CHAPTER 1

NATURE, OBJECTIVE AND

SCOPE OF AUDIT

Highlights

1. Meaning, nature and scope of audit

2. Objectives of audit
3. Inherent Limitations of audit
4. Benefits of audit
5. Meaning of assurance engagements
6. Difference between reasonable assurance engagement and limited assurance engagement
7. Meaning and basic purpose of engagement and quality control standards
8. Practicality of above concepts by studying through examples and case studies

1. Introduction
Q. Users of Audited Financial Statements
1. Be it investors desirous of investing their money in companies, shareholders anxious to know
financial position of companies they have invested.
2. Banks or financial institutions willing to lend funds to credit-worthy organizations.
3. Governments desirous of collecting taxes from trade and industry in accordance with applicable
laws.
4. Trade unions negotiating with corporate managements for better wages.
5. Insurance companies wanting to settle property claims caused by fire or other disasters.

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 NATURE, OBJECTIVE AND SCOPE OF AUDIT

2. ORIGIN OF AUDITING

Auditing has existed Coming to more recent The word “audit” The Institute of Chartered
even in ancient times in history, the first Auditor originates from Latin word Accountants of India was
many societies of world General of India was “audire” meaning “to established as a statutory
including India. The appointed in British India hear”. In medieval times, body under an Act of
reference to auditing is in 1860 having both auditors used to hear the Parliament in 1949 for
found in Kautilya’s accounting and auditing accounts read out to them regulating the profession
Arthshastra even in functions. Later on, to check that employees of Chartered Accountancy
4th century BC. It talks office of Auditor General were not careless and in the country.
about fixed accounting was given statutory negligent. Industrial
year, a process for closure recognition. Presently, revolution in Europe led
of accounts and audit Comptroller and Auditor to astronomical expansion
for the same. Concepts General of India is an in volume of trade and
of periodical checking independent constitutional consequently demand of
and verification existed authority responsible auditors.
even in those times. Even for auditing government
there are references in receipts and expenditures.
his monumental work to
misstatements in financial
statements due to abuse of
power.

• Understand that preparation and presentation of financial statements of an entity is responsibility

of management of entity.
• The auditor expresses an opinion on financial statements by means of written audit report.

In doing so, he has to see that financial statements would not mislead anybody by ensuring that:
1.The Accounts have been drawn up with reference to entries in the books of account;
2.The Entries in the books of account are adequately supported by sufficient and appropriate evidence;
3.None Of the entries in the books of account has been omitted in the process of compilation;
4.The Information conveyed by the statements is clear and unambiguous;
5.The Financial statement amounts are properly classified, described and disclosed in conformity
with accounting standards; and
6.The Statement of accounts presents a true and fair picture of the operational results and of the
assets and liabilities.

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 NATURE, OBJECTIVE AND SCOPE OF AUDIT

Production Accounting

Financial Law
Management

AUDITING
Data
Economics
Processing

Statistics & Behavioral

Mathematics Science

1. Auditing and Accounting: Auditing reviews the financial statements which are nothing but a
result of the overall accounting process.
2. Auditing and Law: An auditor should have a good knowledge of business laws affecting the
entity.
3. Auditing and Economics: Auditor is expected to be familiar with the overall economic
environment of the client.
4. Auditing and Behavioral Science: Knowledge of human behavior is essential for an auditor
to effectively discharge his duties.
5. Auditing and Statistics & Mathematics: Auditor is also expected to have the knowledge of
statistical sampling for meaningful conclusions and mathematics for verification of inventories.
6. Auditing and Data Processing: EDP auditing in itself is developing as a discipline in itself.
7. Auditing and Financial Management : Auditor is expected to have knowledge about various
financial techniques such as working capital management, funds flow, ratio analysis, capital
budgeting etc.
8. Auditing and Production: Good auditor is one who understands the client and his business
functions such as production, cost system, marketing etc.

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 NATURE, OBJECTIVE AND SCOPE OF AUDIT

3. OBJECTIVES OF AUDIT
In conducting audit of financial statements, objectives of auditor in accordance with SA-200 “Overall
Objectives of the Independent auditor and the conduct of an audit in accordance with Standards on
Auditing” are: -
1. To obtain reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud or error, thereby enabling the auditor to express an
opinion on whether the financial statements are prepared, in all material respects, in accordance
with an applicable financial reporting framework; and
2. To report on the financial statements, and communicate as required by the SAs, in accordance
with the auditor’s findings.

REASONABLE ASSURANCE V/S ABSOLUTE ASSURANCE

• Reasonable assurance is to be distinguished from absolute assurance.
• Absolute assurance is a complete assurance or a guarantee that financial statements are free from
material misstatements.
• However, reasonable assurance is not a complete guarantee. Although it is a high-level of assurance
but it is not complete assurance.

4. SCOPE OF AUDIT-WHAT IT INCLUDES

The following points are included in scope of audit of financial statements: -
(1) Coverage of all aspects of entity
A. Audit of financial statements should be organized adequately to cover all aspects of the entity
relevant to the financial statements being audited.
(2) Reliability and sufficiency of financial information
A. The auditor should be reasonably satisfied that information contained in underlying accounting
records and other source data (like bills, vouchers, documents etc.) is reliable and sufficient basis
for preparation of financial statements.
B. The auditor makes a judgment of reliability and sufficiency of financial information by making
a study and assessment of accounting systems and internal controls and by carrying out
appropriate tests, enquirers and procedures.
(3) Proper disclosure of financial information
A. The auditor should also decide whether relevant information is properly disclosed in the financial
statements. He should also keep in mind applicable statutory requirements in this regard.
B. It is done by ensuring that financial statements properly summarize transactions and events recorded
therein and by considering the judgments made by management in preparation of financial
statements.
C. The management responsible for preparation and presentation of financial statements makes many
judgments in this process of preparing and presenting financial statements. For example, choosing
of appropriate accounting policies in relation to various accounting issues like choosing method of
charging depreciation on fixed assets or choosing appropriate method for valuation of inventories.
D. The auditor evaluates selection and consistent application of accounting policies by management;
whether such a selection is proper and whether chosen policy has been applied consistently on a
period-to-period basis.

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 NATURE, OBJECTIVE AND SCOPE OF AUDIT

Q. What is Historical Financial Information?

“Historical financial information” means information expressed in financial terms in relation to a particular
entity, derived primarily from that entity’s accounting system, about economic events occurring in past
time periods or about economic conditions or circumstances at points in time in the past.
For example, when purchases and sales are reflected in financial statements of an entity, these are
examples of historical financial information. These are about transactions which have occurred in past.

Since financial statements are prepared on the basis of historical financial information, it is
logical that audit of financial statements is also based upon such historical financial information.
Therefore, audit of financial statements is based upon historical financial information.

4.1 Scope of Audit-What It Does Not Include

1) Auditor is not expected to perform duties which fall outside domain of his competence.
For example,
a. Physical condition of certain assets like that of sophisticated machinery cannot be determined
by him. Similarly, it is not expected from an auditor to determine suitability and life of civil
structures like buildings. These require different skillsets which may be performed by qualified
engineers in their respective fields.
b. An auditor is not an expert in authentication of documents. The genuineness of documents
cannot be authenticated by him because he is not an expert in this field.
2)An audit is not an official investigation into alleged wrong doing. He does not have any specific
legal powers of search or recording statements of witness on oath which may be necessary for
carrying out an official investigation.

4.2 Difference Between Audit & Investigation

A) Audit is distinct from investigation. Investigation is a critical examination of the accounts with
a special purpose. For example, if fraud is suspected and it is specifically called upon to check the
accounts whether fraud really exists, it takes character of investigation.
B) The objective of audit, on the other hand, as has already been discussed, is to obtain reasonable
assurance about whether the financial statements as a whole are free from material misstatement,
whether due to fraud or error, thereby enabling the auditor to express an opinion.
C) The scope of audit is general and broad whereas scope of investigation is specific and narrow.

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 NATURE, OBJECTIVE AND SCOPE OF AUDIT

5. INHERENT LIMITATIONS OF AUDIT

Q. Why Auditor Cannot Provide Absolute Assurance?
The process of audit suffers from certain inbuilt limitations due to which an auditor cannot obtain an
absolute assurance that financial statements are free from misstatement due to fraud or error. These
fundamental limitations arise due to the following factors: -

(1) Nature of Financial Reporting

a. Preparation of financial statements involves making many judgments by management. These
judgments may involve subjective decisions or a degree of uncertainty. Therefore, auditor
may not be able to obtain absolute assurance that financial statements are free from material
misstatements due to frauds or errors.
b. One of the premises for conducting an audit is that management acknowledges its responsibility of
preparation of financial statements in accordance with applicable financial reporting framework
and for devising suitable internal controls. However, such controls may not have operated to
produce reliable financial information due to their own limitations.
For example, that management of a company has devised a control that all purchase bills should reflect
stamp and signatures of an authorised person in “Goods Receiving Section” of the company stating the
date and time of receiving goods in premises. It is an example of internal control devised by the company
to ensure that only those purchase bills are produced for payment for which goods have been actually
received. Now, what happens if concerned accountant and authorised person in “Goods Receiving
Section” collude. It is a case of overriding of internal controls devised by the company due to collusion
between two persons. Such a probable collusion is one of limitations of internal controls itself.

(2) Nature of Audit procedures

a. The auditor carries out his work by obtaining audit evidence through performance of audit
procedures.
b. However, there are practical and legal limitations on ability of auditor to obtain audit evidence.
For example, an auditor does not test all transactions and balances. He forms his opinion only
by testing samples. It is an example of practical limitation on auditor’s ability to obtain audit
evidence.
c. Management may not provide complete information as requested by auditor. There is no way
by which auditor can force management to provide complete information as may be requested by
auditor. In case he is not provided with required information, he can only report. It is an example
of legal limitation on auditor’s ability to obtain audit evidence.
d. The management may consist of dishonest and unscrupulous people and may be, itself, involved
in fraud. It may be engaged in concealing fraud by designing sophisticated and carefully organized
schemes which may be hard to detect by the auditor. It may produce fabricated documents before
auditor to lead him to believe that audit evidence is valid. However, in reality, such documents
could be fake or non-genuine.
e. Auditor is not an expert in authentication of documents. Therefore, he may be led to accept
invalid audit evidence on the basis of unauthentic documents.
f. It is quite possible that entity may have entered into some transactions with related parties.
Such transactions may be only paper transactions and may not have actually occurred. The auditor
may not be aware of such related party relationships or audit procedures may not be able to detect
probable wrong doings in such transactions.

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 NATURE, OBJECTIVE AND SCOPE OF AUDIT

(3) Not in nature of investigation

Audit is not an official investigation. Hence, auditor cannot obtain absolute assurance that financial
statements are free from material misstatements due to frauds or errors.

(4) Timeliness of financial reporting and decrease in relevance of information over time
The relevance of information decreases over time and auditor cannot verify each and every matter.
Therefore, a balance has to be struck between reliability of information and cost of obtaining it.
For example, an auditor who is conducting audit of a company since last two years. During these
two years, he has sought detailed information from management of company regarding various
matters. During his third year stint, he chooses to rely upon some information obtained as part of
audit procedures of second year. However, it could be possible that something new has happened and
that information is not relevant. So, the information being relied upon by auditor is not timely and
may have lost its reliability.

(5) Future events

Future events or conditions may affect an entity adversely. Adverse events may seriously affect ability
of an entity to continue its business. The business may cease to exist in future due to change in market
conditions, emergence of new business models or products or due to onset of some adverse events.
Conclusion : Therefore, it is in view of above factors, that an auditor cannot provide a guarantee that
financial statements are free from material misstatements due to frauds or errors.

6. WHAT IS AN ENGAGEMENT?
Engagement means an arrangement to do something. In the context of auditing, it means a formal
agreement between auditor and client under which auditor agrees to provide auditing services. It
takes the shape of engagement letter.

6.1 External Audit Engagements

The purpose of external audit engagements is to enhance the degree of confidence of intended users
of financial statements. Such engagements are also reasonable assurance engagements. For example,
in India, companies are required to get their annual accounts audited by an external auditor. Even
non-corporate entities may choose to have their accounts audited by an external auditor because of
benefits of such an audit.

7. BENEFITS OF AUDIT-WHY AUDIT IS NEEDED?

1. Audited accounts provide high quality information. It gives confidence to users that information
on which they are relying is qualitative and it is the outcome of an exercise carried out by following
Auditing Standards recognized globally.
2. In case of companies, shareholders may or may not be involved in daily affairs of the company.
The financial statements are prepared by management consisting of directors. As shareholders
are owners of the company, they need an independent mechanism so that financial information is
qualitative and reliable. Hence, their interest is safeguarded by an audit.
3. An audit acts as a moral check on employees from committing frauds for the fear of being discovered
by audit.
4. Audited financial statements are helpful to government authorities for determining tax liabilities.

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 NATURE, OBJECTIVE AND SCOPE OF AUDIT

5. Audited financial statements can be relied upon by lenders, bankers for making their credit
decisions i.e. whether to lend or not to lend to a particular entity.
6. An audit may also detect fraud or error or both.
7. An audit reviews existence and operations of various controls operating in any entity. Hence, it is
useful at pointing out deficiencies.

8. AUDIT- MANDATORY OR VOLUNTARY?

1.It is not necessary that audit is always legally mandatory. There are entities like companies who are
compulsorily required to get their accounts audited under law.
2. Even non-corporate entities may be compulsorily requiring audit of their accounts under tax laws.
For example, in India, every person is required to get accounts audited if turnover crosses certain
threshold limit under income tax law.
3.It is also possible that some entities like schools may be required to get their accounts audited for
the purpose of obtaining grant or assistance from the Government.
4.Audit is not always mandatory. Many entities may get their accounts audited voluntarily because of
benefits from the process of audit. Many such concerns have their internal rules requiring audit due
to advantages flowing from an audit.

9. WHO APPOINTS AN AUDITOR?

1. Generally, an auditor is appointed by owners or in some cases by constitutional or government
authorities in accordance with applicable laws and regulations. For example, in case of companies,
auditor is appointed by members (shareholders) in Annual General Meeting (AGM). Shareholders
are owners of a company and auditor is appointed by them in AGM.
2. However, in case of government companies in India, auditor is appointed by Comptroller and
Auditor General of India (CAG), an independent constitutional authority. In case of a firm who
engages an auditor to audit its accounts. In such a case, auditor is appointed by partners of firm.
There may be a situation in which auditor may be appointed by a government authority in accordance
with some law or regulation.
For example, an auditor may be appointed under tax laws by a government authority.

10. TO WHOM REPORT IS SUBMITTED BY AN AUDITOR?

The outcome of an audit is written audit report in which auditor expresses an opinion. The report is
submitted to person making the appointment. In case of companies, these are shareholders- in case
of a firm, to partners who have engaged him.

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 NATURE, OBJECTIVE AND SCOPE OF AUDIT
NOTES

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 NATURE, OBJECTIVE AND SCOPE OF AUDIT

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