Chapter One

Introductions of Auditing
1.1 Definition of auditing
 Auditing is defined as 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.
 This description of auditing includes several key

words and phrases. Each of them is discussed in

this section briefly.
 Information and established criteria: To do an
audit, there must be information in a verifiable form
and some standards [criteria] by which the auditor can
evaluate the information.
 Accumulating and evaluating evidence: Evidence
is defined as any information used by the auditor to
determine whether the information being audited is in
accordance with the established criteria.
 Competent, independent person: The auditor must be
qualified to understand the criteria used and competent
to know the types and amount of evidence to
accumulate to reach the proper conclusion after the
evidence has been examined.
 Reporting: The final stage in the audit process is the

audit report, which is the communication of the

findings to users
1.2 Professional and legal liabilities
of auditor
1.2.1 . PROFESSION
 A profession is a vocation of the highest

standing.
 It calls on its members to serve the public by

offering to them highly technical and always

confidential advise and services, which
require a different standard of conduct from
the tradesman
Characteristics of Profession

 Specialized Body of Knowledge 

A highly developed profession has a very highly
specialized written body of knowledge.  
 Standard of qualification of admission 

A profession to be a profession must have well-

recognized and accepted predetermined criterion
of qualification for admission in to the profession.
The standards include educational requirements as
well as other normal and legal criteria fulfillment.
 Standard Conduct of behavior 
A profession has standard of conduct of behavior to be observed by the professional
through prescribed code of ethics that attempt to enforce general rule conduct, and
maximum and mini mum rules on competency and responsibility to client and
colleagues.

Good example of such code of conduct is the "Oath of Hippocrates" which is sworn
by medical doctors at their graduation.  
 Level of status recognition Auditing 

The quality and level of professional services demanded by society determines the
level of status and recognition to the profession.

The level of status and recognition earned in a society is a function of the quality of
professional service rendered which in turn are a function of standard of professional
qualification and the degree of the social, moral and legal responsibility assumed.  
 Acceptance of social responsibility and legal liability
A profession to be a Profession must accept
responsibility for the consequences of its action. Not only
legal responsibility which arises out of the contractual
obligation, but also moral responsibility to the profession
itself and the profession to the society at large
1.3 Fundamental Principles Of Auditing

 In order to achieve the objectives of auditing profession, auditors have to

observe a number of prerequisites or fundamental principles. The
fundamental principles are:
1. Integrity: Auditors should be straightforward and honest in performing
professional services.
2. Objectivity: Auditors should be fair and should not allow prejudice or
bias, conflict of interest or influence of others to override objectivity.
3. Professional Competence and Due Care: Auditors 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 developments in
practice, legislation and techniques.
4. Confidentiality: Auditors should respect the
confidentiality of information acquired during the
course of performing professional services and should
not use or disclose any such information without
proper and specific authority or unless there is a legal
or professional right or duty to disclose it.
 5. Professional Behavior: Auditors must act in a manner consistent with the
good reputation of the profession and refrain from any conduct which might
bring discredit to the profession.
6. Technical Standards: Auditors should carry out professional services in
accordance with the relevant technical and professional standards.
 Auditors have a duty to carry out with care and skill, the instructions of the

client or employer insofar as they are compatible with the requirements of

integrity, objectivity and, in the case of professional accountants in public
practice. In addition, they should conform to the technical and professional
standards promulgated by:
 IFAC (e.g., International Standards on Auditing);

 International Accounting Standards Board;

 The member’s professional body or other regulatory body; and

 Relevant legislation.
1.3 Legal Liability And Responsibility Of Auditors

 Definition of Legal Terms  

 Discussion of auditor’s liability is best described by defining some of the
common terms of the business law. The following are few to mention
 Ordinary or Simple Negligence: Absence of reasonable care that can be
expected of a person in a set of circumstances. When negligence of an
auditor is being evaluated, it is in terms of what other competent auditors
would have done in the same situation.
 Gross Negligence (also called recklessness or constructive fraud): is a
serious occurrence of negligence tantamount to a flagrant or a reckless
departure from the standard of due care. These terms are frequently used
interchangeably and are equivalent to sloppy auditing or lack of a
reasonable basis for a belief. Lack of even slight care in discharging
responsibility.

 Fraud: Knowledge (intentionally) misrepresenting facts to
decide the other party and with the result that the party is
injured. It occurs when a CPA issue an opinion on the
financial statement knowing that the financial statements
or the audit report thereon is false.
 Privity of contract: is the relationship between two or
more parties that creates contractual duty. In auditing,
context, the CPA and the client have a privity or a
contractual relationship that is usually established by a
contract called an engagement letter.
 An engagement Letter: A written letter contract
summarizing contractual relationship between the
auditor and client.
 Breach of Contract: Failure of one or both parties in a

contract to fulfill the requirements of the contract

Auditors Legal Liability To Client

 A typical lawsuit involves a claim that the auditor did not

discover an employee defalcation (theft of assets) as a
result of negligence in the conduct of the audit.
 The lawsuit can be for breach of contract,
 a tort action for negligence, or both. Tort action (wrongful
act or damage (not involving breach of contract) for which
an evil action can be brought) can be based on ordinary
negligence, gross negligence or fraud. Tort actions are
common because the amounts recoverable under them are
normally larger than under breach of contract.
1.4 Auditors Responsibility for Detecting Misstatements

 The auditors have responsibility to plan and perform

the audit to obtain reasonable assurance about whether
the financial statements are free of material
misstatement of either caused by error or fraud.
 Reasonable Assurance: Assurance is a measure of

level certainty that the auditor has obtained at the

completion of the audit.
 Reasonable assurance is not defined in the literature,

but it is presume less than certainty or absolute

assurance and more than low level of assurance.
Why not absolute assurance?
 The fact that auditing is based on sample base, there is

no assurance for the absence of error/fraud in the

amounts not included in the sample.

 The other reason is that, some frauds are so

professionally canceled that the application of GAAS
will not reveal it. Hence, with these limitations the
auditor cannot provide absolute assurance
THE NEED FOR FINANCIAL STATEMENT AUDIT

 Financial information users, especially external users

may need an independent verification of the fairness of
information stated in financial statements.
 Because there is a likely hood that unreliable
information may be provided to decision makers for
reason of :
a. Conflict of interest (biases and motives of
provider): The information may be biased in
favor of the provider. Such as misstatement of
the information
 In a lending decision, to enhance the chance

of obtaining loan
 Misstating revenues to attract investors
C. Improperly recorded information: As the
entity become larger, so does the volume of
their exchange transaction. This increases the
likely hood that improperly recorded
information will be in the report
D. Complex exchange transaction: exchange
transaction between entities have become
increasingly complex and hence more difficult
to record properly.
GENERALLY ACCEPTED AUDITING STANDARD (GAAS)

 Basic principles governing an audit issued by the Institute of Chartered

Accountants of USA that govern an independent audit of financial
information are as follows:
A. GENERAL STANDARDS.
1. Adequate training and proficiency
2. Independence in mental attitude
3. due professional care
B. STANDARDS OF FIELD WORK
1. Proper planning and supervision
2. Sufficient understanding of internal control
3. Sufficient competent evidence
C. STANDARDS OF REPORTING
1. Whether statements are prepared in accordance with GAAP
2. Circumstances when GAAP not consistently followed
3. Adequacy of information discloser
4. Expression of opinion on financial statement.
MATERIALITY AND THE AUDITOR

 Materiality is an essential consideration in determining

the appropriate type of report for a given set of
circumstances.
Cont…
 So what is the concept of materiality? The common
definition of materiality as it applies to accounting and,
therefore, to the audit is:
 A misstatement in the financial statement can be

considered material if knowledge of the misstatement

would affect a decision of a reasonable user of the
statement.
 In applying this definition, three grading of materiality

are used for determining the type of opinion to issue.

Cont…
1. Amounts are immaterial : When a
misstatement in the financial statements
exist, due to of the two conditions
a. scope restricted by client or by
circumstances or
b. statements are not in accordance with
GAAP, but is unlikely to affect the decisions
of a reasonable user, it is considered to be
immaterial.
Cont…
2. Amounts are material but do not overshadow
the financial statement as a whole: The second
level of materiality exists when a misstatement
in the financial statement would affect a users'
decision, but the overall statements are still
fairly stated, and therefore, useful.
For example, knowledge of a large
misstatement in permanent assets might affect
a user's willingness to loan money to a company
if the assets were the collateral.
Cont…
3. Amounts are so material or so pervasive that
overall fairness of statements is in question:
ERROR AND FRAUD
Error – An error represents an unintentional
misstatement of the financial statement. It may be
material or immaterial.
 Mistake in gathering and reporting data
 Mistake in application of GAAP
 Unintentional omission of amount
 Informative disclosure on financial statement.
Cont…
Fraud: Fraud represents an intentional misstatement of
the financial statement which can be material or
immaterial. The misstatement due to fraud may occur
due to either of:
 Misappropriation of assets defalcations or employee

fraud. E.g. theft of cash or another asset.

 Fraudulent financial reporting often called management

fraud. E.g. intentional misstatement of sales near the

balance sheet date to increase reported earnings.
TRUTH AND FAIRNESS

 The term truth and fairness are essential

elements of audit report. There is no
statutory or professional definition of truth
and fairness.
 Truth and fair is a technical in the phrase to

be looked at as entirely. In general, the word

"true" means, information is factual confirms
to reality, not false.
Cont…
The information confirms with standards.
Fairness means; clear distinct and plain
 Impartial, not biased or
 Just and equitable

To show true and fairness accounts must be

prepared
 In accordance with GAAP
 On constant basis so as not to be misleading
 The accounts must be taken from books and

records.
CLIENT ACCEPTANCE PROCEDURE
The auditor should review the following points.
1. Prior Audit Review: Review the reasons why
a company is looking for a new auditor. It
may be the company is performing due
diligence and looking for a lower cost
option for audit reviews, or the company
may be a new firm that has just increased
revenues to the point where it needs an
audit.
Cont…
2. Ratings and Public Records: The financial ratings
and public records of a company should be reviewed
before an audit client is accepted.
 Review credit reports,
 legal history,
 tax problems,
 litigation records, r
 Regulatory actions,
 bankruptcy issues,
 consumer complaints and professional liability

claims
Cont…
3. Reputation: Your reputation as an auditing
firm is partly based on the companies you
audit.
 Ensure the image of your auditing firm by

only accepting clients who share the same

ethical and business integrity foundation as
your firm.
 Interview senior management and executives

to gain an understanding of their business

principles
 Business Structure: Review the business
structure of a potential client.
 Look for red flags such as overseas plants or

operating facilities, high turnover in upper

management and a short operating history
 UNIT TWO
Auditor's report
 The Auditor's report is a formal opinion, or disclaimer
thereof, issued by either an internal auditor or an
independent external auditor as a result of an internal or
external audit or evaluation performed on a legal entity or
subdivision thereof (called an “auditee”).
 Reports are essential to audit and assurance
engagement, because they communicate the
auditor’s findings. Users of financial statement
rely on the auditor’s report to provide assurance
on the company’s financial statement.
2.1 Components of Audit Report
 To enable users understand audit report, professional standards
provide uniform wording for auditor’s report.
 An audit report has to contain a minimum of the following seven
parts.

 1. Report title: - Auditing standard requires that the report be

titled and that the title include the word “independent”.
 For example, appropriate title would be “independent auditors
report”, “report of independent auditors”, or “independent
accountant’s opinion”.
 The requirement that the title includes the word independent is
intended to convey to users that the audit was unbiased
2. Audit Report Address: - the report is usually
addressed to the company, its stockholders or
board of directors
3. word “independent”.: - The first paragraph of the
report does three things:-
 It makes a simple statement that CPA firm has conducted

an audit to distinguish it from review or compilation.

 It state financial statements that were audited in the

wordings given by management together with exact dates

or periods
 It shows that the statements are the responsibilities of

managers and the auditors work is to give an opinion to

indicate that the selection of GAAP is up to managers.
4. Scope Paragraph: - The scope paragraph is a factual
statement about what the auditor did in the audit.
 This paragraph first states that the auditor followed

generally accepted auditing standards.

 The remainder briefly describes important aspects of an

audit.
 The scope paragraph states that the audit is designed to

obtain reasonable assurance about whether the

statements are free of material misstatement.
5. Opinion Paragraph: The final paragraph in the
standard report states the auditors conclusions based on
the results of the audit.
 This part of the report is so important that often the

entire audit report is referred to simply as the auditor’s

opinion.
 The opinion paragraph is stated as an opinion rather

than as a statement of absolute fact or a guarantee.

 The intent is to indicate that the conclusions are based

on professional judgment.
 The auditor is required to state an opinion about
financial statement taken as a whole, including the
conclusion about whether the company followed
Generally Accepted Accounting Principles.
 Financial statements are presented fairly when the

statements are in accordance with generally accepted

accounting principles but that it is also necessary to
examine the substance of transactions and balances for
possible misinformation
6. Name of CPA Firm: the name identifies the
CPA firm or practitioner who performed the
audit
7. Audit Report Date: The appropriate date for
the report is one on which the auditor has
completed the most important auditing
procedures in the field
Kinds of Audit Opinion

 There are five common types of auditor’s

reports, each one presenting a different
situation encountered during the auditor’s
work.
1. Standard Unqualified Opinion Report
2. Unqualified opinion with explanatory
paragraph or modified wording
3. Qualified opinion Report
4. Adverse Opinion Report
5. Disclaimer of opinion Report
1. Standard Unqualified Audit Report
This type of report is issued by an auditor when:
 All statements- B/S, I/S or R/E and
statements of cash flow-are included in the
financial statement.
 The general standards have been followed in

all respects on the engagement

 Sufficient evidence has been accumulated
 The F/S are presented in accordance with

GAAPs
 There are no circumstances requiring the
additions of an explanatory paragraph or
modification of the wording of the report
 The standard unqualified audit report is sometimes
called a clean opinion, because there are no
circumstances requiring a qualification or modification
of the auditor’s opinion.
2.Unqualified Audit Report with Explanatory Paragraph or Modified
Wording

 The unqualified audit report with explanatory

paragraph or modified wording meets the criteria of a
complete audit with satisfactory results and financial
statements that are fairly presented, but the auditor
believes it is important or is required to provide
additional information.
 The followings are the most important causes
of the addition of an explanatory paragraph or
a modification in the wording of the standard
unqualified report.
1. Lack of consistent Application of GAAP
2. Consistency versus Comparability
3. Substantial Doubt about Going Concern
3. Qualified, Adverse and Disclaimer Audit Reports

 The three conditions requiring departure from

unqualified audit report are:
1. The scope of the audit has been restricted
2. Financial statements have not been prepared in
accordance with generally accepted accounting
principles
3. The auditor is not independent
3. Qualified Opinion Report
 A Qualified Opinion report is issued when the

auditor encountered one of the two types of

situations which do not comply with generally
accepted accounting principles, however, the
rest of the financial statements are fairly
presented.
 The two types of situations which would cause an auditor to
issue this opinion over the unqualified opinion are:
 Deviation from GAAP – this type of qualification occurs when
one or more areas of the financial statements do not conform
with GAAP (e.g. are misstated), but do not affect the rest of the
financial statements from being fairly presented when taken as a
whole.  
 Limitation of Scope - this type of qualification occurs when the
auditor could not audit one or more areas of the financial
statements, and although they could not be verified, the rest of
the financial statements were audited and they conform with
GAAP
 4. Adverse Opinion Report
 An Adverse Opinion is issued when the auditor determines

that the financial statements of an auditee are materially

misstated and, when considered as a whole, do not
conform to GAAP.

 It is considered the opposite of an unqualified or clean

opinion, essentially stating that the information contained
is materially
 incorrect,
 unreliable, and
 inaccurate in order to assess the auditee’s financial
position and results of operations.
 Investors, lending institutions, and governments very
rarely accept an auditee’s financial statements if the
auditor issued an adverse opinion, and usually request
the auditee to correct the financial statements and
obtain another audit report
5. Disclaimer of Opinion Report
 It commonly referred to simply as a
Disclaimer, is issued when the auditor could
not form, and consequently refuses to
present, an opinion on the financial
statements.
 This type of report is issued when the auditor

tried to audit an entity but could not

complete the work due to various reasons
and does not issue an opinion
Auditing Standards provide certain situations where a
disclaimer of opinion may be appropriate:
A. A lack of independence, or material conflict(s) of
interest, exist between the auditor and the auditee
B. There are significant scope limitations, whether
intentional or not, which hinder the auditor’s work in
obtaining evidence and performing procedures
C. There is a substantial doubt about the auditee’s ability
to continue as a going concern or, in other words,
continue operating
D. There are significant uncertainties within the auditee