Auditing

Nature,purpose,scope,theory of
auditing and internal control

Adil Awan
Roll no 30
Bs[a/f] 7th
 Purpose of audit
• Audit provides:
 A knowledgeable review of company business and of the accounts
 An impartial view

• People interested to ensure these two things includes:

 Creditors, taxation authorities,directors,the public, shareholders and
employees

• Auditors can give assurance to owners that their agents have

accounted properly for their actions, so owners can asses how well
management have discharged their ownership.
 Nature of audit
• Auditing is “to express an opinion whether financial statements are
prepared ,in all material respects ,in accordance with an identified
financial reporting framework”

• Auditor gives ‘true and fair view’ about it that the financial information
is according to ‘appropriate criteria’.

• Auditor should follow

 Code of ethics of professional accountants
 Conduct audit according to International standards of auditing
 Plan and perform audit with an attitude of professional scepticism
Scope of audit
‘range of audit procedures which are required to achieve the objective of
the audit’
• Procedures should follow requirements of ISAs,relevant professional
bodies, legislation regulations and terms of the audit engagement and
reporting requirements.
• Limitation of audit:
 It gives reasonable assurance that financial statements are free from
mist-statements
 Audit does not give of future viability of the entity
 Not give assurance of management's effectiveness and efficiency
 Auditor use judgments in deciding what audit procedures to use and
what conclusions to draw
 Auditors do not check every item in the accounting record they check
only sample
 Limitation of accounting and internal control system
 They report generally some months after the balance sheet date.
 They can give only opinion but not certify whether accounts are
completely correct.
Responsibility for financial statements
The responsibility of preparing and presenting the financial
statements is that of management of entity.
Role of auditor
 auditor perform independent examination because owners can access how
well management have discharged their stewardship.
 Owners have limited liability company which is run by hired
management. They are hired to perform well so they can produce accounts
that show good perfrmance.owners want that management should not
manipulate accounts.
Scope of external audit[ statuory audit for following]
Undertaking Principal legislation

Limited companies Company ordinance[1984]

Co-operative societies Co-operative societies
act[1927]
Banking companies Banking companies
ordinance[1962]
Modarabas Modaraba companies
ordinance[1980]
 Other entities requiring a statutory audit may include charities
,investment businesses and trade unions.
 Non-statutory audit is performed by independent auditors because
stake-holders want them rather law require them.
Advantages of non-statutory audit
• It can provide means of settling accounts between the partners.
• When audited accounts are available this make the accounts
acceptable to tax authorities and creditors.
• Sale of business, negotiation of loan ,overdraft facilities can be
availed due to audited accounts.
• Sleeping partner can be satisfied by audited accounts
Difference b/w external and internal auditor
• External auditors are independent while internal are responsible to
management.
• Responsibilities of external are fixed by law, but internal auditor
responsibilities are decided by management.
• External auditor report to members ,internal auditor report to
management.
• External auditor express an opinion on the truth and fairness of
accounts. Internal auditor work may range over many operational and
financial areas determined by management.
Duties of auditor
• Proper accounting records have been kept
• The accounts are in agreement with the accounting records
• The accounts have been maintained in accordance with local
legislation, international or national accounting standards
• Balance sheet,incomestatement and cash flow statement shows a true
and fair view of the company's affairs.
Auditor work will involve:
• Making test and enquiries s they consider necessary
• Checking accounts against underlying records
• Review the accounts for compliance with legislation and accounting
records.
 Auditing and accounting concept
Matching concept
All costs have been matched to the revenues they have to produce.
Going concern
Financial statements are prepared on going concern basis.
Consistency
Accounting policies and practices should be applied consistently from year to
year.
Prudence
Losses should be recorded if we know earlier and gains should be postponed till
they are earned.
Materiality
Financial should disclose all material items. an item is material if its omission
can affect decision of users.
Substance over form
the asset under finance lease should be recorded in its books along with
obligation there against.
Expectation gap
• Many people think that the auditors report to the directors of a
company rather than members.
• Some think that a qualified audit report is more favorable than
an unqualified audit report, whereas the converse is true.
• There is a perception that it is the auditor`s duty to detect to
fraud, when in fact the detection of fraud is the responsibility
of the directors.
Chronology of audit :
Ascertain the system and internal control
1-Determine audit approach
2-Ascertain relevant system and controls
3-Document relevant system and controls
4-Confirm relevant system controls
5-Evaluate operations of system and controls
Test the system and internal controls
6-If system is effective then select and perform tests and controls
7-if in-effective submit interim management and letter[remove
discrepancies and move to step 6]
Test financial statements
8-if test are in-effective apply substantive tests
9-if tests are effective then apply restricted substantive procedures
10-Carry out final review
11-Report to members
12-Submit final management letter after results of step 8[substantive
tests].

Determine audit approach

Stage 1-is to determine its scope and auditor`s general approach.
• A letter of engagement will be submitted or confirmed before the start of
each annual audit.
• Audit planning memorandum to be placed on file.
Ascertain the system and internal controls

Stage 2-is to determine the flow of documents and extent of controls in

existence .auditors should make a rough record of the system during this
fact finding stage which will be converted to a formal record.
Stage 3-is to prepare a comprehensive record to facilitate evaluation of
the systems.
• Charts
• Narrative notes
• Internal control questionnaire
• Flowcharts
Stage 4-confirm that the system recorded is the same as that in operation.
• Auditors will confirm their understanding of the system by
performing walk-through tests.
Asses the system and internal controls
Stage 5-the purpose of evaluating the system is to gauge their reliability
and formulate a basis for testing their effectiveness in practice.
following the evaluation ,the auditors will be able to recommend
improvement to the system and determine the extent of the further
tests to be carried .
Test the system and internal controls
Stage 6-if the controls are strong, the records should be reliable and
consequently the amount of detailed testing can be reduced.
• Check that controls are as effective in practice as they are on paper.
they will carry out tests of controls.
• The controls are effective, auditors will only carry out restricted
substantive procedures
• If they are in-effective then extensive substantive procedures would
be carried out.
• Stage 6 would be carried if controls are effective in stage 5.
Stage 7-it is normal practice to send management an interim comments
letter identifying weaknesses and recommending improvements.
Stage 8 and 9-these tests are not concerned with the workings of the
system, but with substantiating the figure in the books of account,
and eventually, in the final accounts themselves. substantive tests are
designed to asses the effect of errors should errors exist.
• To support the figures in the accounts and the assertions which
support them;
• Where errors exist, to asses their effect in monetary terms.
Before designing a substantive procedure it is essential to consider
whether any errors produced by weak system could lead to material
differences. if the answer is `no` there is no pointing in performing a
test.
Stage 10-the aim of the overall review is to determine the overall
reliability of the accounts by making a critical analysis of content
and presentation.
Stage 11-the report to members is the end product.
Stage 12-the final letter to management is an important non-statutory
end product. its purpose is to make further suggestions for
improvements in the system.
Types of audit
System based audit
Used for small and large companies is based on assumption that such
companies have internal control system which will constitute a reliable
base for preparation of accounts.
Substantive audit
The companies which do not have satisfactory internal control
‘substantive audit’ is conducted which involves extensive verification of
transactions, followed by a detailed examination of the balance sheet.
Risk-based audit
Development of auditing techniques which are responsive to risk factors in
an audit. the auditors apply judgments to determine what level of risks
pertains to different areas of a clients system and devise appropriate
audit tests. the effort is directed at riskiest areas, so that chance of
detecting errors is improved .
Interim audit
It will normally take place approximately three-quarters of the way
through the financial year.
• The work on internal control system would be carried out in interim audit
while majority of balance sheet work during the final audit.
Final audit
The work will be carried out in a single phase commencing typically short
time before the year end and continuing into post balance sheet period.
Continous audit
Large companies sometimes carry out more than one interim audit .the audit
staff will either make several visits to client throughout year.
Advantages
• the regular attendance of auditors may act as a deterrent to fraud
• Weakness in client system are noticed earlier and if they exist errors and
frauds may be discovered more quickly.
• It is sometimes possible to start balance sheet work before year end .this
will lead to swifter financial reporting.
• Auditor work is spread more evenly throughout the year .this will help to
relieve the pressures on staff that arise for many audit firms during the first
few months each year.
Disadvantages
• Auditor staff who spend much of their working on one client may find
their independence adversely affected.
• Auditor frequent visits may cause inconvenience to the client.
• It is possible that figures may be altered after they have been checked.
• It may be found that outstanding points and queries raised at one visit are
forgotten and not followed up at large stage. strict control is needed to
ensure that this does not happen particularly where staff assigned to the
audit have changed.
Postulates of auditing
• Postulate is something which is assume to be true as the basis for an
argument, something taken for granted.
1-Financial statements and financial data are verifiable.
2-There is no necessary conflict of interest between auditor and the
management of company under audit.
3-The financial statements and other information submitted or
verification are free from collusive and other unusual irregularities.
4-The existence of a satisfactory system of internal control eliminates the
probability of irregularities.
5-Consistent application of generally accepted accounting principles
results in the fair presentation of financial position and the results of
operations.
6-In the absence of clear evidence to the contrary, what was held true in
the past for the enterprise under examination will hold true in the
future.
7-When examining financial data for the purpose of expressing an
independent opinion thereon, the auditors act exclusively in the
capacity of auditor.
8-The professional status of the independent auditors imposes
Commensurate professional obligations.
 Internal control
Internal control indicates the whole system of controls employed by
management in the conduct of the business. It includes methods:
• Protect its assets against their improper disbursement.
• Protect against the incurrence of improper liabilities.
• Assure the accuracy and dependability of all the financial and
operating information.
• Judge operating efficiency
Internal control=internal check+internal audit
Internal check: a system under which the work relating to carrying
out and recording of transactions is allocated amongst various
persons in such a manner that the work of one person is
automatically checked by another and thus possibilities of fraud or
error or irregularity are minimised,if not completely eliminated.
Internal audit:
It is a continuous review of operations and records undertaken
within the business and is normally done by specially assigned staff.
It should operate independently of the internal check and in no case
should divest anyone of the responsibilities placed upon him.
Scope
The examination and evaluation of the adequacy and effectiveness of
the organization system of internal control and the quality of
performance in carrying out assigned responsibilities.
Role of internal auditor
• Reliability and integrity of information
• Compliance with policies,plans,procedures,laws,regulations.
• Safe guarding of assets.
• Economical and efficient use of resources.
Approach to internal auditing
1-Evaluation of internal control:
• Information is adequate and accurate.
• Resources of business are protected against losses :
(1)Theft
(2)Embezzlement
(3)Carelessness

2-Review of accounting efficiency

(a)Procedures are effective
(b)Mechanical or electronic equipments is used
(c)Space is fully utilized
(d)Peronnel is adequate
3-Appraisal of performance of organization
(a)Implementation
(b)Compliance with procedures
(c)Review of individual performance
(d)Checking up plan of organization

4-Place of an internal auditor:

Internal audit is a staff function rather than a line one.

5-Internal audit report

Principles of internal auditing
• Financial and accounting operations must be separated.
• Responsibility for the performance of the job must be clearly stated
so that there may be no room for doubt or confusion subsequently.
• Too much confidence should not be pinned in one individual.
• Rotation principle relating to transfer of an employee from one job
to another should be the inflexible guiding rule.
• Mechanization of the wherever feasible and practicable, should be
resorted to.
• The work should be so arranged that work done by one employee
should be promptly checked by another independent employee.
• The arrangement of the work should be in such a manner that
written record of the part played by each employee such be
maintained and the work should pass through several hands in a
well-defined manner.
• Clear and well defined rules should be laid down and practically
followed relating to dealing of cash,ordering,receiving and issuing
goods. Instructions should be in writing in the form of accounting
manuals.
• Employees must be in bond so that the tempted employee must be
deterred from committing fraud and employer be protected.
• Although not a substitute for protective financial internal control,
yet double entry system of accounting must be used.
Advantages of internal control
• Save timing
• Reduction in cost
• Assurance to auditor of the reliability