continuous audit.
3. Little chance of collusion: There is no possibility of friendly ties
developed between the audit staff and the client staff and as such, the
chances of any collusion between them are minimized.
4. No loose of interest: The is no loss of link in the work as the entire audit
is completed in a single continuous session.

Disadvantages of periodical audit

1. Delay: As the work of audit usually takes a long time to be completed,
the presentation of final accounts in the annual general meeting is likely to
be delayed.

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2. Unsuitability: In large concern where the number of transactions are

voluminous and often quite complex, periodical audit is not practicable and
for this reason, they do often not prefer it.
3. Non detection of errors and frauds: For lack of detailed checking,
errors and frauds may continue to remain undetected. The following are the
main difference between continuous audit and Periodical audit
Continuous audit Periodical Audit
1. Audit work is done continuously Audit work is done at the end of the
throughout the year year.

2. It is suitable to big concerns. It is suitable to small concerns.

3. Detailed checking is possible. Detailed checking is not possible.

4. It is expensive It less expensive.

5. Scope for fraud minimized. Scope for frauds is more

6 Audit work becomes mechanical Audit work does not become

mechanical

7. It creates moral checks on It does not create moral check upon

Clients’ staff. the
client staff

8. Accountancy and auditing go Audit begins where accountancy

together. ends

INTERIM AUDIT:
Interim audit means an audit that is conduct in between two annual audits.
Its objectives are to enable the company declare an interim dividend. It
involves a complete examination a review of the account and records of the
business up to the date of the interim audit. Thus interim audit may be
ordered for a quarter or six months.
Advantages of interim audit
1. Errors and frauds can be more quickly found and detected during the
course of the year.
2. This type of audit is good where the interim figure is necessary.
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3. There is a moral check on the staff of the client as the account are
checked say, after three or six months.
4. The final audit can be completed very soon, if there has been an interim
audit.
Disadvantages
1. Interim audit may prove expensive because it involves addition work on
the part of the auditor.
2. Figure may be altered in the account that have already been audited.
3. It will mean that the audit staff will have to prepare notes that they furnish
interim audit.
DISTINCTION BETWEEN THE CONTINUOUS AUDIT AND INTERIM AUDIT
1. Object: The object of continuous audit is not ascertaining the profit or
loss of the undertaking for a given period. But the objective of interim audit
is to certain and check the profit and loss for a given period.
2. Scope of audit: In continuous audit, detailed and expensive checking of
books of accounts is done. However, in the case of interim audit is detailed
and extensive check books accounts is not done.
3. Period of audit: In the case of continuous audit, the work of audit is
carried on up to any data according to the convenience of the auditor and his
client while in the case of interim audit the work of audit is up to definite
data according to the instructions of the client.
4. Trial balance: In the case of continuous audit, no trial balance is
prepared through the totals of certain accounts may be noted while is the
case of interim audit. The trial balance has to be prepared or checked.
5. Verification: In continuous audit the verification of assets and liabilities
are undertaken at the close of financial year. However, in interim audit, the
verification of assets and liabilities are undertaken at the time of such audit.
6. Prepare: In the case of continuous audit, the auditor’s report is
submitted at the end of the financial year while in the case of interim audit,
the report is submitted at the time of audit.
OTHER TYPES OF AUDITS
 Procedural audits
These require examination of procedures or records for reliability and
accuracy. They usually relate to company’s internal control systems,
laid down guidelines and procedures and records of the company.
 Management audits

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These involve investigation of the company’s entire management to

ascertain whether the directors are running the company in the most
optimal way for the benefit of the shareholders. It improves quality and
efficiency of management in addition to checking the budgetary
system.
 Occasional audit
The name itself indicates that it is a type of audit that will be done
when the possibility of misappropriation or fraud is suspected. The sole
traders and firms will follow this type of audit.
 Standard Audit
This type of audit refers where some of the important items are
audited thoroughly and other items by test checking. This will be used
only where there is a perfect internal check system is in operation.
 Balance sheet audit
In this type of audit, the audit is commenced from the balance sheet
working back to the books of original entry and relative documents.
This is essentially a partial audit, since it verifies the items appearing
in the balance sheet and does not start the work of verification with
primary books. This type of audit can be successful in those
organizations where an effective internal check is in operation.

THEORIES OF AUDITING
There are several different theories that may explain the demand for audit
services.
The policeman theory claims that the auditor is responsible for searching,
discovering and preventing fraud. In the early 20th century this was certainly
the case. However, more recently the main focus of auditors has been to
provide reasonable assurance and verify the truth and fairness of the
financial statements.
The detection of fraud is, however, still a hot topic in the debate on the
auditor’s responsibilities, and typically after events where financial
statement frauds have been revealed, the pressure increases on increasing
the responsibilities of auditors in detecting fraud.
The lending credibility theory suggests that the primary function of the audit
is to add credibility to the financial statements. In this view the service that
the auditors are selling to the clients is credibility. Audited financial
statements are seen to have elements that increase the financial statement
users’ confidence in the figures presented by the management (in the

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financial statement). The users’ are percieved to gain benefits from the
increased credibility, these benefits are typically considered to be that the
quality of investment decisions improve when they are based on reliable
information.
The theory of inspired confidence (Theory of rational expectations) (Limperg
1932) addresses both the demand and the supply for audit services. The
demand for audit services is the direct consequence of the participation of
third parties (interested parties of a company) in the company. These parties
demand accountability from the management, in return for their investments
in the company.
Accountability is realized through the issuance of periodic financial reports.
However, since this information provided by the management may be
biased, and outside parties have no direct means of monitoring, an audit is
required to assure the reliability of this information. With regard to the
supply of audit assurance, Limperg (1932) suggests that the auditor should
always strive to meet the public expectations.
Agency theory (Watts and Zimmerman 1978, 1986a, 1986b) suggests that
the auditor is appointed in the interests of both the third parties as well as
the management. A company is viewed as a web of contracts. Several
groups (suppliers, bankers, customers, employees etc.) make some kind of
contribution to the company for a given price. The task of the management
is to coordinate these groups and contracts and try to optimize them: low
price for purchased supplies, high price for sold goods, low interest rates for
loans, high share prices and low wages for employees. In these relationships,
engagement is the agent, which tries to gain contributions from principals
(bankers, shareholders, employees etc). The most prominent and widely
used audit theory is the agency theory

Mautz and Sharaf conceived the following eight postulates of

financial auditing:
(1) the financial statements and the accounting and financial data are
verifiable;
(2) There may not be any conflicts between the auditor and the
management;
(3) the financial statements and all the disclosed information subject to
verification do not contain intentional errors and other irregularities;
(4) An existing internal control eliminates the probability of irregularities;

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(5) the consistent application of generally accepted accounting principles

leads to a reasonable representation of the company’s financial situation and
results;
(6) In the absence of evidence to the contrary, what was considered to be
valid in the company subject to an audit may be extrapolated to the future;
(7) When examining the accounting and financial data with the purpose of
expressing their independent opinion, the auditor strictly acts as an auditor;
(8) the status of an independent auditor imposes adequate obligations. This
set of postulates allows building the technical and legal structure of auditing.
NB
The first postulate leads to the financial statements audit and to the
verifiability counting data. This postulate is basic in the financial conception
of auditing which refers to reliable data – despite the mere social
representations – and, in this approach, if those are not sustained the audit
is not necessary and must be withdrawn. This postulate is also the support
for the theory of evidence, the verification procedures, the application of the
theory of probability to auditing (the sampling theory), and the
establishment of limits to the auditor’s social responsibility. All the auditing
process is virtually based on this postulate and the auditor only takes
responsibility for the veracity of the examined evidence which supports his
opinion. The fifth postulate is also related to this position, when it considers
the consistency of accounting principles as a condition for a reasonable
building of the financial situation and the results of the activity. In effect,
within the generally accepted accounting principles, there is, as a basic
assumption, the going concern assumption. However, there is a generalized
reluctance among auditors to give an opinion on this principle. This issue is
nowadays an important aspect in the relationship between auditors and
society because it asks them to consider with greater accuracy and
thoroughness the issue of the going concern, under all circumstances and
not exceptionally, as it is defended by the traditional currants of auditing.
When the sixth postulate of auditing considers, in the absence of clear
evidence to the contrary, the past to be extrapolated into the future, it limits
and inhibits the participation of the auditor in the output and the review of all
the prospective financial information, based on it subjective character and
therefore not verifiable. The acceptance of this postulate establishes
important limitations in the scope and reach of auditing, by reducing it to the
prospective analysis, not allowing it to analyze, for example, the company’s
going concern, which reflects on the limitation of the auditor’s
responsibilities.

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