CHAPTER ONE

1. AN OVERVIEW OF AUDITING
1.1. Origin and Evolution of Auditing
The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days an
auditor used to listen to the accounts read over by an accountant in order to check them.

Auditing is as old as accounting. It was in use in all ancient countries such as Mesopotamia,
Greece, Egypt, Rome, U.K. and India.

The original objective of auditing was to detect and prevent errors and frauds.

Auditing evolved and grew rapidly after the industrial revolution in the 18th century with the
growth of the joint stock companies the ownership and management became separate. The
shareholders who were the owners needed a report from an independent expert on the accounts
of the company managed by the board of directors who were the employees.

Furthermore, during the 18th century industrial revolution brought in large scale production,
steam power, improved facilities and better means of communication. This resulted in the origin
of Joint stock form of organizations. Shareholders contribute capital of these companies but do
not have control over the day to day working of the organization. The shareholders who have
invested their money would naturally be interested in knowing the financial position of the
company. This originated the need of an independent person who would check the accounts and
report the shareholders on the accuracy of the accounts and the safety of their investment.

In general the following factors necessitate the need for development of modern auditing:
 Increase in size and complexity of business organizations: Post industrial revolution
businesses were increased in number and complexity of transactions.
 Divorce between ownership and management: Owners (shareholders) were separated from
management affairs.
 Legislative control: Government also an interest to ensure that businesses are performing
with in framework and standards. E.g. see commercial code Art. 368-380.

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Therefore, the objective of audit shifted and audit was expected to ascertain whether the accounts
were true and fair rather than detection of errors and frauds.

1.2. Definition and Nature of Auditing

Definitions of Auditing
Auditing is “a systematic and independent examination of accounting data, statements, records,
vouchers, operations and performances of an enterprise to give a true and fair view of financial
statements.” Or Auditing is an examination of accounting records undertaken with a view to
establish whether they correctly and completely reflect the transactions to which they relate.

Audit is an independent examination of financial statements of an entity that enables an auditor

to express an opinion whether the financial statements are prepared (in all material respects) in
accordance with an identified and acceptable financial reporting framework (e.g. international or
local accounting standards and national legislations). Or an audit is a systematic process of
objectively obtaining and evaluating evidence regarding assertions about economic actions and
events to ascertain the degree of correspondence between these assertions and established
criteria, and communicating the results to interested users.

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, independent person. (Arens 14th Edition)

Nature of Auditing
 Audit is a systematic and scientific examination of the books of accounts of a business;
 Audit is undertaken by an independent person or body of persons who are duly qualified
and competent for the job. The auditor must be qualified to understand the criteria used and
must be competent to know the types and amount of evidence to accumulate to reach the
proper conclusion after the evidence has been examined. The competence of the individual
performing the audit is of little value if he or she is biased in the accumulation and evaluation
of evidence.
 Audit is done on the basis of proper evidence (evidential documents like vouchers, receipts,
invoices and etc. Evidence is any information used by the auditor to determine whether the
information being audited is stated in accordance with the established criteria. Thus, Audit is

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 done with the help of vouchers, documents, information and explanations received from the
authorities.
 Audit is a verification of the results shown by the profit and loss account and the state of
affairs as shown by the balance sheet.
 Audit is a critical review of the system of accounting and internal control.
 The auditor has to satisfy himself with the authenticity of the financial statements and report
that they exhibit a true and fair view of the state of affairs of the concern.
 Auditors finally put their expressions of opinion as to the truth and fairness of financial
accounts. The final stage in the auditing process is preparing the Audit Report, which is the
communication of the auditor’s findings to users.

1.3. Accounting Vs. auditing

Most of the users of financial statements and publics confuse auditing with accounting because
of the following points.
Most auditing concerns with accounting information.
Auditors have considerable expertise and knowledge in accounting.
The title “CPA” given for all.

However, Auditing is different from accounting based on the following points.

Points of difference Accounting Auditing
Accounting is the Auditing is determining
1. Meaning identifying, measuring,
process
recording,
of
whether recorded information
classifying, and summarizing of properly reflects the economic
economic events for the purpose of events that occurred during the
providing financial information used accounting period as per U.S.
in decision making. or international accounting
It is recording of all the day to day standards criteria.
transactions in the books of accounts It is the critical examination of
to preparation of financial the transactions recorded in
statements. the books of accounts.
2. Scope It concerned with the preparation of It concerned with checking of
financial statements. It involves accounts. It depends upon the
maintenance of books of accounts. It agreement or upon the
does not go beyond books of provisions of law. It goes
accounts beyond books of accounts.
3. Objective To know financial results and To verify the truth or fairness
financial position. of accounts.

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4. Nature of work Accounting is constructive in nature. Auditing is analytical in
It is concerned with nature. It is concerned with
finalization of accounts. establishment of reliability of
financial statements.
5. Guiding Principles Accounting is guided by GAAP Auditing is guided by GAAS

6. Qualification Accountants need not to be Auditors need to be chartered

chartered Accountant. Accountant.
7. End result Accountants produce financial Auditors produce audit report.
statements.
8. Commencement Accounting starts from Auditing begins when
bookkeeping. accounting ends.

 Bookkeeping Vs. Accounting

Bookkeeping is the process of recording daily activities of the business, including receipts,
payment, purchases, sales and expenditure. A bookkeeper is usually hired in medium to large
companies that is responsible for recording these transactions. Bookkeeping is considered as a
small part of accounting. Accounting uses the books in order to create the financial statements.
Bookkeeping involves recording each and every transaction that happens in the day, which is
then tallied at the end of the day and the end of the month.

 Auditing Vs. Investigation

The process of inspecting the books of accounts of an entity and reporting on it is known as
Auditing. It is general Examination.

Investigation is an effort made to find out the facts, behind a particular situation, in order to
discover the truth. An inquiry conducted, for establishing a specific fact or truth is known as
investigation. It is critical and in depth examination.

1.3. Type of Audit and Auditors

Type of Audit
1. Operational audit is a review of any part of an organization’s operating procedures and
methods for the purpose of evaluating efficiency and effectiveness. This type of audit is
called performance audit or management Audit. It is more difficult to objectively evaluate
whether the efficiency and effectiveness of operations meets established criteria than it is for
compliance and financial statement audits. Also, establishing criteria for evaluating the

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 information in an operational audit is extremely subjective. In this sense, operational
auditing is more like management consulting than what is usually considered auditing. The
aim of operational audit is to forward recommendation to the management for improving the
operation.

2. Compliance audit is (1) a review of an organization’s financial records performed to

determine whether the organization is following specific procedures, rules, or regulations set
by some higher authority; (2) an audit performed to determine whether an entity that receives
financial assistance from the federal government has complied with specific laws and
regulations. The objective is to determine whether the organization is operating as per the
procedure. Results of compliance audits are typically reported to management, rather than
outside users, because management is the primary group concerned with the extent of
compliance with prescribed procedures and regulations. Therefore, a significant portion of
work of this type is often done by auditors employed by the organizational units.

3. Financial statement audit is an audit conducted to determine whether the overall financial
statements of an entity are stated in accordance with specified criteria (usually U.S. GAAP or
international accounting standards). Usually performed by a firm of CPA.

Examples of the three types of Audits

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Types of Auditors
1. Internal Auditors are auditors employed by all types of organizations to audit for the
company’s board of directors and management. Internal auditors’ responsibilities vary
considerably, depending on the employer. Especially they produce operational audit.
2. External Auditors are Certified public accountants (CPAs) who perform all types of audit on
fee bases. Certified public accounting firms are responsible for auditing the published
historical financial statements of all publicly traded companies, most other reasonably large
companies, and many smaller companies and noncommercial organizations. Because of the
widespread use of audited financial statements in the U.S. economy, as well as
businesspersons’ and other users’ familiarity with these statements, it is common to use the
terms auditor and CPA firm synonymously, even though several different types of auditors
exist. The title certified public accounting firm reflects the fact that auditors who express audit
opinions on financial statements must be licensed as CPAs. CPA firms are often called
external auditors or independent auditors to distinguish them from internal auditors. Most of
the time they produce financial statement audit.
o Independent auditors are certified public accountants or accounting firms that perform
audits of commercial and noncommercial financial entities.
o Criteria to be an independent auditor is differs from country to country but in Ethiopia:
 Higher level of educational qualification
 Two years experience
 Qualification of CPA (ACCA)
3. Government Auditors are auditors employed by local, regional, or federal government.
Especially they produce Compliance audit.
4. Internal revenue agents are auditors who work for the Internal Revenue Service (IRS) and
conduct examinations of tax payers’ returns.
5. Government accountability office auditor is an auditor working for the U.S. Government
Accountability Office (GAO); the GAO reports to and is responsible solely to Congress.

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1.4. Objectives of Auditing
There are two main objectives of auditing. They are primary objective and the secondary.
A. Primary objective – as per Section 227 of the Companies Act 1956, the primary duty
(objective) of the auditor is to report to the owners whether the balance sheet gives a true and
fair view of the company’s state of affairs and the profit and loss account gives a correct
figure of profit of loss for the financial year.
B. Secondary objective – it is also called the incidental objective as it is incidental to the
satisfaction of the main objective. The incidental objective of auditing are:
i. Detection and prevention of Frauds, and
ii. Detection and prevention of Errors.
 Fraud refers to intentional misrepresentation of financial information with the intention to
deceive. It is the willful misrepresentation made with an intention of deceiving others. It is
also a deliberate mistake committed in the accounts with a view to get personal gain. In
accounting, fraud means two things. Frauds can take place in the form of manipulation of
accounts, misappropriation of cash and misappropriation of goods. It is of great
importance for the auditor to detect any frauds, and prevent their recurrence.

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 Errors refer to unintentional mistake in the financial information arising on account of
ignorance of accounting principles i.e. principle errors, or error arising out of negligence of
accounting staff i.e. Clerical errors.

1.5. Economic demand for Auditing

Information risk reflects the possibility that the information upon which the business risk
decision was made was inaccurate. Thus, Auditing can have a significant effect on information
risk.

Causes of Information Risk

a) Remoteness of Information In a global economy, it is nearly impossible for a decision

maker to have much firsthand knowledge about the organization with which they do
business. When information is obtained from others, the likelihood of it being intentionally
or unintentionally misstated increases.
b) Biases and Motives of the Provider If information is provided by someone whose goals are
inconsistent with those of the decision maker; the information may be biased in favor of the
provider.
c) Voluminous Data As organizations become larger, so does the volume of their exchange
transactions. This increases the likelihood that improperly recorded information is included
in the records—perhaps buried in a large amount of other information.
d) Complex Exchange Transactions In the past few decades, exchange transactions between
organizations have become increasingly complex and therefore more difficult to record

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 properly. For example, the correct accounting treatment of the acquisition of one entity by
another poses relatively difficult accounting problems.

Reducing Information Risk

i. User Verifies Information The user may go to the business premises to examine records and
obtain information about the reliability of the statements. Normally, this is impractical
because of cost. In addition, it is economically inefficient for all users to verify the
information individually. Nevertheless, some users perform their own verification. For
example, the IRS does considerable verification of business and individual tax returns to
determine whether the tax returns filed reflect the actual tax due the federal government.
ii. User Shares Information Risk with Management There is considerable legal precedent
indicating that management is responsible for providing reliable information to users. If users
rely on inaccurate financial statements and as a result incur a financial loss, they may have a
basis for a lawsuit against management. A difficulty with sharing information risk with
management is that users may not be able to collect on losses. If a company is unable to
repay a loan because of bankruptcy, it is unlikely that management will have sufficient funds
to repay users.
iii. Audited Financial Statements Are Provided The most common way for users to obtain
reliable information is to have an independent audit. Typically, management of a private
company or the audit committee for a public company engages the auditor to provide
assurances to users that the financial statements are reliable.

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