Chapter 1: NATURE, OBJECTIVE AND

SCOPE OF AUDIT
Table of Contents
1.Origin of Audit .................................................................................................. 1
2. Audit- Mandatory or Voluntary? .............................................................. 1
3. Who Appoints an Auditor? .......................................................................... 1
4. To Whom Report is Submitted by an Auditor? ...................................... 1
5.Meaning and Nature of Auditing ............................................................... 2
6.Interdisciplinary Nature of Auditing........................................................ 3
7.SA-200 “Overall Objectives of the Independent Auditor and the
conduct of an Audit in accordance with Standards on Auditing” ....... 4
7.1 Objectives of Auditor ................................................................................................ 4
7.2 Scope of Audit............................................................................................................. 5
7.3 Inherent limitations of the Audit .......................................................................... 6
8.Benefits of Audit ..............................................................................................8
9.What is an Assurance Engagement ........................................................... 9
9.1 Elements of Assurance Engagement ....................................................................... 9
9.2 Review v/s Audit ....................................................................................................... 10
9.3Reasonable Assurance engagement vs Limited Assurance engagement 10
9.4 Prospective financial information ......................................................................... 11
10. QUALITIES OF AUDITOR ........................................................................11
11.Engagement and Quality control Standards ......................................... 12
11.1 Why are Standards Necessary? ........................................................................... 13
 1.Origin of Audit

✓ Auditing existed in ancient civilizations, including India. Kautilya’s

Arthashastra (4th century BC) referred to a fixed accounting year, account
closures, Audits, and financial misstatements due to power abuse.
✓ The term “Audit” comes from the Latin word “audire”, meaning “to hear.” In
medieval times, Auditors listened to accounts being read out to verify
accuracy and prevent negligence.
✓ The Industrial Revolution in Europe led to rapid trade expansion, increasing
the need for Auditors to ensure financial accuracy and accountability.
✓ British India appointed its first Auditor General in 1860, handling both
accounting and Auditing responsibilities, marking the beginning of formal
Auditing in the country.
✓ The Comptroller and Auditor General of India (CAG) later became a statutory
and Independent constitutional authority responsible for Auditing government
revenues and expenditures.
✓ The Institute of Chartered Accountants of India (ICAI) was established un-
der an Act of Parliament in 1949 to regulate the Chartered Accountancy pro-
fession in India.
Quick Summary
Arthashastra, audire = “to hear.”, Auditor General in 1860, CAG, ICAI

2. Audit- Mandatory or Voluntary?

Audit may be mandatory for certain entities, like companies and businesses
crossing tax threshold limits. Some entities, like schools, require Audits for
government grants. However, Audit is not always compulsory—many organizations
opt for voluntary Audits due to their benefits. Internal policies may also mandate
Audits for better accountability.

3. Who Appoints an Auditor?

✓ Auditor is appointed by owners or in some cases by constitutional or
government authorities in accordance with applicable laws and regulations.
✓ In case of a company Auditor is appointed by Shareholders of the company
✓ In case of a firm Auditor is appointed by partners of firm.

4. To Whom Report is Submitted by an Auditor?

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.
 5.Meaning and Nature of Auditing
“An Audit is an Independent examination of financial information of any entity,
whether profit oriented or not, and irrespective of its size or legal form, when
such an examination is conducted with a view to expressing an opinion thereon”.
Analysis of definition
❖ Audit is an independent examination of financial information.
❖ The entity whose financial information is examined need not necessarily be
profit oriented like in case of a business.
❖ Audit can be undertaken in respect of any organization be it a small, medium
or large. Further, it can be conducted for any entity irrespective of its legal
structure.
❖ The purpose of Audit is to express an opinion on the financial statements.
Quick Revision
Audit = Independent Examination of Financial Information +
Of any entity profit oriented or not irrespective of size or legal form +

Conducted to Express an opinion of such Financial Information

In doing so, Auditor must ensure that financial statements would not mislead
anybody by ensuring that:
❖ The accounts have been drawn up with reference to entries in the books of
account.
❖ The entries in the books of account are adequately supported by sufficient
and appropriate evidence (SAAE).
❖ None of the entries in the books of account has been omitted in the process
of compilation.
❖ The information conveyed by the statements is clear and unambiguous.
❖ The financial statement amounts are properly classified, described and
disclosed as per applicable financial Reporting framework (AFRF); and
❖ The statement of accounts presents a true and fair picture of the
operational results and of the assets and liabilities.
Student notes
 Quick Revision
a Accounts drawn with reference to them
b Entries Supported by SAAE
c Not Omitted
d Information Clear and Unambiguous
e Financial Statements Amounts are properly classified, described and dis-
closed.
f Statement of ac- Gives true and fair picture
counts

6.Interdisciplinary Nature of Auditing

Auditing and Accounting: Auditing reviews the financial statements which are
nothing but a result of the overall accounting process.
Auditing and Law: An Auditor should have a good knowledge of business laws
affecting the entity.
Auditing and Economics: Auditor is expected to be familiar with the overall eco-
nomic environment of the client.
Auditing and Behavioural Science: Knowledge of human behaviour is essential
for an Auditor to effectively discharge his duties.
Auditing and Statistics & Mathematics: Auditor is also expected to have the
knowledge of statistical sampling for meaningful conclusions and mathematics for
verification of inventories.
Auditing and Data Processing: EDP Auditing is developing as a discipline in itself.
Auditing and Financial Management: Auditor is expected to have knowledge
about various financial techniques such as working capital management, funds f
low, ratio analysis, capital budgeting etc.
Auditing and Production: Good Auditor is one who understands the client and his
business functions such as production, cost system, marketing etc.
Student notes
7.SA-200 “Overall Objectives of the Independent Auditor and
the conduct of an Audit in accordance with Standards on
Auditing”
Overview of SA 200
Objectives of Auditor Scope of Audit Inherent limitations of
What is included and not the Audit

7.1 Objectives of Auditor

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: -

(a)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 applica-
ble financial Reporting framework (AFRF); and

(b) To Report on the financial statements, and communicate as required by the

SAs, in accordance with the Auditor’s findings.
Analysis of Objective
❖ Auditor’s objective is to obtain a Reasonable Assurance whether financial
statements as a whole are free from material misstatement whether due
to fraud or error.
o Reasonable Assurance is not a complete guarantee. Although it is a
high-level of Assurance, but it is not complete Assurance.
❖ Misstatements in financial statements can occur due to fraud or error or
both.
❖ Express an opinion on whether the financial statements are prepared, in all
material respects, in accordance with an applicable financial Reporting
framework.
❖ The opinion is Reported and communicated in accordance with Audit find-
ings through a Written Report as required by Standards on Auditing.
Quick Revision
Obtain R.A. that FS are free from MM due to fraud or error
Report and communicate as per SA’s
 7.2 Scope of Audit
Scope refers to range or reach of something.
The following points are included in scope of Audit of financial statements: -
(a) Coverage of all aspects of entity:
❖ Audit of financial statements should be organized adequately to cover
all aspects of the entity relevant to the financial statements being
Audited.
(b) Reliability and sufficiency of Financial information
❖ 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.
❖ 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,
enquiries and procedures.
(c) Proper disclosure of financial information:
❖ 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.
❖ 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.
❖ 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.
(d) Historical financial information:
❖ Financial statements are prepared based on historical financial
information. Therefore, Audit of financial statements is based
upon 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.
The following are not included in the scope of Audit: -
(a). Responsibility of preparation and presentation of financial statements.
(b). Auditor is not expected to perform duties that fall outside the domain of
competence.
(c). Auditor is not an expert in authentication of documents.
(d). Audit is not an official Investigation.
Include in Audit Not included in Audit
Coverage of all aspects of entity Outside domain of competence
Reliability and Sufficiency of financial Preparation and Presentation of finan-
information cial statements
Proper disclosure of financial infor- Not expert in authentication of docu-
mation ments
Historical financial information Not an official Investigation

7.3 Inherent limitations of the Audit

The Auditor is not expected to and cannot reduce Audit rick to zero and cannot
therefore provide absolute Assurance that the financial statements are free
from material misstatement whether due to fraud or error. This is due to
Inherent limitations of the Audit. These fundamental limitations arise due to the
following factors: -
(1). Nature of financial Reporting
❖ 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.
❖ Management design Internal controls, such Internal controls may not
operate to provide reliable financial information due to their own
limitations.
(2). Nature of Audit procedures
❖ The Auditor carries out his work by obtaining Audit evidence through
performance of Audit procedures. However, there are practical and legal
limitations on ability of Auditor to obtain Audit evidence.
❖ Practical Limitations: an Auditor does not test all transactions and
balances. He forms his opinion only by testing samples.
 ❖ Legal Limitations: 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.
❖ 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 is quite possible that entity may have entered some transactions with
related parties. 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.
(3). Not in the nature of official 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 of 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.
(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
Student notes
 Quick Revision
The Nature of Financial Reporting:
The preparation of financial statements involves judgment by management.
The Nature of Audit Procedures:
There are practical and legal limitations on the Auditor’s ability to obtain
Audit evidence such as:
Possibility that management or others Fraud may involve sophisticated and
may not provide, intentionally or unin- carefully organised schemes.
tentionally, the complete information
relevant for preparation and presenta-
tion of FS.
Not in the nature of Investigation:
An Audit is not an official Investigation into alleged wrongdoing.
Timeliness of financial Reporting and decrease in relevance of information
over time:
Relevance of information, and thereby its value tends to diminish over time,
and there is a balance to be struck between the reliability of information and
its cost.
Future events:
Future events or conditions may affect an entity adversely. Adverse events
may seriously affect ability of an entity to continue its Business.

8.Benefits of Audit
1. Audited accounts provide high quality information.
2. Helps in safeguarding of interest of shareholders.
3. 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 de-
termining tax liabilities.
5. Audited financial statements can be relied upon by lenders, bankers for
making their credit decisions.
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.
Quick Revision
High Quality infor- Moral check Relied upon by bankers
mation
Safeguards Interest Determining tax liability Detect fraud or error
Reviews Existence and Operations of Internal controls
 9.What is an Assurance Engagement
“Assurance engagement” means an engagement in which a practitioner expresses
a conclusion designed to enhance the degree of confidence of the intended users
other than the responsible party about the outcome of the evaluation or meas-
urement of a subject matter against criteria.

9.1 Elements of Assurance Engagement

1. A three-party relationship involving a practitioner, a responsible party, and

intended users
❖ A practitioner is a person who provides the Assurance. Practitioner is
broader than Auditor. Audit is related to historical information whereas
practitioner may provide Assurance not necessarily related to historical
financial information.
❖ A responsible party is the party responsible for preparation of subject
matter.
❖ Intended users are the persons for whom an Assurance Report is
prepared. These persons may use the Report in making decisions.
2. An appropriate subject matter
❖ Refers to the information to be examined by the practitioner.
3. Suitable criteria
❖ Refer to benchmarks used to evaluate the subject matter like standards,
guidance, laws, rules and regulations.
4. Sufficient appropriate evidence
❖ The practitioner performs an Assurance engagement to obtain sufficient
appropriate evidence. It is on the basis of evidence that conclusions
arrived, and an opinion is formed by Auditor.
5. A Written Assurance Report in appropriate form
❖ A Written Report is provided containing conclusion that conveys the
Assurance about the subject matter it is the outcome of Assurance
engagement.
Student notes
 Quick Revision
Three party relationship Between practitioner, a responsible
party, and intended users
subject matter Information to be Examined
Suitable criteria Benchmarks used to examine
Sufficient appropriate evidence Evidence obtained to reach conclusion

A Written Assurance Report in appro- Report containing conclusion of the

priate form engagement

9.2 Review v/s Audit

A Review is a Limited Assurance engagement, it provides lower level of Assurance
than Audit.
Basis Review Audit
Level of Assurance Limited Assurance Reasonable Assurance
Audit Procedures Fewer Audit Extensive and Elaborate
procedures Procedures
Information Historical Information Historical Information
Tested

9.3Reasonable Assurance engagement vs Limited Assurance

engagement
Basis Reasonable Assurance Limited Assurance
engagement engagement
Assurance Provides high level of Lower level of Assurance than
Assurance. Reasonable Assurance
engagement.
Audit Proce- Performs elaborate and Performs fewer procedures as
dures extensive procedures to compared to Reasonable
obtain sufficient Assurance engagement.
appropriate evidence.
Conclusion Draws Reasonable Involves obtaining sufficient.
conclusions based on appropriate evidence to draw.
sufficient appropriate Limited conclusions.
evidence.
Example Audit engagement. Review engagement.
 9.4 Prospective financial information
“Prospective financial information” means financial information based on
assumptions about events that may occur in the future and possible actions by an
entity. It can be in the form of a forecast or projection or combination of both.
❖ It is not an Assurance that is related to historical financial statements.
❖ Practitioner obtains sufficient appropriate evidence to the effect that
management’s assumptions on which the prospective financial
information is based are not Unreasonable, the prospective financial
information is properly prepared on the basis of the assumptions, and it
is properly presented, and all material assumptions are adequately dis-
closed.
❖ The Auditor is, therefore, not in a position to express an opinion as to
whether the results shown in the prospective financial information will
be achieved. Therefore, practitioner provides a Report assuring that
nothing has come to practitioner’s attention to suggest that these
assumptions do not provide a Reasonable basis for the projection.
❖ Hence, such type of Assurance engagement provides only a “moderate”
level of Assurance.

Quick revision
Not related Obtain Whether And ade- Auditor is Provides
to SAAE on they are quate not able to moder-
Historical Manage- not Unrea- disclosure express ate
Financial ments sonable of material opinion level of
information assumptions assumptions Assur-
ance
10. QUALITIES OF AUDITOR
An Auditor is concerned with the Reporting on financial matters of business
and other institutions. Financial matters inherently are to be set with the
problems of human fallibility; errors and frauds are frequent.
❖ Tact, caution, firmness, good temper, integrity, discretion, industry
judgement, patience, clear headedness and reliability are some of qualities
which an Auditor should have. In short, all those personal qualities that go
to make a good businessman contribute to the making of a good Auditor.
❖ In addition, he must have the shine of culture for attaining a great height.
❖ He must have the highest degree of integrity backed by adequate
independence.
 ❖ The Auditor, who holds a position of trust, must have the basic human
qualities apart from the technical requirement of professional training and
education.
❖ He is called upon constantly to critically review financial statements and it
is obviously useless for him to attempt that task unless his own knowledge
is that of an expert.
❖ An exhaustive knowledge of accounting in all its branches is the sine qua
non of the practice of Auditing. He must know thoroughly all accounting
principles and techniques.

11.Engagement and Quality control Standards

1. Standards on Auditing (SAs)

❖ Apply in Audit of historical financial information.
❖ Apply in the context of Audit of financial statements by Independent Au-
ditor.
❖ These establish high quality benchmarks and are followed by Auditors in
conducting Audit of financial statements.
❖ Ex: SA 200, SA 230, SA 315, SA 500, SA 700
2. Standards on Review Engagements (SREs)
❖ Apply to Review engagement related to Historical financial information.
❖ It is Limited Assurance engagement standard.
❖ It is due to review involves fewer procedures as compared to Audit.
❖ Ex: SRE 2400, SRE 2410
3. Standards on Assurance Engagements (SAEs)
❖ Apply to Assurance engagement related to matters other than Historical
financial information.
❖ It does not include “Audit” or “review” of historical financial information.
❖ Such type of Assurance engagements, examination is not of historical fi-
nancial information or engagement may relate to providing Assurance re-
garding non-financial matters like design and operation of internal control
in an entity.
❖ Ex: SAE 3400, SAE 3420
4. Standards on Related Services (SREs)
❖ These standards apply in engagements to perform agreed-upon procedures
regarding financial information.
❖ An engagement in which practitioner may be called upon to assist manage-
ment with the preparation and presentation of historical financial infor-
mation without obtaining Assurance on that information.
❖ Ex: SRS 4400, SRS 4410
5. Standards on Quality Control (SQCs)
❖ Issued to establish standards and provide guidance regarding a firm’s re-
sponsibilities for its system of quality control for the conduct of Audit and
review of historical.
financial information and for other Assurance and related service engage-
ments.
❖ SQC 1 has been issued in this regard.
❖ It requires Auditors/practitioners to
• Establish system of quality control so that firm and its personnel comply
with
professional standards and regulatory & legal requirements and
• Reports issued are appropriate.

11.1 Why are Standards Necessary?

1. Standards ensure carrying out of Audit against established benchmarks at par
with global practices.
2. Standards improve quality of financial Reporting thereby helping users to
make diligent decisions.
3. Standards promote uniformity as Audit of financial statements is carried out
following these Standards.
4. Standards equip professional accountants with professional knowledge and
skill.
5. Standards ensure Audit quality.
Quick Revision
Audit in Improve quality Promote Provide account- Audit
accordance of FR, helps us- uniformity ants knowledge Quality
with ers in decision (Comparability) and skills
Benchmarks making

Student notes