UNIT 1: OVERVIEW OF AUDITING

Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Definition and Basic Features of Auditing
1.3 Demand for Audit
1.4 Accounting Vs Auditing
1.5 Types of Audits and Auditors
1.6 The Nature of External Auditing in Ethiopia
1.7 Summary
1.8 Glossary
1.9 Answers to Check Your Progress Exercise
1.10 Model Exam Questions

1.0 AIMS AND OBJECTIVES

When you have studied this unit you should be able to:
 describe what auditing is.
 describe the nature of financial statement audits.
 explain why audits are demanded by society.
 describe the various types of audits and types of
auditors.

1.1 INTRODUCTION

Without question, the independent audit function plays an important role in both business and
society. Numerous third parties, including investors, creditors, and regulators, depend on the
competence and professional integrity of independent auditors.

Economic decisions are typically based upon the information available to the decision maker.
To obtain the most benefit, users should have economic information that is both relevant and
reliable.

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This need for relevant and reliable financial information creates a demand for accounting and
auditing service.

1.2 DEFINITION AND BASIC FEATURES OF AUDITING

Auditing is the accumulation and evaluation of evidence about information to determine and
report on the degree of correspondence between the information and established criteria.
Auditing should be done by a competent and independent person.

Auditing enable the auditor to express opinion whether the financial statements are prepared,
in all material respects, in accordance with an identified financial reporting framework. This
framework (criterion) might be generally accepted accounting principles (GAAP), or the
national standard of a particular country.

Financial statements include balance sheet, income statement, statement of cash flow, notes
and explanatory material that are identified as being part of financial statements.
The phrases used to express the auditor’s opinion are that the financial statements ‘give a
trued and fair view’ or ‘present fairly in all material respective’.

Note that the auditor does not certify the financial statements or guarantee that the financial
statements are correct, he reports that in his opinion they give a ‘true and fair view’, or present
fairly’ the financial position.

1.3 DEMAND FOR AUDIT

There is a need for auditing when ownership is separated from control. At a practical level, it
helps prevent or detect misstatements-errors or fraud. It may prevent or detect misstatements
on the part of (1) the employees who actually handle the money, or (2) management.
Auditing is needed to enhance the credibility of financial information prepared by an entity.
The independent audit requirement fulfils the need to ensure that those financial statements
are objective, free from bias and manipulation and relevant to the needs of users.

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1.4 ACCOUNTING VS AUDITING

Accounting is the collecting (recording, classifying), summarizing, reporting and interpreting

of financial data.

Auditing is the testing of those accounting records for fairness, appropriateness. An

accountant only needs to know generally accepted accounting principles (GAAP). The
auditor needs to know GAAP, plus how to select and evaluate evidence related to the
assertions of financial statements.

Accounting is constructive. It starts with the raw financial data to process and produce
financial statements.

Auditing on the other hand is analytical work that starts with financial statement to lend
credibility and fairness of the measurements.

1.5 TYPES OF AUDITS AND AUDITORS

A. Types of Audits
Audits are often viewed as falling into three major types:
(1) Audits of financial statements,
(2) Operational audits, and
(3) Compliance audits.

1. Audits of financial statements: - The goal is to determine whether the

financial statements have been prepared in conformity with generally accepted accounting
principles.
2. Operational audits: - An operational audit is study of some specific unit of an
organization for the purpose of measuring its performance. The operation of a unit can be
evaluated for its effectiveness and efficiency.
3. Compliance audits: - Compliance audit determines whether the specified
rules, regulations, or procedures are being carried out or followed.

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B. Types of Auditors
The most known types of auditors are
1. Independent auditors,
2. Internal auditors,
3. Government auditors.

1. Independent (external auditors): - Independent auditors have no connection to the firm as

an owner or employee/manager. The basic task of independent auditor is to confirm to the
owners that the employees are correctly reporting on their financial position and
performance.

2. Internal auditor: - An internal auditor is paid salary as employee on the organization that
is being audits. He/she is responsible to appraise and investigation the performance of
unit and/or units within the organization and give recommendation to top management.

3. Government audit: - The government auditor is paid a salary by the government. He/she
is responsible to the legislature or executive.

1.6 THE NATURE OF EXTERNAL AUDITING IN ETHIOPIA

In Ethiopia audits seem to be done primary on account of government regulation. For

example, NGOS are audited because the assets of the NGOS are deemed a “national asset,” the
use of which is ultimately accountable to the government of Ethiopia.

Auditing in Ethiopia could be viewed in five main areas.

1. The office of the auditor general (OAG)
(OAG)
The powers and functions of the office of the OG are circumscribed through the
proclamations that established it, its sphere of activity lies in government audit.
2. The audit service corporation.
corporation. The duty and functions of
this entity involve mostly commercial audits of commercial and productive enterprises
wholly or partially owned by government.
3. Private audit firms.

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 4. Ministry of finance audit and inspection.
inspection.
Auditing activity in this area includes audit of ministries and government departments
by MF auditors and inspectors, including tax audit by Inland Revenue authorities.
5. State corporations’ and enterprises’ auditors.
auditors.
These are audits performed by internal auditors within enterprise.

1.7 SUMMARY

This unit should have given you good understanding on the nature of the audit. The
objectives of an audit have also been covered and need to borne in mind at all times. It has
also covered the three major types of audits and auditors. It has dealt with the basic areas of
auditing in Ethiopia.

1.8.GLOSSARY

- Audit of financial statements:

Examination of financial statements to determine that the statements are in conformity
with specified criteria, usually GAAP.
- Auditing: A systematic process of
objectively obtaining and evaluating evidence regarding assertions about economic
actions and events to ascertain the degree of correspondence between those assertions and
established criteria and communicating the results to interested users.
- Compliance Audit: An audit that
attempts to measure the degree to which an auditee complies with some predetermined
criteria.
- Government Auditors: Auditors
employed by government entities.
- Independent auditors Certified public
accountants who have an audit practice and offer auditing services to the public.
- Internal Auditors: Full-time employees
of private organizations who conduct audits for the organization.

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- Operational Audit: An audit that
measures the effectiveness and efficiency of an organization.

UNIT 2: THE AUDITING PROFESSION

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Independence
2.3 Professional Qualification Requirements
2.4 Professional Ethics
2.5 Legal Responsibility and Liability
2.6 Summary
2.7 Glossary
2.8 Answers to Check Your Progress Exercise
2.9 Model Exam Questions

2.0 AIMS AND OBJECTIVES

When you have studied this unit you should be able to:
o understand independence in fact and in appearance.
o understand the AICPA code of professional ethics.
o define the major legal concepts that relate to auditors’ liability.
o describe the auditor’s responsibility for the detection of fraud and error.

2.1 Introduction

This unit covers the basic codes of professional conduct, which the auditors need to bear in
mind in carrying out their duties. The main source of material for code of professional
conduct in this unit is the AICPA’s code of professional ethics.

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This unit also covers the duties and legal liabilities of auditors.

Broadly defined, the term ethics represents the moral principles or rules of conduct
recognized by an individual or group of individuals. Ethics apply when an individual has to
make a decision from various alternatives regarding moral principles.
2.2 INDEPENDENCE

The AICPA code of professional conduct requires a member in public practice to be

independent in the performance of professional services as required by standards promulgated
by bodies designated by council.

The requirement is stated in terms of “standards promulgated by bodies designated by

council” to conveniently permit inclusion or exclusion of independence requirements for
certain types of services provided by CPA firms. For example, independence is required for
audits of annual financial statement but a CPA firm can do tax return and provide
management services without being independent. Independence in auditing means an
unbiased viewpoint in the performance of audit test, the evaluation of results, and the issuance
of the audit report.

Independence has two distinct aspects. First, the public accountants must in fact be
independent toward any enterprise they audit. Second, the relationships of public accountants
with audit clients must be such that they will appear independent to third parties.

Independences in fact refers to the auditor’s ability to maintain unbiased and impartial mental
attitude or state of mind in all aspects of work. As such independence in fact is not subject to
objective measurement and therefore can be judged only by the auditor.

Independence in appearance refers to the auditor’s freedom from conflict of interest, which
third parties may infer from circumstantial evidence.

The following paragraphs illustrate some of the common situations, which may impair
independence.

 Investment interest in audit client: - An auditor’s investment in

shares, bonds, mortgage, and notes of an audit client or its associates, either direct or

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 indirect, may impair independence. In this situation, an auditor may be in a position to
issue an opinion or to influence the client’s financial statements for personal financial
gains at the expense of his/her capacity as auditor. Such an investment is not limited to
the auditor but also applies to his or her immediately family and to partners and their
immediate families.

 Non audit functions and services: - Certain functions are

incompatible with the auditing function. These include functioning as a director, officers
or employee of an audit client. The auditor’s involvement in these functions and services
creates a conflict of interest.

 Litigation between CPA firm and client: When there is a lawsuit or

intent to start a lawsuit between a CPA firm and its client, the ability of the CPA firm and
client to remain objective is questionable.

 Hospitality or goods and services: - This will affect independence

unless it is modest.

 Undue dependence on income: - If the amount of income from a

client is very large as compared to the total annual income of the audit firm, independence
will be impaired since the auditors want to maintain this financial interest.

2.3 PROFESSIONAL QUALIFICATION REQUIREMENTS

A professional accountant should perform professional services with due care, competence
and diligence and has a continuing duty to maintain professional knowledge and skill at a
level required to ensure that a client or employer receives the advantage of competent
professional service based on up-to-date development in practice, legislation and techniques.

Auditing standards require auditors to have adequate educational requirement as well as other
moral and legal criteria fulfillment. The educational requirements are composed of theoretical
knowledge and practical experience.

2.4 PROFESSIONAL ETHICS

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All recognized professions have developed codes of professional ethics. Professional ethics
refer to the basic principles of right action for the member of a profession. Professional ethics
may be regarded as a mixture of moral and practical concepts. Thus the professional ethics of
an accountant would signify his behavior towards his fellows in the profession and other
professions and towards members of the public.

The fundamental purpose of such codes is to provide members with guidelines for
maintaining a professional attitude and conducting themselves in a manner that will enhance
the professional stature of their discipline.

The AICPA code of professional conduct considers the following to be followed by auditors
(accountants) in the conduct of professional relations with others.

- Integrity: - An accountant should be

straightforward, honest and sincere in his approach to his professional work.
- Objectivity: - An accountant should be
fair and should not allow bias to override his objectivity. When reporting on financial
statements, which come his review, he should maintain an impartial attitude.
- Independence: - When in public
practice, an accountant should both be and appear to be free of any interest which might
be regarded, whatever its actual effect, as being incompatible with integrity and
objectivity.
- Confidentiality:
Confidentiality: - A professional
accountant should respect the confidentiality of information acquired in the course of his
work and should not disclose any such information to a third party without specific
authority or unless there is a legal or professional duty to disclose.
- Technical standards: - An accountant
should carry out his professional work in accordance with the technical and professional
standards relevant to that work.
- Professional competence: - An
accountant has a duty to maintain his level of competence throughout his professional

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 career. He should only undertake works, which he or his firm can expect to complete with
professional competence.
- Ethical behavior: - An accountant
should conduct himself with a good reputation of the profession and refrain from any
conduct, which might bring discredit to the profession.
- Contingent fess: - The AICPA code of
professional conduct prohibits a CPA firm from rendering any professional services on a
contingent fee basis.
- Responsibilities to colleagues: - The
auditor should promote cooperation and good relations with other members of the
profession.
- Advertising: - The advertising should
not be false or misleading,” should not contravene “professional good taste,” should not
make “unfavorable reflection on the competence or integrity of the profession,” and
should not” involve a statement the contents of which” cannot be substantiated.

2.5 LEGAL RESPONSIBILITY AND LIABILITY OF AUDITORS

The auditor is responsible for his report. The auditor then has certain duties to fulfill to the
users of the financial statements that he reports on.

Responsibilities impose liabilities if things go wrong.

Liable for what?

The CPA can be sued under the following legal concepts.
(i) Prudent man concept: - The auditor is responsible for exercising due professional
care, and he is subject to lawsuit if he fails to do so.
(ii) Liable for acts of others: - The partners are jointly liable for civil actions against
a partner.

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 (iii) Lack of privileged communication: - CPAS do not have the right under common
law to withhold information from the courts on the grounds that the information is
privileged.

A. Auditors’ liability to their clients

When CPAS take on any type of engagement, they are obliged to render due professional care.
This obligation exists whether or not it is specifically set forth in the written contract with the
client. Thus, CPAS are liable to their clients for any losses proximately caused by the CPA’ S
failure to exercise due professional care. That is to recover its losses, an injured client need
only prove that the auditors were guilty of negligence and that the auditors’ negligence was
the proximate cause of the client’s losses.

B. Auditors’ liability to third parties

Bankers and other creditors or investors who utilize financial statements covered by an audit
report can recover damages from the auditors if it can be shown that the auditors were guilty
of fraud or gross negligence in the performance of their professional duties.

Moreover, the auditors can be held liable for negligence to a limited class of third parties if
the auditors have actual knowledge of such third parties or if there exists a special relationship
between the auditors and the third parties.

The clients (plaintiffs) must prove that they sustained losses that they relied on the audited
financial statements, which were misleading, that this reliance was the primate cause of their
losses, and that the auditors were negligent.

C. Auditors’ responsibility for the detection of fraud and error

The detection and prevention of error and fraud is the management’s responsibility by
designing and implementing appropriate internal control systems. The auditor is not
responsible for the prevention and detection of error and fraud. The auditor is responsible to
design audit procedures to reduce the risk of not detecting a material error or fraud, to an
appropriate level to provide reasonable assurance. Accordingly, the auditor must exercise due
care in planning, performing, and evaluating the results of audit procedures.

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Independence and confidentiality are very important principles which have given rise to
detailed rules by the AICPA.

The determination of the extent to which auditors should be legally responsible for the
reliability of financial statements is relevant to both the profession and society. Clearly the
existence of legal responsibility is an important deterrent to the inadequate and even dishonest
activities of some auditors.

Ethics: The moral principles or rules of conduct recognized by an individual or particular

group of individuals.
Fraud : A Knowing intent to deceive.
Gross negligence: Fragrant negligence that is tantamount to a reckless departure from the
standard of due care.

2.7 AUDITING PRINCIPLES

Auditing principles are generally, guidelines that help direct or chart goals and aims.
Principles are based on concepts or assumptions, and/or developed from particular
observations. The following are the basic principles:

(a) Integrity, objectivity and independence.

independence. The auditor should be straightforward,
honest, and sincere in his approach to his professional work.
(b) Confidentiality: - the audit should respect the confidentiality of information acquired
in the course of his work and should not disclose any such information to a third party
without specific authority unless there is legal or professional duty to disclose.
(c) Skills and competence: - the audit should be performed and the reports prepared with
due professional care by persons who have adequate training, experience and
competence in auditing.
(d) Documentation: - the auditor should document matters which are important in
providing evidence that the auditor was carried out with the basic principles.
(e) Planning: - the auditor should plan his work to enable him to conduct an effective
audit in efficient and timely manner.

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 (f) Audit evidence: - the auditor should obtain sufficient appropriate audit evidence
through the performance of compliance and substantive procedures to enable him to
draw conclusion there from and give opinion on the financial statements.
(g) Accounting system and internal control: The auditor should gain or understanding
of the accounting system and related internal controls to determine the nature, extent,
and timing of audit procedures.

2.8 AUDIT STANDARDS

Standards are authoritative rules for measuring the quality of performance. The existence of
generally accepted auditing standards is evidence that auditors are very concerned with the
maintenance of a uniformly high quality of audit work by all independent public accountants.
The 3 GAAS are stated in their entirety as follows:

General standards
1. The examination is to be performed by a person or persons having adequate
technical training and proficiency as auditor.
2. In all matters relating to the assignment, an independence in mental attitude is
to be maintained by the auditor or auditors.
3. Due professional care is to be exercised in the performance of the examination
and the preparation of the report.

Standards of fieldwork
1. The work is to be adequately planned and assistants, if any, are to be properly
supervised.
2. The auditor should obtain a sufficient understanding of the internal control
structure to plan the audit and to determine the nature, extent and timing of tests to be
performed.
3. Sufficient competent evidential matter is to be obtained through inspection,
observation, inquiries, and confirmation to afford a reasonable basis for an opinion
regarding the financial statements under examination.

Standards of reporting

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1. The report shall state whether the financial statements are presented in
accordance with generally accepted accounting principles.
2. The report shall identify those circumstances in which such principles have not
been consistently observed in the current period in relation to the preceding period.
3. Informative disclosures in the financial statements are to be regarded as
reasonably adequate unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding the financial
statements, taken as a whole, or an assertion to the effect than an opinion cannot be
expressed.

Keep in mind, however, that these standards represent the minimum requirements for all audit
engagements.

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