Audit Two Aaa

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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Check Your Progress Exercise – 1
Why auditors cannot provide absolute assurance?
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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.
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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.
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.
Check you Progress Exercise – 2

What is the contribution of internal auditor in the audit of annual financial statements?
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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.
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.
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- 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.
- Operational Audit: An audit that
measures the effectiveness and efficiency of an organization.
1.9 ANSWER TO CHECK YOUR PROGRESS EXERCISES

Auditors can provide only reasonable assurance. They cannot provide absolute assurance due
to the inherent limitation of auditing principles and standards, inherent limitations of
accounting principles, use of samples in auditing, and the existence of human error.

The contribution of internal auditor in the audit of annual financial statements is to assist the
external auditors.
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1.10 MODEL EXAM QUESTIONS
Part I. Short Answer

(a) Give a definition of an audit, and explain the basic features of auditing.
(b) What is the principal use and significance of auditing to users of financial statements?
Part II. Multiple Choices

1. How does an independent audit aid in the communication of economic data?
a) It confirms the accuracy management’s financial representations.
b) It lends credibility to the financial statements.
c) It guarantees that financial data are fairly presented.
d) It assures the readers of financial statements that any fraudulent activity has
been corrected.
2. What is the essence of the external audit function?
a) To detect fraud
b) To examine individual transactions so that the auditor may certify their
validity.
c) To determine whether the client’s financial statements are fairly stated.
d) To assure the consistent application of correct accounting procedures.
3. Primary purpose of an operational audit is to provide:
a) means of assurance that internal control structure is functioning as planned.
b) a measure of management performance in meeting organizational goals.
c) The results of internal audits of financial and accounting matters to a
company’s top-level management.
d) aid to the independent auditor who is conducting the audit of the financial
statements.
4. Compared to the eternal auditor, what is more likely to concern an intern auditor?
a) Fairness of the financial statements c) Management policies and procedures
b) Cost accounting procedures d) Generally accepted accounting principles.
5. Which of the following criteria is unique to the auditor’s function?
a) General competence
b) Familiarity with the particular industry of which the client is a part.
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c) Due professional care d) Independence.
UNIT 2: THE AUDITING PROFESSION
Contents
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
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.
This unit also covers the duties and legal liabilities of auditors.
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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
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
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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
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
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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
career. He should only undertake works, which he or his firm can expect to complete with
professional competence.
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- 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.
1. What is the basic purpose of a code of ethics for a profession?
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2. Who makes the ultimate decision as to whether or not auditors
maintain an appearance of independence from their audit clients?
a. auditors
b. client
c. audit committee
d. public
3. In which of the following situations would a CPA firm be in violation
of the rules of professional conduct in determining it fess?
a. A fee based on whether or not the auditor’s report leads
to the approval of the client’s application for a bank loan.
b. A fee to be established at a later date by the court due to
the bankruptcy of the client.
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c. A fee base on the nature of engagement rather than upon
the actual time spent on the engagement.
d. A fee based on the fee charged by the client’s former
auditors.
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.
(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.
Definition of Terms
Negligence: is violation of legal duty to exercise a degree of care that an ordinary prudent
person would exercise under similar circumstances with resultant damages to another party.
Gross negligence: is lack of event slight care. Many jurisdictions consider gross negligence
equivalent to constructive fraud.
fraud.
Fraud: is defined a misrepresentation by a person of a material fact, known by that person to

be untrue.
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Constructive fraud: differs from fraud as defined above in that constructive fraud does not
involve a misrepresentation with the intent to deceive.
Privity: is the relationship between parties to a contract.
Breach of contact: is failure of one or both parties to a contract to perform in accordance with
the contract’s provisions.
Proximate cause: exists when damage to another is directly attributable to a wrongdoer’s act.
Contributory negligence: is negligence on the part of the client that has contributed to his or
her having incurred a loss.
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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.
Check Your
ou Progress Exercise – 2
1. A CPA firm will be liable for any fraudulent scheme it does not detect.
a) true
b) false
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2. A CPA firm will not be liable if it can show that it exercised the ordinary care and
skill of a reasonable man in the conduct of its own affairs.
a) true
b) false
2.6 SUMMARY
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.
2.7 GLOSSARY
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.
Privity: A contractual relationship.
2.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. The basic purpose of a code of ethics is to provide members with professional
attitude and maintain the confidence of users.
2. d 3. a

1. b 2. b
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Part I. Short Answer

1. Auditors must not only to be appear independent; they must also be independent in
fact.
Required
(a) Explain the concept of an “auditor’s independence” as it applies to third-party reliance
upon financial statements.
(b) What determines whether or not an auditor is independent in fact?
(c) Explain how an auditor may be independent in fact but not appear to
be independent.
2. How does the prudent man concept affect the liability of the auditor?
3. What is meant by “contributory negligence”? Under what conditions will this likely to
be a successful defense?
Part II. Select the Best Answer

1. The CPA should not undertake an engagement if the fee is
based upon which of the following?
a) The findings of a taxing authority.
b) A percentage of audit net income
c) Per diem rates.
d) Rates set by a city ordinance.
2. In a common law action against an accountant, the lack of
privity is a viable defense if the plaintiff:
a) is a creditor of the client who sues the accountant for
negligence.
b) can prove the presence of gross negligence, which
amounts to a reckless disregard for the truth
c) is the accountant’s client.
d) bases his action on fraud.
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UNIT 3: AUDITING PRINCIPLES AND TOOLS
Contents
3.1 Introduction
3.2 Auditing Objectives
3.3 Auditing Principles
3.4 Audit Standards
3.5 Audit Planning and Audit Program
3.6 Audit Working Papers
3.7 Audit Sampling
3.8 Summary
3.9 Glossary
3.0 AIMS AND OBJECTIVE
 be aware of basic auditing principles.
 be aware of planning issues for an audit.
 state the typical contents of working papers.
 describe sampling as applied to auditing.
3.1 INTRODUCTION
The objectives of each audit must be clearly specified in order to ensure appropriate goal
achievement. Appropriate auditing principles and standards should be developed by auditors
to direct the objectives.
Audit planning is a vital area of the audit which is primarily conducted at the beginning of the
audit process.
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This unit also considers the basic contents of audit working papers and audit sampling.
3.2 AUDIT OBJECTIVES
The objective of the ordinary examination of financial statements by the auditor is expression
of an opinion on the fairness of the financial statements. It is customary in the audit to
identify audit objectives for the audit in general and for each account reported in the financial
statements. These objectives are derived from management’s assertions.
The auditor’s objectives are closely related to management assertions. Audit objectives are
intended to provide a framework to help the auditor accumulate sufficient and competent
evidence required by the third standard of fieldwork and decide the proper evidence to
accumulate given the circumstances of the engagement.
A distinction must be made between general audit objectives and specific audit objectives for
each account balance. The general audit objectives discussed here are applicable to every
account balance but stated in broad terms. Specific audit objectives are applied to each
account balance on the financial statement.
The relevance of the audit evidence should be considered in relation to the general audit
objectives of statements. To achieve this objective the auditor needs to support the following
financial statement assertions (i.e. assertions by management embodied in the financial
statements).
1. Existence: - an asset or liability exists at a given date. Auditors
spend a great deal of time on this assertion confirming the existence of assets such as
inventories, plant assets, receivable, and cash. Clearly this is a fundamental assertion;
no other assertion is relevant if the asset or liability does not exist.
2. Completeness: - there are no unrecorded assets or liabilities,
transaction or events.
3. Occurrence: - a transaction or event occurred during the
relevant accounting period (i.e. has correct cut-off been applied?).
4. Measurement: - a transaction or event is recorded at the proper
amount and in the correct period.
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5. Ownership: - an asset pertains (i.e. belongs) to the entity.
6. Valuation: - the asset or liability is recorded at an appropriate
carrying value.
7. Presentation and disclosure: - must be in accordance with the
relevant legislation and accounting standards (i.e. the applicable financial reporting
framework).
After the general objectives are understood, specific objectives for each account balance on
the financial statements can be developed.
Check Your Progress Exercise-1

1. What are assertions and what are the seven classifications of assertions?
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3.3 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.
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(e) Planning: - the auditor should plan his work to enable him to conduct an effective
audit in efficient and timely manner.
(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.
3.4 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 10 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.
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Standards of reporting
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.
Check Your Progress Exercise -2

What three categories are GAAS divided into?
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3.5 AUDIT PLANNING AND AUDIT PROGRAM
The first standard of fieldwork states:
“The work is to be adequately planned, and assistants, if any, are to be properly supervised.”
The concept of adequate planning includes investigating a prospective client before deciding
whether to accept the engagement, obtaining an understanding of the client’s business
operations, and developing an overall strategy to organize, coordinate, and schedule the
activities of the audit staff.
In planning the audit the auditor needs to consider the following:

1. The terms of the engagement and the expected date of the report.
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2. The nature of the client’s business, include applicable statutory and contractual
requirements.
3. The experience gained during previous audit engagements.
4. The accounting policies and degree of complexity of the accounting system.
5. Materiality and the components of audit risk.
6. Any involvement of other auditor.
7. Any involvement of internal auditors and persons having special expertise.
8. The intended reliance on internal control.
9. The level of experience and the number of audit staff for the engagement.
10. The timing and effectiveness of performing of the audit procedures.
(a) Client acceptance

The auditors should investigate the history of the prospective client, including such matters as
the identities and reputations of the directors, officers, and major shareholders, its financial
statements and audit report.
Sources of information
 Communication with predecessor auditors.
 Make enquiries of other third parties (e.g.
banker.).
 Consult the client’s legal cousel.
(b) Obtaining the engagement

After the auditors have collected the necessary information on the potential client, they will be
in a position to assess the various risk involved with the audit and determine whether to
attempt to obtain the engagement. Often they will be asked to submit a proposal which will
include information on the nature of services that the firm will offer, the qualification of the
firm’s personnel, and other information to convince the prospective client to select the firm.
Fee arrangement: when the business engages the services of independent public accountant,
it will usually ask for an estimate of the cost of the audit.
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Engagement letter: The preliminary understandings with the client should be summarized by
the auditors in an engagement letter, making clear the nature of the engagement, any
limitations on the scope of the audit, work to be performed by the client’s staff, schedule dates
for performance and completion of examination, and the basis for computing the auditors’ fee.
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(c) Obtaining an understanding of the client’s business.
After the engagement is accepted, the auditors must obtain a detailed understanding of such
factors as the client’s financial position and operating results, organization structure, product
lines, and methods of production and distribution. This will help auditors to evaluate the
appropriateness of the accounting principles in use or the reasonableness of the many
estimates and assumptions embodied in the client’s financial statements.
(d) Developing an overall audit strategy

After obtaining knowledge of the client’s business, the auditor should formulate an overall
audit strategy for the upcoming engagement. The best audit strategy is the approach that
results in the most efficient audit.
In planning an audit, the auditors must consider carefully the appropriate levels of materiality
and audit risk.
Materiality: In planning the audit, auditors should design their audit procedures to avoid
wasting time searching for immaterial misstatements that cannot affect their report.
Audit risk: The term audit risk refers to the possibility that the auditors may unknowingly fail
to appropriately modify their opinion on financial statements that are materially misstated.
In developing an audit plan, the auditors must consider factors that affect audit risk.
(e) Audit plans

The planning process is documented in the audit working papers through the presentation of
audit plans, audit programs, and time budget. An audit plan is an overview of the
engagement, outlining the nature and characteristics of the client’s business operations and the
overall audit strategy. A typical audit plan includes the following:
1. Description of the client’s company-its structure, nature of business, &

organization.
2. Objectives of the audit.
3. Nature and of extent of other services.
4. Timing and scheduling of audit work.
5. Work to be done by the client’s staff.
25
6. Staffing requirement during the engagement.
7. Target dates for completing major segments of the engagement.
8. Preliminary judgment about materiality and risk levels for the engagement.
(f) Designing audit programs

An audit program is a detailed list of audit procedures to be performed in the course of the
examination. An audit program is designed to accomplish certain objectives with respect to
each major account in the financial statements. These objectives follow directly from the
assertions that are contained in the client’s financial statements.
3.6 AUDIT WORKING PAPERS
Working papers are records kept by the auditor of the procedures applied, the test performed,
the information obtained, and the pertinent conclusions reached in the audit. For example,
when samples are takes for audit tests, the items drawn must be recorded and computations
must be made.
Working papers provide:

 The principal support for the auditor’s report.
 A means for coordinating and supervising the audit, and.
 Evidence that the audit was made in accordance with GAAS.
Working papers normally include the audit plan and programs, documentation of the auditor’s
understanding of the internal control structure, the assessed level of control risk, account
analyses explaining the composition of account balances, reconciliation of related records,
letters of confirmation and representation, recommended journal entries if necessary to correct
the accounts, and trial balances and other schedules that summarize the contents of other
working papers.
3.7 AUDIT SAMPLING
1. Definition: Application of audit procedures to less than 100 % of the items

within an account balance or class of transactions to obtain and evaluate audit evidence
26
about some characteristic of the items selected in order to form or assist in forming a
conclusion concerning the population.
Sampling risk
Because the auditor dose not examine all the items in the population when applying audit
sampling, there is a risk that the conclusion that he draws will be different from that which he
would have drawn had he examined the entire population. This is ‘sampling risk’.
The following are the basic factors affecting sample size:
 Population size.
 Standard deviation.
 Materiality.
 Reliability.
Statistical and non-statistical sampling

Statistical sampling involves the use of mathematical procedures, such as probability theory to
draw conclusions reached about the population. Non-statistical sampling techniques rely on
the auditors’ judgment to draw conclusions.
2. Constructing sampling.
The steps involved in sampling can be summarized as follows:
o Sample design: - when designing an audit sample, the auditor should consider
the specific audit objectives, the population from which the auditor wishes to sample,
and the sample size.
o Selection of the sample: - the auditor should select sample items in such a way
that the sample clan be expected to be representative of the population.
o Evaluation of the sample: - having carried out, on each sample item; those
audit procedures that are appropriate to the particular audit objective, the auditor
should:
(a) Analyze any errors detected in the sample.
(b) Project the errors found in the sample to the population, and
(c) Reassess the sampling risk.
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Check your progress Exercise -3
1. Define sampling risk.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3.8 SUMMARY
This is an important unit that covers the need for properly documented planning, risk analysis,
and the production of an overall audit plan and audit program.
Working papers are important as they record the various elements of audit evidence obtained
sampling is a necessary and valid means of forming conclusions on audit evidence. The
Sampling process involves sample design, selection of the sample, and evaluation of the
sample.
3.9 GLOSSARY
Client assertions: Explicit or implicit representations by management that are embodied in

the financial statements.
Working papers: The trial balances, checklists, programs, and other documentations that
compose evidence that the auditor has performed the audit in conformity with generally
accepted auditing standards.
3.10 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Assertions are explicit or implicit representations by management that are embodied in the
financial statements. These financial statement assertions are completeness, occurrence,
measurement, ownership, valuation, and presentation and disclosure.
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1. General standards
2. Standards of fieldwork
3. Standards of reporting.

1. Sampling risk is the that the auditor’s conclusion based on a sample may be different
from the conclusion he or she would reach if the test were applied to an entire population.
3.11 EXAM TYPE QUESTIONS
Part I. Select the Best Answer

1. Which of the following should the auditors obtain form the prodecessor
auditor before accepting the engagement?
(a) Analysis of balance sheet accounts.
(b) Analysis of income statement accounts.
(c) All matters of continuing accounting significance.
(d) Facts that might bear on the integrity of management.
2. Which of the following is an element of sampling risk?
(a) Choosing an audit procedure that is inconsistent with the audit objective.
(b) Concluding that no material misstatement exists based on taking a sample that
includes no misstatements from a materially misstated population.
(c) Failing to detect an error an error on a document that has been inspected by an
auditor.
(d) Failing to perform audit procedures that are required by the sampling plan.
Part II. Short Answer

1. Financial statements contain certain broad assertions regarding the accounts and classes of
transaction included in the financial statements.
(a) Who makes the assertions?
(b) List and describe each of the assertions
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UNIT 4: THE AUDITING PROCESS
Contents
4.1 Introduction
4.2 The Examination Process
4.3 Audit Evidence
4.3.1 Sufficient, Appropriate Evidence
4.3.2 Procedures to Obtain Evidence
4.3.3 Sufficiency of Evidence
4.3.4 Appropriateness of Audit Evidence
4.4 Working Papers
4.4.1 Functions of working Papers
4.4.2 Confidential Nature of Working Papers
4.4.3 Organization of the Working Papers
4.4.4 Contents of Working Papers
4.5 Summary
4.6 Glossary
o describe why auditors seek audit evidence
o explain audit evidence in terms of its competence and relative strength of
persuasiveness.
o indicate the factors that affect the sufficiency and competency of evidential matter.
o explain the nature and purpose of audit working papers.
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4.1 INTRODUCTION
When auditors are employed to express an opinion on the financial statements of an entity,
they must ensure that they have sufficient competent evidence on which to base such an
opinion. In this unit you will learn to answer the question what constitute sufficient
competent evidence.
Audit evidence is a fundamental concept in auditing. Audit evidence consists of underlying

accounting data and all corroborative information available to the auditor.
Both categories of evidential matter are required in making an audit in accordance with
GAAS.
The principal types of corroborating information areas follow:
Analytical evidence
Analytical evidence involves comparison of current period client data, such as total revenues
or return on assets, with expected values for the data based on (1)historical or budgeted
amounts for the client or (2) industry data.
The reliability of analytical evidence is dependent on the relevance of the comparable data.
Documentary Evidence
Documentary evidence includes a wide variety source documents as well as such items as
minutes of board of director or executive committee meetings, lease agreements various other
contracts, and bank statements.
Confirmations
Confirmations constitute a special class of documentary evidence involving direct written
responses by knowledgeable third parties to specific requests for factual information.
Written representations
Written representations are signed statements by responsible and knowledgeable individuals
that bear on one or more of management’s assertions.
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Mathematical evidence
Mathematical evidence results from recompilations by the auditor and comparison of those
results the client’s computations.
Oral evidence
During the audit, an auditor receives oral responses to numerous inquiries directed to officers
and employees of the client and others.
Physical evidence
Physical evidence is obtained from the physical examination or inspection of tangible assets.
4.2 DOCUMENTS AND RECORD EXAMINATION
In the early stages of an audit, the external auditors must become familiar with many aspects
of the client’s business. For example, the auditors must obtain knowledge of the client’s
organization plan, financial structure, physical facilities, products, accounting policies, and
the control procedures. However, information about the internal activities of the client is not
in itself sufficient.
If this information is to be interpreted and evaluated in a proper perspective, the auditor must
also understand the business environment in which the client operates. The auditors can gain
considerable information about both the client’s business environment and internal operations
by examining the client’s general records. The term general records is used to include the
following categories:
1. Non-financial records
 Articles and certificates of corporations and bylaws
 Partnership contract
 Minutes of directors and shareholders meetings
 Contracts with customers and suppliers
 Contracts with officers and employees
 Government regulations directly affecting the enterprise
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 Correspondence files
2. Financial records
 Income tax returns of prior years.
 Financial statements and annual reports of prior years.
3. Accounting records
 General ledger.
 General journal.

1. Identify the two categories of evidential matter.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. List the types of corroborative information that may be obtained in an audit.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
4.3 AUDIT EVIDENCE
During financial statement audits, the auditors gather and evaluate evidence to form an
opinion on whether financial statements follow the appropriate criteria, usually GAAP.
Gathering sufficient appropriate audit evidence is the very essence of auditing. The third
standard of fieldwork states:
Sufficient appropriate evidence should be obtained by such means as inspection, observation,

enquiry, confirmation, computation and analysis, to afford a reasonable basis to support the
content of the report
4.3.1 Sufficient, Appropriate Evidence

The auditor’s judgment as to what constitutes sufficient appropriate evidence is influenced by
such factors as:
33
a. Materiality of the item.
b. Inherent risk and control risk considerations.
c. The experience gailed during previous audit examination as to the
reliability of the client’s records and representation.
d. The persuasions of the evidence.
e. Fraud or error while performing as audit procedures.
1. What are the three general records that the auditors can
examine to obtain understanding of the client’s internal activities and the business
environment?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. List three factors, which may influence the sufficiency and
appropriateness of evidence?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
4.3.2 Procedures to Obtain Evidence

Audit evidence is any information that corroborates or refutes an assertion. Here we will
briefly recap a number of audit procedures.
Physical examination: - means to review physical evidence of an asset. For example, the
auditors might physically examine plant equipment or inventory items to obtain evidence as to
their existence or condition.
Confirmation: - is the process of obtaining evidence by written, direct communication with

the debtor, creditor, or other party of the transaction.
Tracing: - is the proof establishing the completeness of transaction processing by following a

transaction forward through the accounting records.
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Vouching: - is the process of establishing other accuracy of recorded transactions by
following a transaction back to supporting documents from a prior processing step.
Re-performance: - is the process of repeating a client activity.
Observation: - is the process of viewing a client activity. For example, the auditors may
observe the application of internal control procedures.
Inspection: - involves a reading or point – by – point review of a document or second. For

example, the auditors may inspect a loan agreement.
Reconciliation: - are used to establish agreement between two sets of independently
maintained but related records.
Enquiries: - are questions directed toward appropriate client reasoned. The responses to the
question may be oral or in written.
Analytical procedures: - are evaluations of financial information made by a study of expected

relationships among financial and non-financial data.
Check Your Progress Exercise - 3

1. Define audit evidence.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
4.3.3 Sufficiency of Evidence

The term sufficient relates to the quantity of evidence the auditors should obtain. The amount
of evidence that is considered sufficient to support the auditor’s opinion is a matter of
professional judgment. However, the following considerations may be useful in evaluating
the sufficiency of audit evidence.
1. The amount of evidence that is sufficient in a specific situation varies inversely with
the appropriateness of evidence available. Thus, the more appropriate the evidence,
the less the amount of evidence that is needed to support the auditors’ opinion.
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2. The need for audit evidence is closely related to the concept of materiality. The more
material a financial statement amount, the greater the need for more evidence as to its
validity.
3. As the relative risk associated with a particular engagement increases, the auditors
should require more evidence to support their opinion.
4.3.4 Appropriateness of Audit Evidence
The appropriateness of audit evidence refers to its quality or reliability. To be appropriate,
evidence must be both valid and relevant.
The competency (or reliability) of accounting records is directly related to the effectiveness of
the client’s internal controls. Strong internal controls enhance the accuracy and reliability of
the financial records.
The competency of corroborative information depends on many factors. The considerations

that have the widest applicability in audit are:
- relevance
- source
- timeliness
- objectivity
Several factors contribute to the quality of evidence, including the following:

1. When auditors obtain evidence from independent sources outside of the client
company, the reliability of the evidence is increased.
2. Strong internal control contributes substantially to the quality of accounting records
and other evidence created within the client organization.
3. The quality of evidence is enhanced when the auditors obtain information directly, -
that is, by first hand observation, correspondence, or computation, rather than by
obtaining the information second hand.
4.4 WORKING PAPERS
Working papers are vitally important tools of the auditing profession.
36
Working papers are the connecting link between the client's accounting records and the
auditors report. They document all of the work performed by the auditors and provide the
justification for the auditors’ report.
The documentation of audit evidence is provided in working papers. Working papers provide
- The principal support for the auditor’s report.
- A means for coordinating and supervising the audit.
- Evidence that the audit was made in accordance with
GAAS.
4.4.1 Functions of working Papers

Audit working papers assist auditors in several major ways: they
a) Provide a means of assigning and coordinating audit work;
b) Aid seniors, managers, and partners in supervising and reviewing the
work of assistants;
c) Provide the support for the auditors’ report;
d) Document the auditors’ compliance with GAAS; and
e) Aid in planning and conducting future audits of the client.
4.4.2 Confidential Nature of Working Papers

Much of the information gained in confidence by the auditors is recorded in their working
papers; consequently, the working papers are confidential in nature.
Since audit working papers are highly confidential, they must be safeguarded at all times.
4.4.3 Organization of the Working Papers

The auditors usually maintain two files of working papers for each client:
1) Current files for every completed examination and
2) A permanent file of relatively unchanging data.
4.4.4 Contents of Working Papers

Working papers would normally include the following matters:
 Information concerning the legal and organizational structure of the entity.
 Copies of important legal documents, agreements and minutes.
37
 Information concerning the industry, and economic environment.
 Evidence of the planning process.
 Evidence of the auditors’ understanding of the accounting and internal control
systems.
 Evidence of inherent and control risk asses ments.
 Analysis of transactions and balances.
 Analysis of significant ratios and trends.
 Details of procedures regarding components whose financial statements are audited by
other auditors.
 Copies of communications with other auditors, experts, and other third parties.
 Letters of representation by the client’s management.
 Copies of the approved financial statements and auditors’ reports.

1. Which of the following is not a primary purpose of audit working papers?
a) To coordinate the examination.
b) To assist in preparation of audit report.
c) To support the financial statements.
d) To provide evidence of audit work performed.
2. Which of the following is the most persuasive evidence?
a) Information detained through inquiry direct from independent
sourced audit the client organization.
b) Information obtained through inquiry from the management the
organization.
c) Evidence obtained by re-performing calculations and
reconciliation made by the client.
d) Evidence obtained by observing employment while performing
their tasks..
4.5 SUMMARY
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In this unit we have examined the matters relating to audit evidence. The financial statements
are explained in terms of the primary assertions management makes in them, and these
assertions are identified as the focal points of the auditors’ procedural evidence gathering
work. The unit closes with some basic points about the purpose, confidentiality, and content
of audit working papers.
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4.6 GLOSSARY
Confirmation: A technique in which the auditors request a written response from a specific
third party about a particular item affecting the financial statements.
Current file: The working paper file that includes information relevant to an audit client for
a particular year.
Inquiry: A technique of asking questions to gather audit evidence.

evidence.
Permanent file: The working paper file that includes information of continuing relevance in
performing recurring engagement for an audit client.
4.7 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

1. - Accounting data
- Corroborative information available to the auditor
2. Analytical evidence
- Documentary evidence
- Confirmations
- Mathematical evidence
- Oral evidence
- Physical evidence
1. Non-financial records, financial records and accounting.
2. Materiality of the item
- Inherent risk and control risk consideration
- The persuasiveness of the evidence
Audit evidence is any information that corroborates or refutes an assertion.
1. C 2. C
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Part I. Choose the best answer

1. Which of the following is the least persuasive type evidence?
a. Bank statement obtained from the client.
b. Computation made by the auditor.
c. Pre-numbered client sales invoices.
d. Vendor’s invoice.
2. An auditor’s working papers should:
a. not be permitted to serves as a reference source for the client
b. not contain critical comments concerning management
c. show shat the accounting records agree or reconcile with the financial
d. be considered the primary support for the financial statements being
audited .
3. The strongest criticism of the reliability of audit evidence that the auditor physical
observes is that:
a. the client may conceal items from the auditor
b. the auditor may not be qualified to evaluate the items
observed
c. such evidence is too costly in relation to its reliability
d. the observation must occur at a specific time, which is often
difficult to arrange
Part II. Give short answers for the following questions.

questions.
1. What are the factors that may influence the auditors’ judgement on the
sufficiency and appropriateness audit evidence?
2. “Audit papers are the property of auditors, who may destroy the papers, sell
them or give them away.” Criticize this quotation.
41
UNIT 5: AUDITORS’ REPORTS
Contents
5.1 Introduction
5.2 The auditors’ Standard Report
5.3 Expression of an Opinion
5.4 The Unqualified Report
5.5 Qualified Opinions
5.6 Summary
5.7 Glossary
5.8 Answer to Check Your Progress Exercise
 prepare audit reports to meet different specified situations.
 understand the basic elements of audit report.
 discuss and explain the concept of “true and fair”.
5.1 INTRODUCTION
The audit report is usually the only channel of communication between the shareholders of
the company whose financial statements have been subject to audit and the auditors. As such
the report acts as a bridge taking the large volume of information possessed by auditors and
conveying it to the shareholders in a much abbreviated form.
In order to convey information in a succinct form the audit report has become an extremely
formalized group of phrases, each of which has special significance.
42
43
5.2 THE AUDITORS’ STANDARD REPORT
For convenient reference, the auditors’ standard (unqualified) report is presented below.
Auditors’ report to the shareholders of XYZ

we have audited the accompanying balance sheet of the XYZ Company as of December 31,
19 x 1, and the related statements of income, retained earnings, and cash flows for the year
then ended. There financial statements are the responsibility of the company’s management.
Our responsibility is to express an opinion on those financial statements based on our audit.
We conducted an audit in accordance with generally accepted auditing standards. Those

standards require that we plan and perform an audit to obtain reasonable assurance whether
the financial statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting policies used and significant estimates made by
management, as well as evaluating the overall financial statements presentation. We believe
that our audit provide a reasonable basis for our audit opinion.
In our opinion, the financial statements give a true and fair view of (or present fairly in all
material respects) the financial position of the company as of December 31, 19 x 1 and the
results of its operations and its cash flows for the year then ended in accordance with GAAP.
ABC Auditors
Date
Address
This report contains the following important elements:

- Title: Auditing standards require that the report be
titled and include the word independent.
- Address: The audit report is addressed to the
individual or group that engaged the auditors.
- Introductory paragraph: - The first paragraph of the
report does three things:
44
 Specifies the financial statements to
which the report relates,
 Specifies the respective
responsibilities of directors and auditors, and;
 It makes the simple statement that the
auditor has done an audit.
- Scope paragraph: -The
-The scope paragraph describes the
nature of an audit. The scope paragraph states the following:
 The auditors followed GAAS,
 The audit is designed to obtain a
reasonable assurance about whether the financial statements are free of material
misstatements.
 The audit evidence accumulated and
the auditor believes the evidence accumulated was appropriate for the
circumstances to express the opinion presented.
- Opinion paragraph: The final paragraph in the
standard report states the auditors’ conclusion based on the results the audit examination.
- Name of the audit firm.
- Audit report date.
date. The appropriate data for the audit
report is the one on which the auditor has completed the most important auditing
procedures in the field.
5.3 EXPRESSION OF AN OPINION
The auditors’ opinions when expressing an opinion on financial statements may be

summarized as follows:
1. An unqualified opinion – standard report.
2. A qualified opinion.
3. An adverse opinion.
4. A denial opinion.
All significant reasons for the issuance of a qualified, adverse, or denial of opinion should be
set forth in a reservation paragraph between the scope and opinion paragraph.
45
Auditors must qualify their report whenever there are material deficiencies in the client’s
46
5.4 THE UNQUALIFIED REPORT
The unqualified report is used when the following conditions are met:
1. All statements - balance sheet, income statement, statements of
retained earnings, and statement of cash flows are included in the financial statement.
2. The three general standards have been followed in all respects on
the engagements.
3. Sufficient evidence has been accumulated.
4. The financial statements are presented in accordance with
generally accepted accounting principles.
5. There are no circumstances requiring the addition of an
explanatory paragraph or modification of the wording of the report.
In general, auditors express an unqualified opinion on the client’s financial statements when
there has been no material departure from GAAP and there have been no material unresolved
restrictions on the scope of their audit.
Under certain circumstances, however, auditors may add additional wording to the standard
report even though they are issuing an unqualified opinion. This additional wording draws
attention to certain statutory requirements or a specific matter. Another modification of a
standard audit report is the auditors’ emphasis of a matter regarding the client’s financial
statements. Emphasis of matter may require in the auditor’s unqualified report (1) to
highlight a matter regarding a going concern problem and (2) when there is a significant
uncertainty (other than going concern problem), the resolution of which is dependent upon
future events and which may affect the financial statements.

Part I. Select the best answer
1. The auditors’ report should be dated as of the date the:
a) Report is delivered to the client.
b) Examination is substantially completed.
c) Fiscal period under audit ends.
d) Review of the working papers is completed.
47
2. An auditor’s responsibility to express opinion on the financial
statements is represented in the:
a) Introductory paragraph.
b) Scope paragraph.
c) Opinion paragraph.
d) Explanatory paragraph.
3. Assume that the opinion paragraph of an auditor’s report begins
as follows: “with the foregoing explanation, these financial statements present fairly”
This is:
a) An unqualified opinion.
b) A denial opinion.
c) An except for opinion.
d) Adverse opinion.
5.5 QUALIFIED OPINIONS
Auditors may issue opinions other than unqualified opinion when (1) they do not agree with
the accounting principles used in preparing financial statements or when they believe
disclosures in the statement are inadequate; (2) a change in accounting principle is not applied
properly a as per GAAP, and is not adequately disclosed in the financial statements; (3) there
are limitations on scope of examination; and /or (4) there is major uncertainty affecting a
client’s business’.
A. Qualified opinion -except for:

for: This is issued when there is a
limitation of Scope; or the auditor disagrees with an accounting treatment or
disclosure. The opinion states that except for the effects of some material departure
from GAAP, or some material limitation in the scope of the auditors’ examination, the
financial statements are presented fairly.
The auditors’ reports should have a separate reservation paragraph disclosing the
reasons for the qualification.
B. Adverse opinion: This is a stronger form of ‘except for’
opinion – the disagreement is so material that the financial statements as a whole are
48
misreading. When the auditors express an adverse opinion, they must have
accumulated sufficient appropriate evidence to support their unfavourable opinion.
Whenever the auditors issue an adverse opinion, they should disclose in a separate
paragraph of their report the reasons for the adverse opinion and the principal effects
of the adverse opinion on the client company’s financial position and operating results.
Example, an audit report that included an adverse opinion might have an opinion
paragraph such as the one as follows:
In our opinion, because of the effects of the matters discussed in the preceding paragraph,
these financial statements do not present fairly the financial positions of the company as at
December 31, 19 x 1, and the results of its operations and cash flow position for the year then
ended, in accordance with generally accepted accounting principles.
C. Denial of opinion. A denial (disclaimer) of opinion is no

opinion. In an audit engagement, a denial is required when very significant
restrictions on the scope of the audit preclude compliance with generally accepted
auditing standards.
A very significant scope limitation may be caused by the client or by the timing of the
auditors’ appointment and their audit work or by factors beyond the control of the
client or the auditors, rather than by restrictions imposed by the client.
Summary of auditors’ reports

Materiality Type of report
of the issue
Not material
Unqualifie
d
Departure from
GAAP scope limitation
Material
Qualified ‘except for’ qualified ‘except for’
Very
adverse denial
material
49
1. Identify the four basic types of opinions that an auditor may issue.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. What is meant by the term reservation?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
5.6 SUMMARY
This unit covers the four basic types of audit opinions and explain when each is appropriate.
Depending on the circumstances ,the auditor’s report may take one of the following forms:(1)
a standard report that contains an unqualified opinion, (2) a report that contains an unqualified
opinion with added explanatory language, or (3) a report that expresses one of three other
types of opinion-qualified ‘except for’, adverse or disclaimer.
5.7 GLOSSARY
Adverse opinion: A type of opinion issued by an auditor that states that the financial
statements do not present fairly the financial position, results of operation, and cash flows in
conformity with generally accepted accounting principles.
Audit opinion: That part of the audit reports that presents the conclusions reached by the
auditor.
Audit report: The auditor’s entire communication about what was done and what
conclusions reached in the audit.
Disclaimer of opinion: A report by the auditor that states that an opinion cannot be
expressed.
Going concern: An entity able to continue for a period at least one year beyond the balance
sheet date.
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5.8 ANSWERS TO CHECK YOU PROGRESS EXERCISE

1. B
2. A
3. A

(1) 1. Qualified opinion
2. Unqualified opinion
3. Adverse opinion and
4. Disclaimer
(2) Reservation is a term used to signify the auditors’ inability to express an unqualified
opinion; adverse opinion, or a denial of opinion.
5.9 MODEL EXAMINATION QUESTIONS
Part I. Indicate the best answer choice for each of the following multiple-choice
questions.
1. If a publicly held company issues financial reports that purport to present its financial
position and results of operation but omits the statement of cash flows, the auditor
ordinarily will express a(an)
a. unqualified opinion.
b. Adverse opinion.
c. qualified opinion
d. disclaimer of opinion
2.An auditor may reasonably issue an “except for” qualified opinion for
Inadequate disclosure Scope limitation
1. yes yes
2. yes no
3. no yes
4. no no
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3. What type of audit report (unqualified opinion, except for opinion, adverse opinion, denial
of opinion) should the auditors generally issue in each of the following situations?
Explain.
a) Client imposed restriction limit very significantly the scope of the
auditors’ procedures.
b) The auditors decide that it is necessary to make reference to their
report of another public accounting firm (the secondary auditors).
c) The auditors believe that the financial statements have been stated in
conformity with generally accepted accounting principles in all respects other than
the treatment and disclosure of a material uncertainty.
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UNIT 6: COMPUTER AUDIT
Content
6.1 Introduction
6.2 Uses of Computers in Audit
6.3 Characteristics of Computer Audit
6.4 Controls in CIS
6.5 Computer Assisted Auditing Techniques (CAATS)
6.6 Summary
6.7 Glossary
6.8 Answer for Check Your Progress Exercises
When you have studied this unit, you should be able to:
 understand the problems of auditing computer information systems
(CIS).
 understand the controls operated by a client in a CIS.
 explain the use of CAATS.
6.1 INTRODUCTION
Computers may affect the work of the auditor in two ways:

 The client may use a computer to produce all or part of the financial accounting data.
 The auditor may be able to use a computer to assist in his audit, particularly when the
client has a computer system.
6.2 USE OF COMPUTERS IN AUDIT
A microcomputer may be used by the auditor in the following ways to assist his audit work.
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a) Flowcharting a client’s systems.
systems. Specialist flowcharting
packages can assist the auditor in the production of clear, well presented flowcharts.
b) Evaluation of audit risk. The auditor can input into the
computer his assessment of the audit risk for the various transactions and balanced in
the client’s systems.
c) Preparation of audit programmes. Audit programs can be
typed into a word processor, which again will allow for easy updating in the following
years.
d) Analytical procedures. A standard template can be let up on a
spreadsheet package. Onto this template, the auditor inputs key details such as
balance sheet totals from the financial statements. The spreadsheet then calculates key
accounting ratios to assist the auditor with the analytical procedures.
e) Preparation of audit working papers. When a computer is
available to audit staff at the client’s premises, it can be used to type up audit working
papers.
6.3 CHARACTERISTICS OF COMPUTER AUDIT
There are a number of distinguishing features of computer-based systems that must be

recognized and considered by the auditor. The following are the main features.
a. Concentration of controls in the computer department. The need to
standardized and utilize the computer resources of a business has led to a
concentration of controls in the computer department which represents a potential
weakness. Generally the number of persons involved in the processing of information
in a CIS environment will be fewer than those in a manual environment.
b. Concentration of programs and data.
data. Transactions, master files, and
program data are often held together and there is a corresponding increased potential
for unauthorized access to programs and data.
c. Absence of input documentation.
documentation.
In some systems conventional journal will not be maintained and manual
authorizations are usually replaced by computer authorizations.
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d. Lack of visible transaction trial and output.
output.
Modern systems are usually designed to limit the volume of printed data, and data is
often quickly overwritten with new data. The auditor must assess the implications of
this at the planning stage.
e. Ease of access to data and computer programs.
programs. The problem is
again, one of unauthorized access where data can be altered from remote terminals.
f. Vulnerability of discs, and tapes.
tapes.
Data is more vulnerable than it would be in a manual system to loss, and destruction.
g. System generated transactions.
transactions. Many systems are capable of
generating transactions automatically without user intervention. The lack of
authorization and documentation can be a significant issue if a significant number of
transactions are generated in this way.
h. Single transaction /multiple update.
update.
An incorrect entry may result in incorrect data in may different accounts, particularly
in database systems.
I. Programmed controls.
Programmed controls may limit the visibility of data, and limit input of data.
6.4 CONTROLS IN CIS
The controls that must be exercised by the auditor when micro computers are used in his audit
work include the following:
a) Backup of files.
Backup of all audit files kept on the computer should be made regularly. These
backup copies should be kept in a separate location from the microcomputer.
b) Security of files.
Audit information on client can be very sensitive. Adequate procedures must
therefore be in force to ensure that only authorized audit staff can gain access to the
audit information.
c) Adequacy of documentation.
There is a danger with computers that not all the data or reasoning used to reach a
particular decision will be documented. Adequate documentation should therefore be
55
kept, including print – outs of all major documents, for future reference, together with
the reasons for the decisions made.
d) Testing of programs.
Before any program is used on audits, it should be tested to ensure that it is as fast as
possible error free
Check your progress Exercise – 1

Say true or false
1. Internal control in a CIS department requires not only
subdivision of duties but also the maintenance of adequate documentation.
2. Computers are able to create, update, and erase data in computer
based records without any visible evidence of a change being made.
3. When a company uses CIS consolidation of activities and
integration of functions are to be expected.
4. Every electronic data processing system should have adequate
security controls to safeguard files and programs.
6.5 COMPUTE ASSISTED AUDITING TECHNIQUES (CAATS)
The absence of input documents, or audit trial, or output, might necessitate the use of
CAATS.
Auditors may use audit software during many audit testing procedures. The use of audit
software is particularly appropriate during substantive testing of transactions and balances, as
scrutinize large volumes of data and extract information leaving skilled manual resources to
concentrate upon the investigation of the results.
Typical uses of such programs include:

i. Calculation of checks: Example: - the program
adds the value of open items on a file to ensure that they agree with control records.
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ii. Detecting violation of system rules: Example, the
program checks all accounts on the sales ledger to ensure that no customer has a balance
above a specified credit limit.
iii. Detecting unreasonable items: Example, a check
that no customer is allowed trade discount of more than 5%.
iv. Conducting new calculations and analysis:
Example: - obtaining a sample of sales ledger balances to be used as a basis for a
circularisation of accounts receivable.
v. Selection of items for audit testing: Example: -
obtaining a sample of sales ledger balances to be used as a basis for a circularisation of
accounts receivable.
vi. Completeness checks: Example, checking
continuity of sales invoices to ensure they are all accounted for.
6.6 SUMMARY
The auditor can use microcomputers to assist in the management and carrying out his audit
work. Computer based systems have a number of special features which must be recognized
and considered by the auditor in planning his audit approach.
6.7 GLOSSARY
Computer-assisted audit techniques (CAAT) The tools and techniques, such as audit
software and test data, used by the auditor with the computer to aid in effective and efficient
performance of an audit.
6.8 ANSWER TO CHECK YOU PROGRESS EXERCISE

1. True
2. True
3. True
4. True
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1. What are the special features of a computer – based systems?

2. Discuss briefly the internal controls that should be established
over the operation of a microcomputer.
UNIT 7: CASH AUDIT
Contents
7.1 Introduction
7.2 Nature of Cash
7.3 Audit Objectives
7.3.1 Internal Control Over Cash
7.3.2 Internal Control Over Cash Disbursements
7.3.3 Control Over Petty Cash
7.4 Audit Program for Cash
7.5 Summary
7.6 Glossary
7.8 Model Examination Question
 devise appropriate tests for cash.
 explain the nature of cash receipts and disbursements.
 explain the fundamental internal controls over each receipts and cash disbursement.
 describe the nature of appropriate procedures to accomplish the objectives of cash
audit.
7.1 INTRODUCTION
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This unit examines the audit of cash. For the audit of cash much reliance is placed on third
party confirmation of cash balance.
You should bear in mind that the control of cash is of prime importance in any business. The
overall objective of the audit of cash is to determine that cash is fairly presented in conformity
with generally accepted accounting principles. In most audits, the primary assertions that
generate audit risk for cash are existence, completeness, right and obligation, and presentation
and disclosure.
7.2 NATURE OF CASH
Cash and bank balances are liquid assets and include:

a) Notes and units.
b) Bank current accounts.
c) Bank deposit accounts.
Because of their liquidity, these assets represent the most vulnerable of all the company’s
assets. On the other hand, they are the most easily verified, because they can be confirmed
directly by third parties or by physical counts.
7.3 THE AUDITORS’ OBJECTIVES IN EXAMINATION OF CASH
The auditors have five objectives in the audit of cash:

cash:
1. Consider internal control over cash transactions.
2. Determine the existence of recorded cash and the client’s ownership of
this asset.
3. Establish the completeness of recorded cash.
4. Establish the clerical accuracy of cash schedules.
5. Determine that the statement presentation of cash is appropriate.
The overall objective of the audit of cash is to determine that cash is fairly presented in
conformity with generally accepted accounting principles.
7.3.1 Internal Control Over Cash
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(a) Control Objectives
The central control objectives are that:
 All sums are received and subsequently accounted for.
 No payments are made which should not be made.
 All receipts and payments are promptly and accurately recorded.
(b) Control Procedures

A detailed study of the operating routines of the individual business is necessary in
developing the most efficient control procedures. These universal rules for achieving internal
control over cash may be summarized as follows:
1. Do not permit any one employee to handle transaction from beginning to end.
2. Separate cash handling from record keeping.
3. Centralize receiving of cash as much as possible.
4. Record cash receipts immediately.
5. Encourage customers to obtain receipts and observe cash register totals.
6. Deposit each day’s cash receipts intact.
7. Make all disbursements by cheques with the exception of small from petty cash.
8. Have monthly bank Reconciliation prepared by employees not responsible for the
issuance or custody of cash. The completed reconciliation should be reviewed
promptly by an appropriate official.
9. Forecast expected cash receipts and disbursements and investigate variances from
forecasted amounts.
(c) Internal control over cash receipts.
Cash receipts resulted from a variety of activities. For example, cash is received from revenue
transactions, short and long term borrowings, the issuance of stock, and the sale of marketable
securities, long term investments, and other assets. The scope of this section is limited to cash
receipts from cash sale and collection from customers on credit sales. The basic internal
controls over cash receipts include the following:
 Authority to collect cash should be clearly defined.
 Collections should be recorded when received.
 The collector’s cash receipts should be reconciled to the eventual banking.
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 Receipts should be banked immediately.
 Each day’s receipts should be recorded promptly in the cashbook.
 Sales ledger account should have not access to the cash.
The processing of receipts from cash and credit sales involves the following cash receipts
functions:
- Receiving cash receipts.
- Depositing cash in bank.
- Recording the receipts.
Segregation of duties in performing these functions is an important internal control activity.
Receiving cash receipts

A major risk in processing cash receipts transactions is the possible theft of cash before and
after a record of cash is made. Thus, control procedures should provide reasonable assurance
that documentation establishing accountability is created at the moment cash is received and
that the cash is subsequently safeguarded.
Depositing cash in bank

Proper physical controls over cash require that all cash receipts be deposited intact daily.
Intact means all receipts should be deposited; that is cash disbursements should not be made
out of un-deposited receipts.
Recording the receipts

This function involves journalizing over the counter and mail receipts and posting mail
receipts to customer accounts. Controls should ensure that only valid receipts are entered and
that all actual receipts entered at the correct amount.
To ensure that only valid transactions are entered, physical access to the accounting records or
computer terminals used in recording should be restricted to authorized personnel.

1. What functions are involved in the processing of cash receipts transactions?
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…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………….
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2. What is the meaning of deposited intact daily?
daily?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………….
7.3.2 Internal Control Over Cash Disbursements

There are two cash disbursements functions as follows:
follows:
1. Paying the liability
2. Recording the cash disbursements.
These functions should not be performed by the same department or individual. The basic
internal controls over cash disbursements include:
 Unused checks should be held in a secure place.
 The person who prepares checks should have no responsibility over purchase
ledger or sales ledger.
 Checks should be signed only when evidence of a properly approved transaction
is available.
 These checks should be evidenced by signing the supporting documents.
 Check signatories should be restricted to the minimum practical number.
 Two signatories at least should be required except perhaps for checks of small
amounts.
 Checks should be crossed before being signed.
 Supporting documents should be cancelled as paid to prevent their use to support
further check payments.
 Checks should preferably dispatch immediately.
7.3.3 Control Over Petty Cash

 The level and location of cash floats should be laid down formally.
 Cash should securely hold.
 There should be restricted access to the floats.
 All expenditure should require a voucher system signed by a responsible official,
not the petty cashier.
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 Vouchers should be produced before the check is signed for reimbursement.
 A maximum amount should be placed on a petty cash payment to discourage
normal purchase procedures being by passed.
 Periodically the petty cash should be reconciled by an independent person.

State the functions that apply to cash disbursements transactions.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………….
7.4 AUDIT PROGRAM FOR CASH
The following audit program indicates the general pattern of work performed by the auditors
in the verification of cash.
A. Consider internal control for cash.
1. Obtain an understanding of internal control for cash.
2. Assess control risk and design additional tests of controls for cash.
3. Perform additional tests of control for those controls, which the auditors plan
to consider in their assessment of control risk.
(a) Test the accounting records and reconciliation by re-performance.
(b) Compare the detail of a sample of recorded disbursements in cash payments
journal to accounts payable postings, purchase orders, receiving reports,
invoices, and paid checks.
(c) Compare the detail of a sample of recorded cash receipts listings to the cash
receipts, journal, accounts receivable postings, and authenticated deposit slips.
4. Reassess control risk and design substantive tests for cash.
B. Perform substantive tests of cash transaction and balances.

balances.
1. Obtain analysis of cash balances and reconcile to the general ledger.
2. Send standard confirmation forms to banks to verify amounts on deposit.
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3. Obtain or prepare reconciliation of bank accounts as of the balance sheet date and
consider the need to reconcile bank activity for additional months.
4. Obtain a cutoff bank statement containing transactions of at least seven business days
subsequent to balance sheet date.
5. Count and risk cash on hand.
6. Verify the client’s cutoff of cash receipts and disbursements.
7. Trace all bank transfers for last week of audit year and first week of following year.
8. Evaluate proper financial statement presentation and disclosure of cash.
A. Consider internal control for cash.

1. Obtain an understanding of internal control
By understanding internal control over cash receipts and cash disbursements helps
auditors to observe whether there is appropriate segregation of duties and to enquire who
performed various functions throughout the year.
2. Assess control risk and design additional tests of control.
After obtaining an understanding of the client’s internal control for cash receipts and
disbursements, the auditors perform their initial assessment of control risk.
3. Perform additional tests of control.
Tests directed toward the effectiveness of control help to evaluate the client’s internal
control and determine the extent to which the auditors are justified in reducing the
assessed levels of control risk for assertions about the cash account.
The following are examples of typical tests of controls.

controls.
 Test the accounting records and Reconciliation by re-performance.
 Compare detail of cash receipts listings to cash receipts journal,
accounts receivable postings, and authenticated deposit slips.
 Compare detail of a sample of recorded disbursements in cash
payments journal, accounts payable postings, purchase orders, receiving reports,
invoices, and paid checks.
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4. Reassess control risk and design substantive tests.
When the auditors have completed the procedures described above, they should reassess
control risk and design substantive tests of cash transactions and balances.
B. Substantive tests
 Obtain analyses of cash balances and reconcile to the general ledger.
 Send standard confirmation forms to banks to verify amounts on deposit.
 Obtain or prepare reconciliation’s of bank accounts as of the balance sheet date
and consider the need to reconcile bank activity for additional months.
 Obtain a cut off bank statement.
 Count and list cash on hand.
 Verify the client’s cutoff of cash receipts and disbursements.
 Trace all bank transfers for the last week of audit year and first week of following
year.
 Investigate any cheques representing large or unusual payments to related parties.
 Determine proper financial statement presentation and disclosure of cash.
Check You Progress Exercise – 3

Choose the best answer.
1. Which of the following is the objective of major substantive tests of cash
transactions and balance?
a. Clerical accuracy.
b. Existence and ownership.
c. Completeness.
d. All of the above.
2. The balance sheet figure for cash should include all cash received on the final
day of the year and none receive subsequently.
a. True
b. False
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7.5 SUMMARY
Cash balances are verified with a third party. Auditors can also use to bank letter to questions
related to cash balances.
7.6 GLOSSARY
Negative confirmation: A statement of balances due that is addressed to the customer with
the request that the customer respond directly to the auditor only if the amount shown is
incorrect.
Positive confirmation: A statement of balances due that is addressed to the customer with
the request that the customer respond directly to the auditor regardless of whether the balance
is correct or incorrect.
7.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1. - Receiving cash receipts, Depositing cash in bank, and Recording the receipts.
2. All receipts should be deposited; that is cash disbursements should not be made out of un-
deposited receipts.
receipts.

1. D 2. A
7.8 MODEL EXAM QUESTION
1. The auditors’ work on cash may include an understanding of internal control and
performing tests of controls. Which of these two steps should be performed first? What is
the purpose of tests of controls?
2. State one broad general objective of internal control for cash of the following:
Cash receipts, cash disbursements, and balance.
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UNIT 8: RECEIVABLE / SALES AUDIT
Contents
8.1 Introduction
8.2 Sources and Nature of Receivables
8.3 Financial Reporting Standards
8.4 Audit Objectives
8.5 Internal Control of Sales and Receivables
8.6 Audit Program for Receivables and Sales Transactions
8.7 Summary
8.10 Model Examination Questions
 devise appropriate tests for receivables.
 explain the nature of sales and collection of receivables.
 describe the auditors’ objectives for the audit of receivables and sales.
 describe the nature of the audit procedures to accomplish the auditors’ objectives
for the audit of receivables and sales.
8.1 INTRODUCTION
This unit examines the audit of sales and receivables. You should bear in mind in the audit of
receivables that receivables are a product of the sales cycle and therefore the control
objectives of the sales cycle are relevant. Receivable is a general term that may refer to many
types of receivables whose origin and nature may be different.
Receivables include amounts due from customers, employees, and affiliates on open accounts,
notes, and loans and accrued interest on such balances.
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8.2 SOURCES AND NATURE OF RECEIVABLE
The sales and collection cycle including the receiving of orders from customers are delivery
and billing of merchandise to customers, and the recording and collection of receivables.
Receivables from customers include both accounts receivable and various types of notes
receivable.
It is important to differentiate the origin and nature of receivables to ensure their appropriate
classification and valuation.
8.3 FINANCIAL REPORTING STANDARDS
Financial reporting standards for receivables require:

 separation of trade from non – trade receivables.
 establishment of genuine of trade receivables transactions ensuring “arms length deal”,
and terms of sales.
 assurance of ownership disclosure.
 assurance of collectibility of receivables.
 assurance of consideration for returns and allowances.
 appropriate classification of current and non - current.
8.4 AUDIT OBJECTIVES
The audit objectives for the receivables and sales relate to obtain to sufficient competent
evidence about each significant financial statement assertion that pertains receivables and
sales transactions and balances.
To achieve each of these specific audit objectives, the auditors employ various parts of the
audit planning and audit testing methodology.
The auditors’ objectives in the examination of receivables and sales are:

1. To consider internal control over receivables and sales transactions.
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2. To determine the existence of receivables, the clients ownership of these
assets, and the occurrence of sales transactions.
3. To establish the completeness of receivables and sales transactions.
4. To establish the clerical accuracy of records and supporting schedules of
receivables and sales.
5. To determine that the valuation of receivables is at appropriate net realizable
values.
6. To determine that the statement presentation of receivables and sales is
adequate.
Figure 8.1 Selected specific audit objectives for receivables and sales
Assertion Transaction class Account balance

Category Audit objective Audit objective
Recorded sales transactions represent goods Accounts receivable include all
Category Existence shipped during the period. Recorded cash amounts owed by the customers
or Occurrence receipts transactions represent cash received exists at the balance sheet date.
during the period.
All sales, cash receipts sales adjustments Accounts receivable include all
Completeness that occurred during the period have been claims on customers at the balance
recorded. sheet date.
The entity has rights to the receivables and Accounts receivable at the balance
Rights and
cash resulting from sales transactions. sheet date represents legal claims of
Obligations
the entity.
Valuation All sales, cash receipts and sales Accounts receivable represent gross
adjustments transactions are correctly claims, On customers at the balance
journalized, summarized, and posted. sheet date. The allowance for
uncollectible accounts represent a
reasonable estimate.
Presentation ad The details of sales, cash receipts and sales Accounts receivables are properly
disclosure adjustments support their presentation in the identified and classified.
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8.5 INTERNAL CONTROL OF SALES AND RECEIVABLES
The objectives of internal controls over receivables are to ensure:

a. All goods dispatched are invoiced.
b. Invoicing is at correct price and discount.
c. Goods are only dispatched on credit to approved customers.
d. Invoices are recorded and related to subsequent cash receipts.
e. Receivables are controlled and bad debts pursued.
f. Credit notes approved.
In addition the internal over receivables should be such that the possibility of any falsification
of the receivables accounts is eliminated. An important part of the controls would be to
ensure that the cashier does not have access to the sales ledger, and the sales ledger clerk does
not have access to cash received. Control procedures, over sales and receivables include the
following.
a. Orders.
- The orders should be checked against the customer’s
account.
- All orders received should be recorded on pre –
numbered sales order documents.
- All orders should be authorized before goods are
dispatched.
b. Dispatch.
- Dispatch notes should be pre - numbered and a register
kept of them to relate to sales invoices and orders.
- Goods dispatch notes should be authorized as goods
leave.
c. Invoicing
- Sales invoices should be authorized by a responsible
official.
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- Sales invoices should be checked for prices and
calculations by a person other than the one preparing the invoice.
- All invoices should be pre – numbered consecutively.
- Copies of cancelled invoices should be retained.
d. Receivables.
- A receivable ledger control account should be
prepared and checked to individual sales ledger balances.
- Receivables ledger personnel should be independent of
dispatch and cash receipt functions.
- Statements should be sent regularly to customers.
e. Bad debts.
- The authority to write off a bad debt should be given
in writing and adjustments made to the accounts receivable ledger.
- The use of court action or write – off of a bad debt
should be authorized by an official independent of the cash receipts function.
8.6 AUDIT PROGRAM FOR RECEIVABLES AND SALES TRANSACTIONS
The following audit procedures are typical of the work done in the verification of notes,
accounts receivable, and sales transaction.
A. Consider internal control for receivables and sales.
sales.
1. Obtain an understanding of internal control for receivables and sales. The
auditors’ consideration of internal controls over receivables and sales may begin with
the preparation of a written narrative or flow chart and the completion of an internal
control questionnaire. As the auditors’ confirm their understanding of the sales and
collection cycle, they will observe whether there is appropriate segregation of duties,
and enquire as to who performed various functions throughout the year.
2. Assess control risk and design additional tests of controls for receivables and
sales. After obtain an understanding of the client’s internal control for receivables and
72
sales transactions, the auditors perform their initial assessment of control risk for the
variant financial statement assertions.
3. Perform additional tests and controls: Tests directed towards the effectiveness
of control help to evaluate the client’s internal control, and determine the extent to
which the auditors are justified in reducing their assessed levels of control risk for
the assertion about the receivables and sales accounts. The following are examples
of additional tests:
A. Examine significant aspects of a sample of sales transactions.
B. Compare a sample of shipping documents to related sales invoices.
C. Review the use and authorization of credit memoranda.
D. Reconcile selected cash register tapes and sales invoices with sales
journals.
4. Reassess control risk and design substantial tests. When auditors have
completed the procedures described in the preceding sections, they should assess the
extent of control risk for each financial statement assertions regarding receivables
and sales transactions. The assessment will determine the nature, extent, and timing
of auditors’ substantive tests for receivables and sales.
B. Substantive tests
1. Obtain an aged trail balance of trade accounts receivable and analyses of other
accounts receivable and reconcile to ledgers. When trial balances or analyses
of accounts receivable are furnished to the auditors by the client’s employees,
some independent verification of the listings is essential.
2. Obtain analyses of notes receivable and related interest.
3. Inspect notes on hand and confirm those not on hand with holders.
4. Confirm receivables with debtors.
5. Receive the year-end cutoff of sales transactions.
6. Perform analytical procedures for accounts receivable, sales, notes receivable,
and interest revenue.
7. Verify interest earned on notes and accrued interest receivable.
8. Evaluate the propriety of the client’s accounting for receivables and sales.
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9. Determine adequacy of allowance for uncollectible accounts.
10. Ascertain whether any receivables have been pledged.
11. Investigate fully any notes or accounts receivable from related parties.
12. Evaluate financial statement presentation and disclosure.
Check your Progress Exercise – 1

1. Which of the following can be used as substantive test for
receivables and sales transactions?
(a) Confirm receivable with debtors.
(b) Perform analytical procedures.
(c) Review the year-end cutoff of sales transactions.
(d) All of the above.
2. Which of the following is (are) primary audit objective for
receivables/sales?
(a) Clerical accuracy
(b) Existence
(c) Valuation
(d) Statement Presentation
(e) All of the above
3. Which assertions relating to receivables/sales are addressed when
auditors select a sample of sales invoices and compare details to shipping documents?
(a) Existence
(b) Ownership
(c) Valuation
(d) All
8.7 SUMMARY
Accounts receivable may be a major asset of a company and the major procedure involves
confirmation of receivable with debtors. There are a large number of controls that may be
required in the sales cycle due to the importance of this area and the possible opportunities
that exist for diverting sales away from the business and other persons benefiting.
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8.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE
1. d
2. e
3. d
1. List control objectives for a sales cycle.

2. How can analytical procedures assist in the audit of account receivables?
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UNIT 9: INVENTORY /PURCHASE AUDIT
Contents
9.1 Introduction
9.2 The auditors’ Objectives in the Examination of Inventories and Purchases
9.3 Internal Control Over Inventories and Purchases
9.4 Audit Procedures
9.5 Summary
9.6 Glossary
9.8 Model Examination Question
 identify fundamental internal controls over inventories and purchases.
 describe the auditors’ objectives for the audit of inventories.
 describe the nature of the audit procedures to accomplish the auditors’
objectives for the audit of inventories.
9.1 INTRODUCTION
Inventories are major items on the balance sheet, i.e. in total assets, especially in the current
asset section.
Inventories play also a very significant and important role in preparation of income statement
and determination of net income or loss.
This unit discusses the typical internal control procedures and the auditors’ objectives in the
examination of inventories /purchases.
The processing of purchases transactions involves the following purchasing functions:

- Requisitioning goods and services.
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- Preparing purchase orders.
- Receiving the goods.
- Storing goods received for inventory.
- Preparing the payment voucher.
- Recording the liability.
9.2 THE AUDITORS’ OBJECTIVES IN THE EXAMINATION OF INVENTORIES

AND PURCHASES
The auditors’ have the following objectives in the examination of inventories and purchases.
i. To consider internal control over inventories and purchases.
ii. To determine the existence of inventories, and the client’s ownership of these
assets.
iii. To establish the completeness of inventories and purchase transaction.
iv. To establish clerical accuracy of records and supporting schedules for
inventories and purchases.
v. To determine that the valuation inventories is based on appropriate methods.
vi. To determine the statement presentation of inventories is adequate, including
disclosure of classification of inventories, accounting records and any inventories
pledged as collateral for loans.

State the functions that apply to purchases transactions.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
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9.3 INTERNAL CONTROL OVER INVENTORIES AND PURCHASES CONTROL
OBJECTIVES
Although inventory records may vary considerably from client to client, the control objectives
of a sound system of internal control over inventories are the same in all cases, namely:
o Authorization and purchase procedures.
o Control over goods inwards.
o Inventory records substantiated by physical counts.
o Control over dispatches and goods outwards.
o Inventory levels should be controlled so that materials are available when
required but that inventory is not unnecessarily large. Control procedures over
inventories.
Internal control procedures for inventories affect nearly all the functions involved in
producing and disposing of the company’s products, purchasing, receiving, storing, issuing,
processing, and shipping are the physical functions directly connected with inventories. The
basic internal control procedures are the following:
Approval and control of documents

 Issues from inventories should be recorded only on properly authorized
requisitions.
 Reviews of damaged, obsolete and slow moving inventories should be carried out.
Any write - offs should be authorized.
Arithmetical accuracy
 All receipts and issues should be recorded on inventory
cards.
 The costing department should allocate direct and
overhead costs to the value of work – in – progress according to the stage of
completion reached.
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Control accounts
 Total inventory records may be maintained and
integrated with the main accounting system.
Comparison of assets to records

 Inventory levels should be checked against the records by a person
independent of the stores personnel, and material differences investigated.
 Where continuous inventory records are not kept adequately a full
count should be held at least once a year.
 Maximum and minimum inventory levels should be pre –
determined and regularly reviewed for adequacy.
Assess to assets and records

 Separate centers should be identified at which
goods are held.
 Inventories should be held in their locations so
that they are safe from damage or theft.
 All 8 inventories should be identified and held
together.
 Access to the stores should be restricted.
9.4 AUDIT PROCEDURES
The following audit procedures for the verification of inventories and purchases may be used
by auditors:
(A) Consider internal control for inventories and purchases

(1) Obtain an understanding of internal control for inventories and purchases.
In obtaining an understanding of internal control over inventory, the auditor
should become thoroughly conversant with the procedures for purchasing,
80
receiving, storing, and issuing goods as well as acquiring an understanding of
the cost accounting system and the perpetual records.
(2) Assess control risk and design additional tests of control for inventories and
purchases.
After obtaining an understanding of the client’s internal control over
inventories and purchases, the auditors perform their initial assessment of
control risk for the various financial statement assertions.
(3) Perform additional tests of controls.
Tests directed toward the effectiveness of controls help to evaluate the client’s
internal control and to determine the extent to which the auditors are justified
in reducing their assessed level of control risk for the assessments about the
inventory and purchase accounts.
The following are examples of typical additional test.
a. Examine significant aspects of a sample of purchase
transactions.
b. Test the cost accounting system.
(4) Reassess control risk and design substantive tests.
B. Substantive test.
1. Obtain listings of inventory and reconcile to ledgers.
2. Evaluate the client’s planning of physical inventory.
3. Observe the taking of physical inventory and make test counts.
4. Review the year – end cutoff of purchases and sales
transactions.
5. Obtain a copy of the completed physical inventory, test its
clerical accuracy, and trace test counts.
6. Evaluate the bales and methods of inventory pricing.
7. Review inventory quality and condition.
8. Perform analytical procedures.
9. Determine whether any inventories have been pledged and
review purchase and sales commitments.
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10. Evaluate financial statement presentation of inventories,
including the adequacy of disclosure.

Say true or false
1. Inventories play significant role in the preparation of both
balance sheet and income statement.
2. The financial statement assertion of valuation is not related to
inventories.
3. Adjustments to inventory records should be authorized.
4. Efficient and effective inventory taking requires careful
planning in advance.
5. Auditors should not observe the quality or condition of
inventories
9.5 SUMMARY
This unit discusses the following key points for inventories and purchases:
o Inventory controls focus goods movements, authorization procedures and
physical counts.
o Tests of control for inventory focus on material movement authorization, and
the control of inventory against records.
o The observation of physical count by auditors helps them to identify an
inventory of questionable quality or condition.
9.6 GLOSSARY
Confirmation: - A type of documentary evidence that is created outside the client and
transmitted directly to the auditors.
Observation: - The auditors’ evidence – gathering technique that provides physical evidence.
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Purchase commitment: - A contractual obligation to purchase goods at fixed prices, entered
into well in advance of scheduled delivery dates.
Sales commitments: - A contractual obligation to sell goods at fixed prices, entered into well
in advance of scheduled delivery dates.
9.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISE

B. Refer Section 9.3

1. True 2. False 3. True 4. True 5. False
83
9.8 MODEL EXAM QUESTION
The observation of a client’s physical inventory is mandatory auditing procedure when

practicable and possible for the auditors to carry out and when inventories are material.
Required
a. Why is the observation of physical inventory a
mandatory procedure? Explain.
b. Under what circumstances is observation of physical
inventory impracticable or impossible?
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UNIT 1: OVERVIEW OF AUDITING

1.0 AIMS AND OBJECTIVES

1.2 DEFINITION AND BASIC FEATURES OF AUDITING

1.3 DEMAND FOR AUDIT

1.4 ACCOUNTING VS AUDITING

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

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

1.5 TYPES OF AUDITS AND AUDITORS

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

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

Check you Progress Exercise – 2

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

Auditing in Ethiopia could be viewed in five main areas.

- Audit of financial statements:

1.9 ANSWER TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise – 1

Check Your Progress Exercise – 2

Part I. Short Answer

Part II. Multiple Choices

UNIT 2: THE AUDITING PROFESSION

2.0 AIMS AND OBJECTIVES

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

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

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

 Non audit functions and services: - Certain functions are

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

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

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

2.3 PROFESSIONAL QUALIFICATION REQUIREMENTS

2.4 PROFESSIONAL ETHICS

- Integrity: - An accountant should be

2.5 LEGAL RESPONSIBILITY AND LIABILITY OF AUDITORS

Responsibilities impose liabilities if things go wrong.

Liable for what?

Fraud: is defined a misrepresentation by a person of a material fact, known by that person to

Privity: is the relationship between parties to a contract.

B. Auditors’ liability to third parties

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

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

2.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress Exercise – 1

Check Your Progress Exercise – 2

Part I. Short Answer

Part II. Select the Best Answer

3.0 AIMS AND OBJECTIVE

3.2 AUDIT OBJECTIVES

Check Your Progress Exercise-1

3.3 AUDITING PRINCIPLES

(a) Integrity, objectivity and independence.

3.4 AUDIT STANDARDS

Check Your Progress Exercise -2

3.5 AUDIT PLANNING AND AUDIT PROGRAM

The first standard of fieldwork states:

In planning the audit the auditor needs to consider the following:

(a) Client acceptance

(b) Obtaining the engagement

(d) Developing an overall audit strategy

(e) Audit plans

1. Description of the client’s company-its structure, nature of business, &