Principles of Auditing

Principles of Auditing
University Of Gondar
Faculty of Managements Sciences and Economics

(Distance Education)
Principles of Auditing-I Module for Distance Education
Credit hour- 3
Prepared by Gardachew Worku
Reviewed by P.L. Madhava Rao
July 2008
University of Gondar, Faculty of management sciences and Economics/ Distance education

Course outline
Unit-One: An overview of auditing…………………………………………….…..5
1.1 Meaning and nature of auditing…………………………………….…….6
1.2 Need for auditing…………………………………………………………8
1.3 auditing Vs Accounting ………………………………………………...11
1.4 Types of audit …………………………………………………………..13
1.5 Types of auditors………………………………………………………..17
1.6 Influential auditing principles developing firms…………………….…..20
Unit -Two: The auditing profession:………………………………..…………….25

2.1 Building blocks of a profession ……………………….………………….26
2.2 Generally accepted auditing standards (GAAS)……….…………………..30
2.2.1 General standards……………………………….…..…………….31
2.2.2 Field work standards………………………….….………………34
2.2.5 Reporting standards………………………….…………………..36
2.3 Legal responsibility and liability of auditors………….…………………..38
Unit-Three: Planning and conducting an audit…………………………….……46

3.1 Meaning of audit planning……………………………..…….…….……..47
3.2. Importance of audit planning…………………….....……….….………..48
3.3 Materiality and audit risk……………………………………..…………..59
3.4 Audit sampling…………………………………..…………………..…….61
Unit-Four: Internal control…………………………………….…………………70

4.1 meaning of internal control…………………………..…………..………71
4.2 Need for internal control…………………………..…………..…………72
4.3 Accounting Vs administrative control…………..………….……………73

4.4 Components of internal control……………………………………….…75

4.5 Internal control and control risk…………………………………..……..79
4.6 Limitations of internal control…………………………………………...82
Unit-Five: Audit evidence:………………………………………………………..88

5.1 Nature of audit evidence……………………………………………..…89
5.2 Audit objectives and financial statement assertions……………………..92
5.3 Types of audit evidence…………………………………………………95
5.4 The relation ship of evidence to audit risk………………………………99
5.5 Subsequent events as audit evidence……………………………...……100
5.6 Working papers…………………………………………………...…….104
Unit-Six: Audit reports…………………………………………………………..110

6.1 Nature of audit report……………………………………………………111
6.2 Components of audit report ……………………………………….…….112
6.3 Types of audit report………………………………………………..……117
Unit-seven: Auditing in Ethiopia ………………………..…………………..…..132
7.1 Office of the auditor General …………………….………………..….….133
7.2 Audit Service Corporation……………………………………….…...…..138
7.3 Private auditing firms……………………………………………...….…..139
7.4 Commercial Code of Ethiopia and Auditing……………………...….…..140
Answer key for self test exercises…………………………………………………143
Glossary……………………………………………………………………………..146
References…………………………………………………………………..………149

Course Introduction
Dear student, welcome to the course Principles of Auditing. You will benefit a lot from
this course as an auditor of the organization, as an investor, as an owner of a business or as
a person with a managerial position in any organization.
The need for auditing the financial statements prepared by accountants is obvious when
you consider the way most business firms are managed today. In today’s business
environment, the management of the business is separated from ownership. The owners
follow up the performance of the management of their business through financial
statements. In addition other users of the financial statements need reliable financial reports
for their decision-making regarding the performance of the organization. There fore, there
is a need for some independent person to examine the financial statements and to lend
credibility to those financial statements produced by the management of the business.
An audit is an independent examination of some particular activity. The type of audit
we are primarily concerned with throughout this module is an examination of a company’s
financial statements. This course provides you with the knowledge of how audits are
performed with a focus on financial statement audit.
The course pre-supposes your knowledge of accounting concepts and principles.
This course has been organized in to seven units: The first unit deals with an overview of
auditing, the second unit deals with the profession of auditing, the third unit deals with
audit planning, the fourth unit deals with internal control, the fifth unit deals with audit
evidence, the sixth unit deals with audit reports and the last unit deals with an overview of
auditing in Ethiopia.
There are in-text questions that require you to stop and think of what you have read. So you
are advised to answer those questions before you proceed with your reading. There are also
learning objectives and self test exercises in each unit that are very essential in enhancing
your learning.

UN IT -ONE
AN OVERVIEW OF AUDITING
Introduction
This unit presents background information about the nature of auditing. It describes what
auditing is and why it is needed. More over, it introduces you to various types of audits and
auditors. Auditing is the accumulation and evaluation of evidence about information to
determine and report on the degree of correspondence between the information and the
established criteria.
This unit provides an overview of an audit. For those readers who have relatively little
knowledge about the conduct of an audit engagement this overview is intended to introduce
the important auditing concepts
Objectives:
After studying this unit, you will be able to:

 Define auditing
 Describe various reasons why auditing is needed
 Distinguish between auditing and accounting
 Describe the various types of auditors and audits and
 Describe the influential auditing principles developing firms

1.1 Meaning and nature 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.
Accounting principles board (APB), American Accounting Association (AAA) and
International Federation of Accountants (IFA) have defined auditing in several ways. But
these definitions are in harmony with each other in stating the meaning, objective, and end
product of auditing. Therefore, we will discuss the most poplar definitions that are provided
by the above professional accounting associations.
Accounting principles Board (APB): According to APB, Auditing is an exercise whose

objective is to enable auditors to express an opinion, whether the financial statements give
true and fair view of the entity’s affairs at the end of the period (balance sheet) and its
profit and loss for the period then ended and whether they have been properly prepared in
accordance with the applicable recording framework, where statutory and other
requirements prescribe the term.
International Federation of Accountants (IFA): An audit is an independent examination

of financial information of an entity, whether profit-oriented or not and irrespective of its
size or legal form, when such an examination is connected with a view to expressing an
opinion thereon.
The American Accounting Association (AAA) defines auditing as follows:

Auditing is a systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events to determine the degree of correspondence

between the assertions and established criteria and communicating the results to interested
users.
This definition contains the following key words and phrases which are important in a
wide variety of audit practices.
 Systematic Approach: Auditing is purposeful and logical and it is based on the disciplines
of a structured approach to decision making. It is not haphazard, unplanned or unstructured.
 Obtaining and evaluating evidence: auditing involves a process of obtaining and
evaluating evidence that ultimately guides the auditor’s decision. Evidence is any
information used by the auditor’s to determine whether the information being audited is
stated in accordance with the established criteria.
 Assertions about Economic actions and events: In any audit engagement, an auditor is
given financial statements and other disclosures by management. Through these reports the
auditor obtains managements’ explicit assertions about economic events and events
 Ascertain the degree of correspondence between the assertions and economic criteria
The purpose of obtaining and evaluating evidence is to ascertain the degree of
correspondence between the assertions and established criteria.
 Established criteria: In auditing the auditor checks if financial statements are prepared in
accordance with some established and accepted criteria or standard. The criteria usually
used are called generally accepted accounting standards(GAAP)
 Communicating the results: Auditors will ultimately communicate their findings to
interested users through their final audit report.
The above definition of auditing is more general. In more specific terms: auditing is a
work performed by an auditor to enable him/her to express an opinion on whether the
financial statements are prepared in all material respects in accordance with generally
accepted accounting principles (GAAP). An important point that you should note here is
that an auditor doesn’t certify or guarantee that the financial statements are correct. He/she
just gives an opinion as to whether the financial statements are free from material
misstatements.

Thus an auditor only gives a reasonable assurance that the financial statements are free
from material misstatements. An auditor may fail to detect even material misstatements
because of two reasons: These are:
1-An audit is conducted based on a sample and
2-Auditors rely on internal control systems of the auditee to determine the amount of
work they have to perform and the type and quantity of evidence to be gathered. However,
internal control systems have their own inherent limitations.
Q-Dear student, Define what auditing is about?

______________________________________________________________________
____________________________________________________________
1.2 Need for Audit

An important question a student might ask is “why do organizations require an audit?”
Dependable financial information is essential to the very existence of our society. There are
a number of advantages in conducting auditing. The most significant of these are:
 A Tool for control: The first advantage of auditing is that it serves as a tool to control
over those who handle the resources belonging to others. Audit seeks to ensure that the
officials use the public funds properly. It has been a function of auditing to act as a
check on those who handle the funds belonging to others. The mere fact that there
would be an audit of accounts acts as a check on those using the funds and makes them
cautious. More over, it acts as a moral check on employees, since they fear that the
auditor would discover any errors or frauds. Thus, it acts as a means of protecting
against misuse of funds and reduces the possibility of errors and frauds.
 Enhancing credibility of information: Another important advantage of auditing is
that it enhances the credibility of economic information. It is obvious that one would
place greater reliance on financial statement if it has been audited than would be the

case otherwise. That is auditors lend credibility to the financial statements. This is
because the auditor is an independent and objective expert who has no any stake in the
management of the enterprise under audit. Auditors in their audit report express an
opinion that the company’s presentation of financial position, results of operations and
changes in financial position is in accordance with generally accepted accounting
principles or some other disclosed basis of accounting.
 Improving economy and efficiency: In any type of audit engagement, the auditor
reviews the activities of the enterprise and often forwards suggestions to improve the
efficiency of various activities of the enterprise. Performance audit specifically is
designed to review the operations and activities so that wastages and losses can be
minimized, weaknesses in the system can be identified and overcome and controls can
be strengthened. In general auditing enhances efficient utilization of resources.
 Regulatory requirements make auditing mandatory: In many countries, it is a must
for business organizations to file their audited financial statements to renew their
licenses and permits. Some types of audits are conducted for certain special purposes.
Income tax laws of many countries provide for audit of accounts of large businesses,
primarily as an aid to the tax authorities. Some organizations are legally required to get
their financial statements audited. For instance, the 1960 Commercial code of Ethiopia
requires any share company in Ethiopia to get books of accounts audited annually so as
to renew their license.
Though auditing has the above advantages along with others, just like any other
professional services, auditing has its own limitations. Some of these limitations are:
-Its opinion is based on sampling. i.e... It does not look at 100% of transactions
-It can not predict future events
-It may fail to detect fraudulent transactions (management fraud).
-Evidence obtained is persuasive, rather than conclusive
-Provides reasonable assurance, not absolute assurance
-The inherent limitations in accounting still exists in auditing

Q- Explain the advantages of auditing and its inherent limitations.

_____________________________________________________________________
Activity-1 Answer the following questions as per the

instructions given below
Dear student, this activity helps you understand the need for auditing
and the limitations of auditing.
A-How do you define auditing?
B-What are the benefits of auditing?
C-Auditors only give reasonable assurance but not absolute
assurance about the fairness of financial statement
Presentations. Describe why auditors do not provide an
Absolute assurance?
D-Explain how auditors add credibility to the financial statements?

___________________________________________________
1.3 Distinction between Auditing and Accounting
Many financial statement users and members of the general public confuse auditing with
accounting. The confusion arises because most auditing is concerned with accounting
information and many auditors have considerable expertise in accounting matters. The title
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Certified Public Accountants (CPA) which is given to individuals performing an audit

function has increased the degree of confusion.
Accounting is the process of recording, classifying, summarizing and communicating

economic events in a logical manner for the purpose of providing financial information for
decision-making. The function of accounting is to provide certain types of quantitative that
management and others can use to make decisions. To provide relevant information,
accountants must have a thorough understanding of the principles and rules that provide the
basis for preparing the accounting information. Accounting as a process is constructive in
that it starts with raw financial data and produces financial statements as an end product.
Auditing on the other hand is analytical in that it starts with the end product of accounting
(financial statements) and tries to determine if the financial statements have been prepared
in accordance with generally accepted accounting principles. In auditing the concern is with
determining whether recorded information properly reflects the economic events that
occurred during the accounting period. Since the accounting rules are the criteria for
evaluating whether the accounting information is properly recorded, any auditor involved
with these data must also thoroughly understand the rules. In the context of the audit of
financial statements, the generally accepted accounting principles (GAAP) are the basis for
evaluating the fairness of the information presented in financial statements. We can say that
an auditor can also be called an accountant. How ever, auditors need to know not only
GAAP but also how to select and evaluate evidence related to financial statements.
This means that in addition to understanding accounting, the auditor must also posses
expertise in the accumulation and interpretation of audit evidence. It is this expertise that
distinguishes auditors from accountants. Determining the proper audit procedures, sample
size, particular items to examine, timing of the tests and evaluating the results are problems
unique to auditing
Table1.The comparison of Accounting and Auditing
Basis of comparison Accounting Auditing

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Primary responsibility Preparation of Audit of

financial statement financial
statements
Criteria in discharging Generally accepted Generally
responsibilities accounting principles accepted
(GAAP) auditing
standards
(GAAS)
Its nature Constructive Analytical
End product Financial statements Audit reports
The relation ship between accounting and auditing is just similar to the relation ship that
exists between bookkeeping and accounting. Just as accounting begins with the end results
of bookkeeping, auditing begins with the end results of accounting. In other words,
accounting begins where bookkeeping ends and auditing begins where accounting ends.
Activity-2 Differentiating accounting and auditing
This activity helps you to identify the similarities and differences

between auditing and accounting.
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1.4 Types of audits

There are different types of audits conducted by different types of auditors. Such difference
is based on the scope and objective of the audit and employment of the auditors. Auditors
perform different types of audits. Mainly there are four types of audits: financial statement
audit, operational audit, compliance audit and forensic audit.
1.4.1 Financial statement audit:

This type of audit is conducted to determine whether the overall financial statements such
as income statement, balance sheet, statements of retained earnings and cash flow
statements are stated in conformity with generally accepted accounting principles, although
it is common to conduct audits of financial statements prepared using other assumptions.
The assumption underlying an audit of financial statements is that different groups will
use these statements for different purposes. There fore, the contribution of an independent
auditor is to give credibility to financial statements. Credibility means that the financial
statements can be believed; that is they can be relied upon by outsiders. Audited financial
statements are now the accepted means by which business corporations report their
operating results and the financial position. Financial statements prepared by management
and transmitted to outsiders with out first being audited by independent auditors leave a
credibility gap. The product of financial statement audit is an auditor’s report through
which the auditor expresses his/her opinion. There are four types of audit reports; namely,
unqualified, qualified, adverse and disclaimer.
 Unqualified audit report: Unqualified opinion is issued when the financial

statements are in accordance with generally accepted accounting principles
(GAAP), or when an auditor finds all evidence necessary to his satisfaction, and has
been able to follow the requirements of the generally accepted auditing standards
(GAAS). Unqualified opinion is issued if the financial statements reflect fairly the
financial position of the firm for stated period.
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 Qualified opinion report: An auditor issues qualified opinion when he finds

exceptions, when the auditor cannot follow all generally accepted auditing standard
requirements or when there are limitations on the scope and extent of his work, and
the exceptions do not overshadow the fairness of the financial statements.
 Adverse opinion report: An adverse opinion is issued when generally accepted
accounting principles have been followed in the preparations of the financial
statements and/or the financial statements are materially misstated. The auditor
states that the financial statements do not represent the financial position of the firm,
and explains the reason for stating so.
 Disclaimer Audit report: Disclaimer of opinion means no opinion. This type of
opinion is issued when there is no sufficient information to conclude as to whether
the financial statements present fairly the financial position of the organization
1.4.2 Operational audit: An operational audit is a review of any part of an organization’s
operating procedures and methods for the purpose of evaluating efficiency and
effectiveness. At the completion of an operational audit, recommendations to the
management for improving operations are normally expected. This audit is designed
to measure the performance of an organization, which can be evaluated in terms of
efficiency and effectiveness. This type of audit as it aims on measuring the
performance of the organization is some times called performance audit. Because the
criteria for measuring effectiveness and efficiency are not as clearly established as
are generally accepted accounting principles or tax regulations, an operational audit
tends to require more subjective judgment than other types of audits. In this sense,
operational auditing is more similar to management consulting and hence some
times it is called management audit. Some of the functions of the operational audit
are:
 Planning the work to be performed including the setting of standards by which the
audits is to be evaluated
 Gathering evidence to measure the performance of the operation
 Analyzing and investigating deviations
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 Suggesting corrective actions, where needed , and

 Reporting the results to the appropriate levels of management.
Generally, operational audit helps the organization to effectively allocate resources,
identify problems at early stage, improve communication, and increase profitability. An
operational audit requires subjective judgment since the criteria for measuring effectiveness
and efficiency are not clearly established. The end product of an operational audit is usually
a report to top management containing recommendations for improvements in operations
1.4.3 Compliance Audit: This type of audit helps to determine whether the auditee is following
specific procedures or rules set out by some higher authority such as management, government,
board of directors etc. The performance of compliance audit is dependent upon the existence of
verifiable data and of recognized criteria or standards established by an authoritative body. A
familiar example is the audit of an income tax return by an auditor of the Inland Revenue
Authority (IRA).
1.4.4 Forensic audit: A forensic audit’s purpose is the detection of a wide variety of
fraudulent activities. Some of the examples where a forensic audit might be conducted
include:
-Business or employee fraud
-criminal investigations
-shareholders and partners disputes
-Business economic losses
-Matrimonial disputes.
Activity-3: Read each of the following statements and identify which type
of audit is required for each.
1- The company has six main operational units. The management of the
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company has planned to award the top performing unit and wants to know the
relative performance of each unit.
2- Assume you are certified public accountant and you are invited by the
board of directors of ABC-company to audit the financial statement for the
year ended December 31, 2007.
3- The management of the company has suspected that the directives issued by
the board of directors has been violated by the chief accountant and invites the
auditor to ensure whether the chief accountant adheres to those directives.
1.5 Types of auditors

The types of auditors do differ as do the types of audits. Although our interest is primarily
in the audit of financial statements by certified public accountants, other professional
groups carry on large-scale auditing programs.
There are three most widely known types of auditor: these are Independent auditors,
Government auditors and internal auditors.
Independent Auditors: An independent auditor, also known as Certified Public

Accountant or external auditor has no connection to the organization being audited.
Auditor’s primarily responsibility is the performance of the audit function on published
financial statements of the companies for a given period of time. The CPA certificate is not
only a license to practice but also a symbol of technical competence. Being a certified
public accountant involves passing rigorous examinations, obtaining practical experience
and maintaining competence through continuing professional education. How ever, the
requirement as to the amount of education and public accounting experience may differ
considerably among the various countries. The type of audit usually conducted by
independent auditor is financial statement audit. In Ethiopia, The authorized auditors
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perform financial statement audit. In addition, The Audit Service Corporation, a

government-owned organization, performs financial statement audit.
Independent auditors perform financial statement, compliance and operational audits on fee
basis. That is they are not employees of the organization where they audit. Independent
auditors usually perform four broad categories of services such as attestation service, tax
service, management advisory service and accounting service.
Internal Auditors: These are auditors employed by individual companies and these are the
employees of the organization. A principal goal of the internal auditors is to investigate and
appraise the effectiveness with which the various organizational units of the company are
carrying out their assigned functions. These auditors provide much attention to the study
and evaluation of both accounting and administrative controls.
A large part of the work of the internal auditor consists of operational audits: how ever,
they may conduct compliance audit as well. To operate effectively internal auditors must be
independent of the line functions in an organization. How ever, they can not be independent
of the entity as long as an employer-employee relationship exists. Making internal auditors
directly to the board of directors boost their independence. Users outside the entity are
unlikely to rely on information verified by internal auditors because of their lack of
independence. This lack of independence is the major difference between internal auditors
and independent auditors.
The following table provides a comparison of internal and external auditor
Internal Auditor External auditor

An employee of an organization An independent professional
service provider
Serves management and the board of Serves third parties who require
directors audited financial information
Reviews all operations and controls the Reviews and reports to the board of
company for accuracy, integrity and directors or shareholders about the
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efficiency fairness of financial statements

prepared by management.
Directly concerned with the prevention Incidentally concerned with the
of fraud in the company’s operations prevention of fraud.
Independent of the activities audited Independent of management and
but able to respond to the needs of the the board of directors.
management.
Review are conducted periodically
Reviews activities continually in conjunction with the certification
of financial statements
Reports on a continual basis to Reports annually to the board of
management and the audit committee directors or shareholders.
Government Auditors: These are auditors employed by federal, regional or local

government agencies. At the federal level, the three primary agencies are the Office of the
Auditor General (OAG), The Audit Service Corporation, and The Federal Inland Revenue
Authority. The Office of the Auditor General (OAG) is a federal organization headed by the
Auditor general. This office is responsible for conducting financial statements audit,
compliance audit and operational audit of various federal government offices, before it is
submitted to the other government authorities like the House of the peoples’
representatives. Of course, an increasing portion of the OAG’s audit efforts has been
devoted to evaluate the operational efficiency and effectiveness of various government
programs.
The regional governments have also their own regional audit bureau with similar functions.
The regional audit bureaus are primarily responsible to audit the different sectors of the
regional government for their operational efficiency and effectiveness. More over these
auditors conduct compliance audit to ensure that the regional offices are complying with
legal requirements.
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Federal Inland Revenue Auditors have the responsibility for the enforcement of the tax
laws. The major responsibility of the Inland Revenue Auditors is to audit the returns of tax
payers to determine whether they have complied with the tax laws. These auditors solely
perform compliance audits and some times are called tax auditors. Another government
organ that performs audit is the Audit Service Corporation. The Audit Service Corporation
audits the financial statements of the public enterprises. Thus the type of audit performed
by the Audit service Corporation is financial statement audit.
1.6 Auditing principle Developing firms

The development of auditing standards primarily rests with auditing practitioners,
accounting and auditing educators and professional associations. At the very heart of the
public accounting profession is the American Institute of Certified public Accountants
(AICPA). AICPA is a voluntary national organization of more than 200,000 CPAs in
America.
Three major areas of the AICPA’s work are of a particular interest to students of auditing.
These are:
1-Etablishing standards and rules to guide CPAs in their conduct of audits, accounting,
review services and management advisory services
2-Carrying a continuous program of research and publication which has been a key factor
in the growth of a profession.
3-Contributing to the profession’s system of self-regulation.
The AICPA has assigned the responsibility of issuing official pronouncements on auditing
matters to Auditing standards Board (ASB). Besides AICPA, Financial Accounting
standards Board (FASB), Government Accounting standards Board (GASB) and Securities
and Exchange Commission (SEC) each contribute their part in the development of auditing
and accounting principles.
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Activity-4 Distinguish between the types of audits and auditors

and describe which audit is usually conducted by which type of
auditor?
Dear student, this activity is intended to enable you understand the
different types of audits and auditors. Spend some more minutes and
understand each types of audit and auditors
_______________________________________________________
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Summary
An audit is a systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events to determine the degree of correspondence
between the management assertions and established criteria and communicating the results
to interested parties. The criteria usually used by the auditors to evaluate the financial
statements are generally accepted accounting principles.
Auditing has a number of important advantages like it improves the reliability of financial
statements, enhances the confidence of users, improves management decision making,
increases the effectiveness and efficiency of the organization.
There are three types of audits-financial statement audit, operational audit and compliance
audit. Auditors can be classified as internal auditors, independent auditors and government
auditors.
Auditing is different from accounting. While accounting is the systematic recoding,
classifying, summarizing and reporting of financial information, auditing is the systematic
evaluation of the financial statements. Auditing begins with the end results of the
accounting process-financial statements. Accounting is guided with generally accepted
accounting principles, but auditing is guided with generally accepted auditing standards.
Accounting is constructive in nature, but auditing is analytical in nature.
Auditors issue an opinion on the fairness of the financial statements. Auditors never provide
an absolute assurance as to the fairness of the financial statements. This is because auditing
has some limitations.
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Self Test Exercises-1

Part-I choose the best answer among the given choices
1. Which of the following is primarily responsible for the fairness of the presentations
made in the financial statements?
a. The client’s management
b.The independent auditor
c.The audit committee
d.The board of directors
2. An audit designed to detect violations of laws and regulations would be referred to a
a. Financial statement audit
b. Compliance audit
c. Performance audit
d. Operational audit
3. What is the essence of external audit function?
a. To detect frauds and errors
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.
4. Which is not related to the definition of auditing?
a. Accumulation and evaluation of evidences
b. Accounting system
c. Established criteria
d. Independent competent person
5. Operational audits often have an objective of determining whether an entity’s
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a. Internal control structure is adequately operating as designed

b. Operational information is in accordance with auditing standards
c. Financial statements present fairly the results of operations.
d. Specific operating units are functioning efficiently and effectively.
6. Three types of audits are listed below. Indicate the category to which each statement
Belongs by placing the appropriate letter in the space provided.
A. Financial statement audit
B.Compliance audit
C.Operational audit
________1. The results of such an audit are distributed to a wide range of users.
________2. This type of audit is often called management audit.
________3. This audit relates to fair presentation of statements in accordance with
GAAP.
________4. The scope of the type of audit may encompass all the activities of
department.
Part-II: short answer questions
1. Explain the need for auditing
_______________________________________________________________
________________________________________________________________
2. Discuss the different types of audits
_______________________________________________________________
_______________________________________________________________
3. Briefly describe the reason why auditors can not provide absolute assurance
_______________________________________________________________
_______________________________________________________________
4. Accounting is constructive in nature while auditing is analytical. Elaborate this
statement.
_______________________________________________________________
________________________________________________________________
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UNIT-TWO
THE AUDITING PROFESSION
 Introduction
The previous Unit focused on highlighting the meaning of auditing, types of audits and
auditors, and need for auditing. This unit covers the basic professional auditing standards
that auditors should follow to carry out their professional work. This unit also covers the
duties and legal liabilities of auditors. The basic purpose of the professional codes is to
provide members with guidelines for maintaining a professional attitude and act in a
manner that will enhance the professional status of the discipline.
Dear student you have to continue working on the activities whenever you face them just as
you rightly did in the previous unit.
Objectives:
Upon completion of this unit, you will be able to:
 Describe why auditing is a profession
 Describe the ten generally accepted auditing principles
 Explain the professional ethics of auditors
 Define the major legal concepts that relate to auditor’s liability
 Describe the auditors’ responsibility for the detection of fraud and error.
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2.1 Building Blocks of a profession
To understand the importance of a code of ethics to auditors and other professionals, one
must understand the nature of a profession. Unfortunately there is no universally accepted
definition of what constitutes a profession. Yet for generations, certain types of activities
have been recognized as professions while others have not. Medicine, law, engineering,
theology are examples of disciplines having long accorded professional status. Auditing is a
relatively newcomer to the ranks of the profession, but it has achieved widespread
recognition in recent times. A profession is an activity that involves a responsibility to serve
the public.
Auditing as a profession and just like other professions has some common characteristics.
The most important of these characteristics are:
2.1.1. Responsibility to serve the public: Certified public accountants or simply auditors
are the representatives of the public.-creditors, stockholders, consumers, employees and
others in the financial reporting process. The role of the independent auditor is to assure
that financial statements are fair to all parties and not biased to benefit one group at the
expense of another. This responsibility to serve the public interest must be a basic
motivation for the professional.
There is a saying in public accounting that “The public is our only client.” This expression
is an oversimplification, since the entity being audited pays the auditor’s professional fee.
It has been claimed by public accountants that Auditing is more responsible to the public
than any other professions. This is because millions of clients might be affected if the
auditor is negligent in his professional act. Yes indeed, only one client might be affected if
the Physician or attorney is negligent in his professional act. That is why public accountants
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say no profession is more responsible to the public like auditing. Public accountant must
maintain a high degree of independence from their client if they are to serve the large
community.
2.1.2 Complex Body of Knowledge: Auditing as a profession has specialized body of
knowledge that every member of the profession should acquire through formal education.
Auditing like other professions has complex accumulated body of knowledge. Any
practitioner or student of accounting and auditing has only to look at the abundance of
authoritative pronouncements governing financial reports to realize that accounting and
auditing are complex body of knowledge. As the environment changes, accounting and
auditing principles and practices must adapt. The need for technical competence and
familiarity with current standards of practice is embodied in the code of professional
conduct.
2.1.3 Standards of admission to the profession: Obtaining a license to practice as

certified public accountant requires an individual to meet minimum standards for education
and experience. The individual must also pass the CPA examination showing mastery of the
body of knowledge. The admission to practice as public accountant is restricted by legal
and educational requirements so as to provide quality service to the society.
In Ethiopia the Office of the Auditor General (OAG) issues certificates of competence to
authorized auditors in the following categories:
1) Those private auditors authorized to practice in Ethiopia by the Office of the
Auditor general prior to the issuance of the regulation; or
2) A member of the recognized professional accounting association who possesses a
practicing certificate from the association while residing in Ethiopia; or
3) A member of recognized professional accounting association who is in possession
of a practicing certificate from the association while residing abroad; and
(3.1) Having a working experience of not less than two years in auditing or related field of
activities in Ethiopia prior to the possession of the practicing certificate, and if the applicant
has more than one and less than two years of working experience as an external auditor
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abroad, after possessing a practicing certificate, he/she is required to have an additional

three months working experience as an auditor in Ethiopia in a recognized audit firm; or
(3.2) Having a working experience of not less than two years in auditing or related activities
in Ethiopia, prior to the possession of the practicing certificate from abroad, and the
applicant has returned to Ethiopia with out experience or has less than one year working
experience in a recognized audit firm abroad, after possessing a practicing certificate,
he/she should have one year working experience as an auditor in Ethiopia in a recognized
audit firm; or
(3.3) Having a work experience of less than two years in auditing or related activities in
Ethiopia, prior to the possession of the practicing certificate abroad and if the applicant has
returned to Ethiopia after having a minimum of one year working experience in a
recognized audit firm abroad, after possessing a practicing certificate, he/she is required to
have six months of working experience or less than one year working experience in a
recognized audit form; or
(3.4) Having a working experience of less than two years or no experience in auditing or
similar or related activities in Ethiopia prior to the possession of the practicing certificate
abroad, and if the applicant has returned to Ethiopia without experience or less than one
year working experience in a recognized audit firm.
2.1.4 Professional Associations: There are a number of professional associations which are
devoted them selves with the development of auditing principles and standards. The ten
generally accepted auditing standards are the guidelines developed by AICPA.
2.1.5 Need for public confidence: Certified public accountants must have the confidence
of the public to be successful. The CPAs product is credibility and hence the public
confidence is of special significance. With out public confidence the attest function serves
no useful purpose.
2.1.6 Professional Ethics: professional ethics refers to the basic principles of right action
for the member of a profession. Professional ethics may be regarded as a mixture of moral
and practical concepts. Professional ethics in public accounting as in other professions have
been developed gradually and are still in a process of change as the practice of accounting it
27

self changes. 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 status of their discipline.
The AICPA code of professional ethics considers the following to be followed by auditors
in the conduct of professional relations with others.
Integrity: An auditor should be straight forward, honest and sincere in his approach to his
professional work. By integrity it means honorable, upright, courageous and not being two
faced.
Objectivity: An auditor should be fair and should not allow bias to override his objectivity
when reporting his opinion. He should maintain an impartial attitude.
Confidentiality: Usually auditors have unrestricted access, even to the confidential

documents, of the client while they are conducting an audit. Thus an auditor should respect
the confidentiality of the information acquired in the course of his work and should not
disclose any such information to a third party with out specific authority or unless there is a
legal or professional duty to disclose. A member acquiring information in the course of
professional work should neither use nor appear to use that information for his personal
advantage or for the advantage of any third party.
Independence: When in public practice, an auditor should both be and appear to be free of
any interest which might be regarded, what ever its actual effect, as being incompatible
with integrity and objectivity.
Caring for others: Be caring, kind and passionate, be of service to others; help those in
need and avoid harming others.
Accountability: An auditor should be accountable, accept responsibility for decisions,
setting an example for others.
Due care: This requires competence, and diligence. Competence is the product of
education and experience, and diligence involves steady, earnest and energetic application
and effort in performing professional services
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Activity-5: summarizing why auditing is a profession

Auditing has been claimed by many as a profession which is more
responsible to the public than any other professions. Describe the elements
of a profession and explain why auditing is more responsible to the public
Dear student by exercising this activity you should able to define what a
profession is and the elements of a profession.
____________________________________________________________
2.2 Generally Accepted Auditing standards

In order to maintain high level of quality work, auditors need to have some standards in
accordance with which they perform their activities. This section discusses the authoritative
rules for measuring the quality of audit work.
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
Auditing standards are general guidelines to aid auditors in fulfilling their professional
responsibilities in the audit of financial statements.
What are the standards developed for the public accounting profession?
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The AICPA has set forth ten generally accepted auditing standards: These ten
auditing standards are classified in to three major groups as general standards, field work
standards and reporting standards.
2.2.1-General standards: The general standards relate to the personal integrity and
professional qualifications of the auditors. These standards stress on competence,
independence and due professional care by the auditor. These standards are:
Technical Training and proficiency: an examination should be performed by a person or

persons having adequate technical training and proficiency as an auditor. This requirement
is usually interpreted to mean college or university education in account- ting and auditing,
substantial public accounting experience, ability to use procedures suitable for computer
based systems and technical knowledge of the industry being audited.
Independence in mental attitude: In all matters relating to the assignment; independence

in mental attitude is to be maintained by the auditors. This is the most important auditing
standard. Independence means avoiding relation ships that may impair the auditor’s
objectivity. Independence may be broadly thought of as having financial independence,
independence in mental attitude and personal independence. It is not enough that auditors
are independent (Independent in fact) but they have to also be perceived as being
independent (independence in appearance). Otherwise, the public can loose confidence in
the auditor’s ability to report truthfully on the financial statements.
Independence may be broadly thought of as having four facets: these are:

 Financial independence: financial independence relates to not having a financial
interest in the client.
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 Independence in mental attitude: Independence in mental attitude is essential to

achieve independence in fact.
 Investigative independence: this means that the auditor has the time and resources
to obtain sufficient appropriate audit evidence and that the auditor has access to all
evidence needed to reach the proper opinion as to the fairness of the financial
statements. Investigative independence will be impaired if there was a deadline so
that the job was rushed
 Reporting independence: means reporting at a sufficiently high level that the
report will be acted on. If an auditor, who reported to management when the auditor
believed management to be guilty of fraud would not have reporting independence.
On the other hand, if the auditor reported to an audit committee made up of
independent (non-management) members of the board of directors, the auditor
would have reporting independence.
Independence has two distinct aspects. First, the public accountant 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 independence to third
parties.
Mechanisms to strengthen Independence:

Auditor’s independence may be addressed in statutory law, professional standards and audit
firm policy. Independence may be addressed by:
 prohibiting owners of accounting firms and their staff from holding shares in, lending
to, or otherwise having a beneficial interest , either directly or indirectly in audit clients
 Prohibiting owners and their staff from receiving any benefits from client organizations,
other than through the receiving of audit fees. This prohibits owners and their staff
from accepting:
o loans from the audit client

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o commissions for new business referred by the audit firm to the audit client,
and
o Discounts given to audit staff members normally only available to the
client’s staff.
 Prohibiting owners and their staff from holding any office, including the
office of director, in client organizations
 Prohibiting the undertaking of consulting work such as taxation and
corporate advising work for the existing audit clients.
Some accounting firms establish so-called “Chinese walls” with respect to audit
and management consulting services provided to the one client.
Due professional care: The third general standard requires due care in the performance of
all aspects of auditing. Simply stated the auditor is professionally responsible for fulfilling
his /her duties diligently and carefully. Due care includes consideration of the completeness
of the working papers, the sufficiency of the audit evidence, and the appropriateness of the
audit report. As a professional, the auditor must avoid negligence and bad faith. This
standard requires auditors to carry out their work in an alert and diligent manner
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Activity-6 Explaining General standards of auditing

Explain briefly the three general standards of auditing
This activity increases your knowledge of the general
auditing standards
_________________________________________________
____
2.2.2-Field work standards: The three standards of field work relate to accumulation
and evaluating evidence sufficient for the auditors to express an opinion on the financial
statements. Auditors cannot effectively satisfy the general standards requiring due
professional care if they have not also satisfied the standards of field work. The field work
standard involves adequate planning, sufficient understanding of internal control and
sufficient and competent evidence.
Adequate planning and supervision: The first standard of field work deals with
ascertaining that the engagement is sufficiently planned to ensure an adequate audit and
adequate supervision of assistants. Proper planning can help to effectively detect material
misstatements on the financial statements and to complete the audit engagement in a
reasonable amount of time. Supervision is essential in auditing because a considerable
portion of the field work is done by less experienced staff members.
Sufficient understanding of internal control: One of the most widely accepted concepts
in the theory and practice of auditing is the importance of the client’s internal control
structure to generate reliable financial information. An excellent internal control structure
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provides strong assurance that the client’s records are dependable and that its assets are
protected. A proper understanding of the internal control helps the auditor to determine the
appropriate amount and quality of evidence. Thus, the auditor’s assessment of internal
control has great impact on the length and nature of the audit process.
Sufficient and competent evidence: The third standard of fieldwork requires that the
auditors should gather sufficient and competent evidence to have a basis for expressing an
opinion on the financial statements. The decision as to how much evidence to accumulate in
a given set of circumstances requires professional judgment. The term sufficient refers to
the quantity of information to be gathered while competency refers to the quality of
evidences, as some forms of evidence are stronger and more convincing than others
Activity-7. Explaining standards of field work

This activity helps you to apply your knowledge of the standards of field
work.
Marta is a third year accounting student. Currently she is taking an auditing
course and she is not clear about the standards of fieldwork. She asks you to
explain to her what the standards of field work are.
Explain to Marta the standards of fieldwork.
_______________________________________________________________________
2.2.3-Standards of Reporting: The ultimate objective of independent auditors is to

report on the findings of the audit. The reporting is guided by reporting standards of GAAS.
The standards of reporting deals with generally accepted accounting principles (GAAP),
consistency, adequate disclosure and report content.
These reporting standards can be explained as follows:
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 The report shall state whether the financial statements are presented in accordance
with GAAPs.
 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.
 Informative disclosures in the financial statements are to be regarded as reasonably
adequate unless otherwise stated in the report.
 The report shall either contain an expression of opinion regarding the financial
statements, taken as a whole, or an assertion to the effect that an opinion can not be
expressed. When an over all opinion can not be expressed, the reasons should be
stated. In all cases where an auditor’s name is associated with financial statements,
the report shall contain a clear-cut indication of the extent of the auditor’s
examination and the degree of responsibility he/she is taking.
Q-Distinguish between generally accepted accounting principles

(GAAP) and generally accepted auditing standards (GAAS)
______________________________________________________
_______________________________________________________________
Activity-8-Identfying auditing principles violated by the auditor

Dear student read the following statement and identify the auditing
principles that have been violated by the auditor.
Assume the general manager of ABC trading, Ato Chala, applied for a
bank loan and was informed by the banker that audited financial statements of
the business must be submitted before the bank could consider the loan
application. Ato Chala agreed with Tomas, CPA, to perform an audit.
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Ato Chala informed Ato Tomas that audited financial statements were
required by the bank and that the audit is must be completed with in two
weeks and Ato Chala promised to pay Tomas a fixed fee plus a bonus if the
audit is completed with in two weeks and the bank approved the loan. Ato
Tomas, CPA, agreed and accepted the engagement.
The CPA, Tomas, hired two fresh accounting graduates to conduct the audit
and spent several hours telling them exactly what to do and he told them not to
spend time reviewing internal control but instead, to concentrate on proving
the mathematical accuracy of the ledger accounts and summarizing the data in
the accounting records that support the company’s financial statements.
The audited was completed with in two weeks and Ato Tomas issued audit
report.
Instruction: Exhaustively identify the auditing principles that were violated By
Tomas and support your answer with justification.
__________________________________________________________
2.3 Legal responsibility and Liability of Auditors
The potential liability of CPAs to parties who might be injured as a result of improper
professional practice greatly exceeds that of other physicians or any group of professionals.
One reason for this is the large potential number of injured parties. If a physician or an
attorney is negligent, the injured party usually consists only of the client. If a CPA is
negligent in expressing an opinion on financial statements, literally millions of investors
may sustain losses.
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Definition of Terms
A discussion of auditors’ liability is best prefaced by a definition of some of the common
terms of business laws. These are:
Ordinary negligence is violation of a legal duty to exercise a degree of care that any other
prudent person would exercise under similar circumstances. It is failure to perform a duty in
accordance with applicable professional standards.
Gross negligence: is the lack of even slight care. It is a substantial failure on the part of the
auditor to comply with generally accepted auditing standards (GAAS).
Fraud: is defined as misrepresentation by a person of material fact known by that person to

be untrue or made with reckless indifference as to whether the fact is true, with the
intention of deceiving the other party and with the result that the other party is injured.
Constructive fraud: differs from fraud in that constructive fraud is does not involve a
misrepresentation with the intent to deceive the other party.
Privity: is the relation ship between parties to a contract. A CPA firm is in privities with
the client and any other third party beneficiary.
Third party beneficiary: a person who is named in a contract or intended by contracting
parties to have definite rights and benefits under the contract.
Engagement letter: is the written contract summarizing the contractual relationship
between auditor and client.
Breach of contract: is failure of one or both parties to a contract to perform in accordance
with the contract’s provisions.
Proximate cause: exits when damage to another is directly attributable to a wrongdoer’s

act. The issue of proximate cause may be raised as a defense in litigation. Even though a
37

CPA firm might have been negligent in rendering services, it will not be liable if its
negligence was not the proximate cause of the plaintiff’s loss.
Plaintiff: is the party claiming damages and bringing suit against the defendant.
Contributory negligence: is negligence on the part of the plaintiff that has contributed to
his or having incurred a loss. Contributory negligence may be used as a defense, because
the court may limit or bar recovery by a plaintiff whose own negligence contributed to the
loss.
Comparative negligence: is a concept used by certain courts to allocate damages between
negligent parties based on the degree to which each part is at fault.
Notice that negligence, gross negligence and fraud each represent different degrees of
improper performance by the CPA. The extent to which the CPAs services are found to be
improper determines the parties to whom the CPAs are liable for losses proximately caused
by their improper actions. CPAs are never liable to any party if they perform their services
with due professional care. Having exercised due professional care is a complete defense
against any charge of improper conduct.
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 and third party beneficiaries for any
losses proximately caused by the CPAs failure to render due professional care .In short
ordinary negligence is a sufficient degree of misconduct to make CPAs liable for damages
caused to their clients.
Q-Define the auditing related terms that you have come across.
___________________________________________________________________
___________________________________________________________________
2.3 Auditors’ responsibility for detection of errors and irregularities
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Are auditors responsible to detect errors and irregularities?

_______________________________________________________________
Auditors’ liability to clients most often arises from the CPAs’ failure to uncover an
embezzlement or defalcation being perpetrated against the client by clients’ employees. A
client who has sustained such losses may allege that the auditors’ were negligent in not
uncovering the scheme and sue the auditors for the amount of the loss.
The key factor in determining whether the auditors’ are liable is not just whether the
auditors failed to uncover the fraud. Rather, the issue is whether this failure stems from the
auditors’ negligence.
When CPAs’ examination has been made in accordance with generally accepted auditing
standards, the auditor should not be held liable for failure to detect the existence of errors or
irregularities. This is because an audit has certain limitations; it does not involve a complete
and detailed examination of all records and transactions. Thus there can never be an
absolute assurance that errors and irregularities do not exist among the transactions not
included in the auditors’ tests.
To obtain a judgment against its auditors, an injured client must prove that it sustained a
loss as a result of the auditors’ negligence and the auditors’ negligence is a proximate cause
to sustain a loss. As defendants, the auditors’ can refuse this claim by showing that either
they were not negligent in the performance of their duties or their negligence was not the
proximate cause of the client’s loss. Demonstrating contributory negligence by the client is
one means of showing that the auditors’ negligence was not the cause (or sole cause) of the
client’s loss. The concept of comparative negligence is used to allocate damages between
the client and the auditors based on the extent to which each is at fault.
In general, the detection and prevention of errors and fraud is the managements’
responsibility by designing and implementing appropriate internal control systems. The
auditor is not responsible for the prevention and detection of errors and fraud. The auditor is
responsible to design audit procedures to reduce the risk of not detecting a material error or
39

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.
Activity-9: Explaining auditors’ and clients’ responsibility.

Assume you are an independent auditor of Climax company. During the
past three audits, you have repeatedly warned the top management of
Climax company about the serious weakness of internal control over
cash disbursements. How ever, management has not taken any
corrective action. Shortly after the audit, Climax company learned that
two employees in its accounting department had been embezzling
money for the last two years. The embezzlement scheme involved
authorizing cash disbursement in various expense accounts and then
arranging to have the checks cashed.
The management of Climax company has brought suit against you for
the amount of its losses in this cash fraud.
Instruction:
1-Suggest at least three arguments that you as an auditor can defend
your self to lessen or eliminate the liability.
2-What arguments might Climax company advance to indicate that you
were negligent in failing to discover the embezzlement scheme?

3-briefly describe the auditors’ responsibility for the detection of errors
and irregularities.
____________________________________________________________________
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Summary
One of the requirements that a recognized profession needs to have is developed
professional codes of ethics that guide the behavior of members. Auditing as a profession
has well developed codes of ethics and auditing standards that guide its members in
conducting their day to day professional activities. The auditing standards are classified in
to general standards, field work standards and reporting standards. The general auditing
standards including training and proficiency, independence and due professional care are
personal in nature in the sense that they are concerned with the auditors’ qualification and
the quality of his work.
Adequate planning and supervision, understanding the internal control of the client and
gathering sufficient and competent evidence are the field work standards and these
standards are related to the practices that an auditor exercises in the premises of the client.
41

The ultimate objective of independent auditors is to report on the findings of the audit. The
reporting is guided by reporting standards of GAAS. There are four standards of reporting
which deal with generally accepted accounting principles, consistency, adequate disclosures
and report content. The standards of reporting requires that the auditor should in his/her
report state whether the financial statements are prepared according to generally accepted
accounting principles and state if these principles have been applied consistently.
The principal objective of financial statement audit is to examine the financial statements
and express opinion whether or not they are fairly stated. Financial statements are said to be
stated fairly if they do not contain material errors and frauds. So auditors are responsible to
their client and third party beneficiaries and should exercise sensitive professional and
moral judgment in all their activities. Auditors are liable to their clients and third party
beneficiaries for ordinary negligence, gross negligence and fraud.

Part-I: Choose the best answer among the given choices
1. 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
2. Who is primarily responsible for the fair presentation of the financial statement?
a) The auditor
b) The client
c) The board of directors
d) The shareholders
3. Which one of the following is not the general standard of auditing?
a) Planning
b) Independence
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c) Due care
d) Training
4. Which of the following is an irregularity as defined in the statements on auditing
standards?
a) Misappropriation of assets
b) Clerical mistakes
c) Mistakes in the application of accounting principles
d) Misinterpretation of facts
5. All of the following are standards of filed work except:
a) Understanding internal control
b) Gathering sufficient and competent audit evidence
c) Planning and supervision
d) Training and proficiency.
6. Which of the following best describes generally accepted auditing standards?

a) They are pronouncements issued by the auditing standard board
b) They are procedures for gathering evidence to support financial statements
c) They are rules acknowledged by the accounting profession because of their universal
compliance
d) They are a measure of the quality of the auditor’s performance.
7. The exercise of due professional care requires that an auditor to:

a) Examine all available corroborating evidence
b) Critically review the judgment exercised at every level of supervision
c) Correct errors in the financial statements
d) Attain the proper balance of professional experience and formal education.
8. The exercise of due professional care requires that an auditor to___

a. Examine all available corroborating evidence
b. Critically review the judgment exercised at every level of supervision
43

c. Correct errors in he financial statements

d. Attain the proper balance of professional experience and formal education.
9. While performing an audit, an auditor strives to achieve independence in appearance

in order to:
a. reduce risk and liability
b. become independent in fact
c. maintain public confidence in the profession
d. comply with generally accepted standards of field work.
Part- II. Short answer questions

1. Why auditing is a profession?
___________________________________________________________
___________________________________________________________
2. What is the basic purpose of a code of ethics in the auditing profession?

____________________________________________________________
____________________________________________________________
3. Explain briefly the ten generally accepted auditing standards

____________________________________________________________
____________________________________________________________
4. What is the difference between generally accepted accounting principles (GAAP) and
generally accepted auditing standards(GAAS)
_____________________________________________________________
_____________________________________________________________
5. Describe the auditors’ responsibility with regard to detection of errors and frauds.
_____________________________________________________________
44

______________________________________________________________
UNIT-THREE
PLANNING AND CONDUCTING THE AUDIT
 Introduction
Financial statement audit includes accepting the audit engagement; planning the audit,
review of internal controls of the client, performing audit tests and reporting the findings. In
each phase , the auditor should be aware of the environment including the impact of
regulation, public expectation, and the need to comply with professional standards. The
general auditing standards apply to all phases, field work standards apply to planning the
audit and performing audit tests, and reporting standards apply to reporting the findings.
Objectives
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After studying thus unit, you will be able to:

 Describe the pre-engagement activities of an auditor
 Discuss the importance of planning an audit
 Describe the importance of audit program and
 Describe the audit risk and its components
3.1 Meaning and purpose of Audit planning
Planning means to think in advance before work is performed. It involves making decisions
about the work to be carried out. Audit planning requires making decisions about whether
to accept a client for audit in the first place and this is called pre-engagement planning.
Once the engagement is accepted, audit planning involves making decision about specific
steps that help determine an over all audit strategy and this is called engagement planning.
Adequate planning and supervision is the first and the important auditing standards of field
work. An audit plan is a broad overview of an audit engagement prepared in the planning
stage of the engagement.
The first standard of field work 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 client before deciding whether to accept the engagement, obtaining an
understanding of the client’s business operations, and developing an over all strategy to
organize, coordinate and schedule the activities of the audit staff.
Q- Explain the importance of audit planning.

___________________________________________________________________
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3.2 Importance of Audit planning
Auditors have to plan their audit work carefully before simply entering in to it. Audit
panning is required because it helps the auditors:
 To weight the risks and rewards of taking on a new client in the case of pre-
engagement planning
 To obtain knowledge of the nature of the client’s business so that appropriate
attention is devoted to important areas of the audit.
 To identify the potential problems in advance and deal with them effectively.
 To ensure that sufficient and competent evidence is obtained
 To complete the work expeditiously by controlling costs and to meet important dead
lines
 To properly assign work to assistants and coordinate work carried out by other
auditors and experts.
Although the audit plan differs in form and content among public accounting firms, a
Typical audit plan includes the following:
 Description of the client company-its structure, business and organization
 Objective of the audit (audit for shareholders, special purpose audit etc)
 Nature and extent of the other services
 Timing and scheduling of the audit work
 Work to be done by the client’s staff
 Staffing requirement during the engagement
 Target dates for completing major segments of the engagement
 Any special problems to be resolved in the course of the engagement
 Preliminary judgments about materiality level for the engagement.
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Accepting the Audit Engagement
Q What are the steps involved in deciding whether or not to accept an engagement?
______________________________________________________________________
This is the first phase in the audit panning and it involves a decision to accept or decline the
opportunity to become the auditor for the new client or to continue as an auditor for an
existing clients. 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. The auditor can find the information about the client
by communicating with predecessor auditors, making enquiries of other third parties and
consulting the client’s legal cause. Thus a decision to accept the audit engagement should
not be taken lightly as it has a bearing on the quality of the audit.
The following steps should be considered in accepting the audit engagement. These are:
Evaluate the integrity of management-An auditor accepts an audit engagement only

when reasonable assurance exists that the client’ management can be trusted. Some times
when an auditor accepts a new client, the auditor will be replacing another auditor. In
addition to his knowledge about the client’s management the successor auditor can seek
information, regarding this matter from the predecessor auditor.
Identify special circumstances and unusual risks-The intended users of the audited
financial statements and prospective clients legal and financial stability should be
understood.
Competence to perform the audit-Auditors should determine whether they have the
professional competence to complete the engagement in accordance with GAAS. If the
auditors are not familiar with the potential client’ business they should decline the offer.
48

Evaluate Independence-The auditor must evaluate whether there are circumstances that
would impair its independence with respect to the client.
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 risks involved with the
audit and determine whether to attempt to obtain the engagement. After accepting the
engagement, the auditor should document arrangements made with the client and clarify
matters that may be misunderstood. The preliminary understandings with the client should
be summarized by the auditors in an engagement letter, making clear the nature of the
engagement and 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 auditor’s fee.
Obtaining an understanding of the clients’ 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, organizational structure, product lines and methods of
production and distribution. This will help the 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.
Developing an over all audit strategy- After obtaining the knowledge of the client’s
business, the auditor should formulate an over all audit strategy for the upcoming
engagement. The best audit strategy is the approach that results in the most efficient audit.
Designing Audit program- 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.
An audit plan is an overview of the engagement, outlining the nature and characteristics of
the clients’ business operations and the overall audit strategy. Where as, audit program is a
detailed outline of the auditing work to be performed, specifying the procedures to be
49

followed in verification of each item in the financial statements and giving the estimated
time required. An audit program serves as a useful tool both in scheduling and in
controlling audit work. It indicates the number of persons required and the relative
proportions of senior and staff assistant hours needed and it enables supervisors to keep
currently informed on the progress being made.
The inclusion of detailed audit instructions in the program gives assurance that essential
steps in verification will not be overlooked. These written instructions enable inexperienced
auditors to work effectively with less personal supervision than would otherwise be
required
Audit programs are considerably more detailed than audit plans. The audit plan outlines the
objectives of the engagement, where as the audit program lists the specific procedures that
must be performed to accomplish these objectives.
Activity-11: Applying the steps in accepting an audit engagement

Dear student, the purpose of this activity is to help you relate your
theoretical understanding to practical situations.
Assume you are certified public accountant. The manager of Zengena
Corporation asks you to audit the financial statements for the year 2007.
What would you do before deciding to accept or reject the engagement?
An engagement letter is a formal letter sent by the auditor to the client at the beginning of
an engagement. The letter normally includes the following matters:
50

Scope- a description of the services to be provided, particularly whether there is to be an

audit in accordance with generally accepted auditing standards or a more limited accounting
services are to be provided, and whether additional services are to be provided such as
preparation of the tax returns or tax planning
Responsibility-an explanation of the relative responsibilities of management and the

auditor for assuring that financial statements are with all material respects, in conformity
with generally accepted accounting principles and other matters that often raise questions of
responsibility such as fraud, illegal acts, deficiencies in the design or operation of the
internal control structure and related party transactions.
Procedural arrangements-this is a specification of the schedules to be prepared by the

client, the method and frequency of billing the auditor’s fee and similar matters are
included.
Figure-2 A sample engagement letter
Alex, Aster and Abay (AAA) company

Certified public accountants, Gondar
September,1,2008
Chairman Audit committee
Chechela Corporation
Gondar
Dear Ato Murad
This letter is written to conform our arrangements for our audit of the financial
statements of Chechela corporation for the year ended June 30, 2008
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Our examination will be performed in accordance with generally accepted auditing

standards and will include all procedures which we consider necessary to provide a basis
for expression of our opinion as to the fairness of the financial statements. Our
examination will include procedures to obtain an understanding of the company’s internal
control.
An examination performed in accordance with generally accepted auditing standards
is designed to provide reasonable assurance of detecting errors and irregularities which
would have a material effect upon the financial statements. However, such examination
cannot be relied upon to disclose all errors and frauds. Your management is primarily
responsible for the financial statements and for adopting sound accounting policies and
for maintaining an adequate and effective system of accounting, for safeguarding assets
and for devising an internal control structures that will help to assure the preparation of
the proper financial statements.
Our examination is scheduled for performance and completion as follows:
Begin field work-------------------------September, 25,2008
Delivery of internal control letter------November,15,2008
Completion of field work---------------December, 28,2008
Delivery of audit report-----------------January 12, 2009
Our fees for this examination will be based on the time spent by various members of
our staff at our regular rates, plus direct expenses. We will notify you any circumstances
we encounter that could significantly affect our initial fee estimate of Br 38,000.
In order for us to work as efficiently as possible, it is understood that your accounting
staff will provide us with as much information and assistance as we need.
If these arrangements are in accordance with your understanding, please sign this
letter in the space provided and return a copy to us at your earliest convenience.
Truly yours!
Alex Aster Abay
Accepted By:____________
Date:__________________
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Activity -12: Writing an engagement letter
Dear student, this activity helps you to understand the components of

engagement letter and to write it.
Imagine you are a certified public accountant and are invited to audit the
financial statements of Tana corporation. Further assume you are satisfied
with the integrity of the management of the client and decide to accept and
write an engagement letter
1-Write an engagement letter to the manager of Tana corporation to conform
to his Invitation
2-From your engagement letter:
a. What are the objectives of the audit?
b. What is the scope of the audit?

c. What is your responsibility?
d. What are the audit procedures to be applied?
e. What type of support you want from the client personnel?
f. How do you determine the audit fee?
g. How do you schedule the audit work?
_____________________________________________________________
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Designing Audit program

After the audit plan has been prepared, a detailed written audit program describing the
various steps and procedures, which are needed to implement the audit plan, should be
developed. An audit program lists the audit procedures to be applied in an audit in the given
circumstances along with proper instructions. Thus, an audit program contains the
description of the specific audit procedures to be performed in respect of different aspects
to be covered.
An audit program may be formulated at all stages of audit engagement. At the first stage, it
may list the procedures required to gain sufficient knowledge of the client. At the second
stage an audit program focusing on the compliance procedures required to study and
evaluate the relevant internal controls might be developed. Finally it may list the
substantive procedures useful to decide and carry out based on the knowledge of the client’s
business and the results of his compliance procedures.
In conducting an audit of any organization, there are certain essential elements that should
be kept in mind while formulating audit program. These essential elements of audit
program are:
 Study the relevant legal requirements
 Familiarization with other aspects of the enterprise under audit.
 Analytical review of past performance
 Study and evaluation of internal control
 Examination of arithmetical accuracy or accounting records
 Inspection of documentary evidence and application of other substantive procedures
 Analyzing and review of financial statements and
 Finalization of audit reports
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An audit program is a basic tool of control over the execution of the audit. Thus, it has
several advantages as listed below.
Advantages of audit program:
Provides a coordinated view of the total audit: to develop an audit program, auditors need to
consider all aspects of the audit in a coordinated manner. In the absence of a written audit
program, the auditor may not cover all aspects adequately or even important aspects of the
audit may be forgotten. It through an audit program that you can plan how you would gather
sufficient evidence in a specific situation
Provide a valuable tool for manpower planning: In any organization while conducting audits
there are persons with different skills and experience They have to be assigned on various
audits in such a manner that the audits are performed effectively, the time schedules are met ,
and the costs are minimized. If you prepare written audit programs for all audits, you can
identify the nature of skills and experience that would be required for various audits.
Provides clear instructions: A written audit program provides clear instruction to all
personnel involved in an audit.
Minimize costs and misunderstandings: A clear listing various steps and procedures can
minimize the cost and misunderstandings of the audit personnel during the audit process.
Serves as a basis for planning future audits: The written audit program and the observation
of the audit personnel provide a valuable basis of planning the audit in succeeding years. In
many situations, auditors prepare the audit program for the current year by making appropriate
modifications in the audit program of the pervious year.
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3.3 Materiality and Audit risk

In planning the audit, the auditors must consider carefully the appropriate levels of
materiality and audit risk. Materiality for planning purpose is the auditor’s preliminary
estimate of the smallest amount of misstatement that would probably influence the
judgment of a reasonable person relying upon the financial statements.
Materiality and audit risk need to be considered at the financial statement level as a part of
general planning and at the account balance or transaction class level in planning audit
procedures for a specified balances or classes.
The term materiality is used both often and loosely in accounting and auditing. The
underlying concept is always essentially the same-it is the criterion for distinguishing the
trivial from the important. It refers to the magnitude of the an omission or misstatement of
accounting information that makes it probable that the judgment of a reasonable person
relying on the information would have been changed or influenced by the omission or
misstatement.
Audit risk is the risk that the auditor may unknowingly fail to appropriately modify his/her
opinion on financial statements that are materially misstated. This means that the auditor
will fail to qualify an audit report that he should have qualified
There is always the risk that an auditor provides a wrong audit opinion. This arises when
there is a material error in the financial statements, which was not corrected before the
accounts were published and to which the auditor did not refer in the audit report.
Q- Define what is audit risk and why it occurs?

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_____________________________________________________________________
An audit risk can only happen if three things have happened in sequence. Firstly, a
material error needs to have occurred. Secondly, the error needs to have not been
detected by the client’s system of internal control. Thirdly, the auditor must have failed to
find the error in the course of his substantive testing or analytical review procedures.
It is only when all of these conditions are fulfilled simultaneously that the auditor will give
an inappropriate opinion on a set of financial statements, and the audit risk will materialize.
The chances that the three conditions will occur are Inherent risk, control risk and detection
risk respectively. In other words audit risk is composed of inherent risk, control risk and
detection risk
Inherent risk: refers to the possibility of a material misstatement occurring in an account
assuming that there are no related internal controls. Inherent risk exists independently of the
audit of financial statements. Thus the auditor cannot change the actual level of inherent
risk. However, the auditor can change the assessed level of inherent risk.
Control risk: is the risk that a material misstatement will not be prevented or detected on a
timely basis by the company’s internal control. Effective internal controls over an assertion
reduce control risk. Control risk can never be zero because internal controls cannot provide
complete assurance that all material misstatements will be prevented or detected. Like
inherent risk, the auditor cannot change the actual level of control risk for an assertion.
Detection risk: is the risk that the auditor’s procedures will lead them to conclude that a
material misstatement does not exist in an account balance, when in fact the account is
materially misstated. Detection risk is a function of the effectiveness of auditing procedures
and of their application by the auditor.
Unlike inherent and control risk, the auditor can change the actual level of detection risk by
varying the nature, timing and extent of substantive tests performed on assertion. Applying
more effective audit procedures, use of larger samples, adequate planning and adherence to
quality control standards result in lower levels of detection risk.
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Note that while the detection risk related directly to the effectiveness of the auditor’s
procedures, inherent risk and control risk are functions of the client and its environment.
In planning the audit the auditors must assess the extent of inherent risk and control risk for
each material financial statement account and then plan sufficient audit procedures to
reduce detection risk to the appropriate level
The lower the assessment of inherent and control risks, the higher is the acceptable level of
detection risk. Thus the auditor controls the audit risk by adjusting detection risk according
to the assessed levels of the inherent and control risks.
Activity-13: Differentiating the components of audit risk

Dear student, describe the components of audit risk and explain the relation
ship among the three types of audit risks
_________________________________________________________
3.4 Audit Sampling

Once the auditor has decided which procedures to select and when they should be
performed, it is still necessary to determine the appropriate number of items to sample from
the population and which ones to choose. As business entities have evolved in size,
auditors increasingly have had to rely upon sampling procedures as the only practical
means of obtaining audit evidence. This reliance upon sampling procedures is one of the
basic reasons that audit reports are regarded as expression of opinion, rather than absolute
certifications of the fairness of the financial statements.
Representative samples
Whenever auditors select a sample from the population, the objective is to obtain a
representative one. A representative sample is one in which the characteristics in the sample
58

are essentially the same as those of the population. Auditors can increase the likelihood of
the sample being representative by using care in its design, selection and evaluation. To
reduce sampling risk, the sample size should be increased and the appropriate method of
selecting sample items from the population should be followed.
Major decisions related to sampling are:
I) Determining the appropriate number of items to sample from the population, and
II) Determining which ones to choose.
Q- State what is meant by a representative sample and describe its importance in

sampling the audit population.
_______________________________________________________________________
Statistical and Non -statistical sampling
Audit sampling methods can be divided in to two broad categories: statistical and non-
statistical. Sampling, whether statistical or non statistical (judgmental) is the process of
selecting a group of items (called the sample) from a large group of items called the
population or field and using the characteristics of the sample to draw inferences about the
characteristics of the entire population of items. The underlying assumption is that the
sample is representative of the population, meaning the sample will possess essentially the
same characteristics as the population.
Basic to audit sampling is sampling risk. Sampling risk is the risk that the auditor’s
conclusion based on the sample might be different from the conclusion they would reach if
they examined every item in the entire population.
In non-statistical sampling, the auditor doesn’t quantify sampling risk. Instead, the auditor
selects sample items and conclusions are reached about population on a judgmental basis. A
sample is said to be non statistical (or judgmental) when the auditors estimate sampling risk
by using professional judgment rather than by using statistical techniques.
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Statistical sampling differs from non statistical sampling because it applies mathematical
models to quantify or measure sampling risk in planning the sample and evaluating the
results.
Sampling risk is reduced by increasing the size of the sample. When the sample size is 100
percent of the population, the sample is by definition perfectly representative, and sampling
risk is eliminated entirely. Large samples however, are costly and time-consuming. A key
element in efficient sampling is to balance the sampling risk against the cost of using larger
samples.
Auditors may also draw erroneous conclusions because of non sampling errors. These are
the errors due to the factors not directly caused by the sampling.
For example-failure to apply appropriate audit procedures or failure to recognize errors in
the documents or transactions results in non sampling errors. The risk pertaining to non
sampling errors is referred to as non sampling risk. Non sampling risk can generally be
reduced to low levels through effective planning and supervision of audit engagements and
through implementation of appropriately designed quality control procedures.
Q- Distinguish between sampling and non sampling error
Non-statistical (Judgmental or non-probabilistic) sample selection

methods.
These methods include:
Directed sample selection: The selection of each item in the sample is based on some
judgmental criteria established by management.
Block-sample selection: it is the selection of several items in sequence. Once the first item in
the block is selected, the remainder of the block is chosen automatically.
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Haphazard sample selection: In this method, the auditor goes through a population and
selects items for the sample without regard to their size, source or other distinguishing
characteristics.
Statistical (Probabilistic) sample selection methods.
Statistical sampling is the use of mathematical measurement techniques to calculate formal
statistical results. The primary benefit of statistical methods is the quantification of the
sampling risk. Statistical methods include:
Simple random selection method: In this method, every element of the population has an
equal chance of consisting the sample. Simple random sampling is used to sample populations
that are not segmented for audit purpose. It is simply the method of selecting items for
inclusion in a sample
Systematic sample selection method: This technique involves selecting every n-th item in the
population following one or more random starting points. The interval should be calculated
based on size of the interval, and then items for the sample are selected. The interval is
determined by dividing the population size by the number of sample items desired.
Stratified sample selection method: Stratification is the technique of dividing a population in
to relatively homogeneous subgroups called strata. These strata then may be sampled
separately; the sample results may be evaluated separately; or combined to provide an estimate
of the characteristics of the total population.
Q Explain how statistical sampling methods differ from non statistical sampling
Methods?
Activity-13: Describing the different sampling methods

Imagine inexperienced auditor asks you the advantage and
disadvantage of each type of statistical sampling methods. Explain to
him the advantage and disadvantage of each type of statistical
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sampling methods
_______________________________________________________
Summary
You, as an auditor, have to follow the generally accepted auditing standards in accepting an
audit engagement for financial statement audit. One of the field work standards of auditing
requires adequate planning and supervision.
Audit planning is an important part of the audit engagement. Once the auditor accepts the
engagement he has to prepare and send an engagement letter to the client. The engagement
letter serves as a contract between the auditor and the client.
Adequate planning enables to evaluate the integrity of the client’s management, your
knowledge about the clients business and industry, and the internal control structure of the
client. This information helps the auditor to assess the materiality and audit risk. Audit risk
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is the risk that the auditor may unknowingly fail to appropriately modify his/her opinion on
financial statements that are materially misstated. The audit risk is a combination of
inherent risk, control risk and detection risk. Determining the appropriate sampling
procedure and the appropriate sample size is important in determining the level of audit
risk. Audit sampling is the application of an audit procedure to less than 100% of the items
with in an account balance or class of transactions for the purpose of evaluating some
characteristics of the balance or class. Whenever auditors select a sample from the
population, the objective is to obtain representative one. A representative sample is in
which the characteristic of the sample are the same to those of the population. Audit
sampling methods can be classified as statistical and non statistical. Simple random,
systematic and stratified sample selection methods are statistical sampling methods,
whereas direct sample selection, block sample selection and haphazard sample selection are
non-statistical sampling methods
Self -Test Exercises-3

Part-I choose the best among the given choices
1. Adequate planning and supervision are;

a) General standards of auditing
b) Fieldwork standards of auditing
c) Reporting standards of auditing
d) None
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2. The risk that the auditors' own work will lead to the decision that material
misstatement do not exist in the financial statements, when, infact such misstatement do
exist is:
a) Audit risk
b) Detection risk
c) Inherent risk
d) Control risk
3. The procedures specifically outlined in an audit program are primarily designed to:
a) Gather evidence
b) Detect errors and irregularities
c) Test internal control systems
d) Protect the auditor in the event of litigation
4. A detailed written plan of the audit work to be performed by the auditor, and
specifying the procedures that are designed to gather evidence is known as:
a) Audit procedure
b) Audit engagement
c) Audit evidence
d) Audit program
5. What is the primary purpose of an engagement letter?

a) To remind management that the primary responsibility to the financial statements rests
with them
b) To minimize the detection risk
c) To determine the completion of audit work
d) To Minimize misunderstanding between the client and the auditor
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e) To determine the audit fee
6. The relation ship between control risk and detection risk is:
a) Parallel
b) Direct
c) Inverse
d) Equal
7. One of the following is different from the others?

a) Random sampling
b) Haphazard sampling
c) Systematic sampling
d) Stratified sampling
e) None
Part-II Short answer questions
1. Describe the importance of audit planning and audit program

_____________________________________________________________
____________________________________________________________
2. Explain audit risk and its components.

_____________________________________________________________
_____________________________________________________________
3. Describe the engagement letter and its primary purpose
______________________________________________________________
65

______________________________________________________________
4. Describe the different sampling methods?
____________________________________________________________
____________________________________________________________
UNIT-FOUR
INTERNAL CONTROL
 Introduction
Dear student, from your previous study of generally accepted auditing standards, you may
remember that the second standard of field work states that “auditors have to examine the
66

internal control system of the client before they actually start collecting evidence that
supports the amounts reported on the financial statements.
The amount of audit work the auditors do in examining the financial statement depends
directly on the quality of the client’s internal control system. Form the auditor’s point of
view, this means if the client’s internal control system is strong, and you can rely on it. In
this case you need less time and to complete the audit.
Objectives

 Define and describe internal control and its components
 Distinguish between management and auditor’s responsibility regarding a company’s
internal control; and
 Explain the primary and secondary reasons for conducting an evaluation of a client’s
internal control.
 Distinguish between internal audit and internal control.
 Explain the relation ship between internal control and control risk
 Distinguish between accounting and administrative controls
 Limitations of internal control
4.1 Meaning and importance of Internal control
Internal control is the process, designed by an entity’s board of directors, management and
other personnel. It is designed to provide reasonable assurance regarding the effectiveness
and efficiency of operations, reliability of financial reporting and compliance with
applicable laws and regulations.
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In other words, internal control consists of all the measures taken by the organization for
the purpose of:
1-Protecting its resources against waste, fraud and inefficiency
2-Ensuring accuracy and reliability in accounting and operating data
3-Securing compliance with the policies of the organization and
4-Evaluating the level of performance in all organizational units of the organization.
In principle, a company is expected to establish adequate policies and procedures to

achieve the objectives of accounting controls. The specific internal control policies and
procedures depend on the nature of transactions and, the data processing system and other
similar factors.
An organization’s internal control structure consists of the policies and procedures
established to provide reasonable assurance that the organizations related objectives will
be achieved. The concept of reasonable assurance recognizes that no structure is perfect and
that the cost of an entity’s internal should not exceed the benefits expected to be derived.
Internal control extends beyond the accounting and financial functions and its scope is
company wide and touches all activities of the organizations. It includes the methods by
which top management delegates authority and assigns responsibility for such functions as
selling, purchasing, accounting, and production.
4.2 Need for Internal controls

The evolution of large corporate enterprises, including a great variety of specialized
technical operations and employees numbered in the tens of thousands, has made it
impossible for corporate executives to exercise personal, firsthand supervision of
operations. No longer able to rely upon personal observations as a means of appraising
operating results and financial position, and the necessity has come to depend upon a
stream of accounting and statistical reports. The information carried by this stream of
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reports enables management to control and direct the enterprise. It keeps management
informed as to whether company policy is being carried out, whether government
regulations are being observed, and whether financial positions are sound and profitable.
Business decisions of almost every kind are based at least in part on accounting data.
These decisions range from such minor matters as authorizing overtime work or purchasing
office supplies to such major issues as a shift from making one product to another or
making choice between leasing or buying a new plant. The internal control structure
provides assurance to management of the dependability of the accounting data used in
making these decisions. The independent auditors obtain an understanding of the internal
control structure in order to plan the audit and to determine the nature, timing, and extent of
the other auditing work necessary to permit them to express an opinion as to the fairness of
the financial statements.
Internal control is intended to achieve the following objectives:

1) Detect and eliminate errors and frauds
2) Exercise moral pressure over the employees and
3) Ensure reliability of accounting information
4) Verify the compliance with company policies
Q-Define the internal control and its importance

________________________________________________________________
4.3-Accounting Vs Administrative controls
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Internal controls can be classified in to two broad categories: accounting controls and
administrative controls.
Accounting Controls: These are controls related to the accounting system. They are
concerned with achieving the following objectives. To make sure that:
-Transactions are executed in accordance with the management’s authorization
-Transactions are promptly recorded in a proper manner to ensure timely preparation and
communication of reliable financial information
-Accountability for assets is maintained and assets are safeguarded from un authorized access,
use or disposal.
Administrative controls: These controls emphasize on the effectiveness and efficiency of

the management decision-making process. Administrative controls emphasize on controls
for management decision concentrating on authority and responsibility for authorization of
information. Administrative controls include the organizational structure, procedures and
records related to the decision process.
The plan of the organization refers to the organizational structure and the methods of
assigning authorities and responsibilities. A proper plan of the organization is important for
effective operation of the entire internal control system. Accounting controls have a direct
impact on the reliability of financial information, administrative controls, on the other hand,
have only an indirect effect on the financial information. Therefore, in financial statement
audit, the auditor will be primarily concerned with reviewing accounting controls rather
than administrative controls. But auditors should not forget that administrative controls that
have impact on the reliability of financial information should also be also reviewed.
Q-Give examples at least three examples of accounting and administrative controls

_____________________________________________________________________
Activity-13: Differentiating accounting controls from administrative

controls
Dear student, Internal controls are often classified as Accounting controls and
70

administrative controls. The purpose of this activity is to help you distinguish

between the two kinds of controls. Below is the list of activities. Consider
each activity and decide whether the given activity involves accounting
controls or administrative controls,
1. Rotation of duties
2. Plan of the organization
3. Periodic reconciliation
4. Preparation of monthly trial balance
5. Limiting direct physical access to assets and records
6. Approval and control of documents
________________________________________________________________
4.4 Components of internal control structure

Internal control structure varies significantly from one organization to another. The specific
control features used depend upon such factors as the size, nature of the operations, and
objective of the organization for which the structure was designed.
For the purpose of the financial statement audit, internal control structure should consist of
the following three major elements: Control environment, the accounting system and
control procedures.
1-Control environment: The internal control environment consists of the over all sets of
factors designed to achieve the organization’s policies and procedures. It reflects the overall
attitude of management and board of directors regarding the importance of controls in the
71

company. If top management believes that internal control is important, others in the
organization will sense that and respond conscientiously observing the policies and
procedures established.
The internal control environment consists of the following factors:

-management philosophy and operating style
-Organizational structure
-Board of Directors
-Methods of assigning authority and responsibility
-Management control methods
-Internal Auditing
-personnel policies and practices
-External influences
-Integrity, ethical values and commitment to competence
Moreover, the internal control environment will be effective if each control environment
factor is maintained as follows:
 Management creates favorable control environment within the organization. It
prescribes appropriate controls and adheres to established controls. Management places
emphasis on taking and controlling business risk, financial goals and financial
reporting.
 Organizational structure provides an overall frame work for planning, coordinating, and
controlling operations. The organizational chart accurately should reflect line of
authority, and reporting relationships that is delegation of authority and assignment of
responsibility.
 The Board of Directors overseas business activities and its audit committee monitor
financial reporting.
 Methods of assigning authority and responsibility are clearly established and
communicated.
72

 Internal auditing assists management in monitoring the effectiveness of control policies

and procedures and internal auditors should be independent of the units they audit and
must be qualified.
 Personnel policies and practices should result in hiring trustworthy, ethically competent
and adequate number of employees.
Q-Think of any organization in your locality and evaluate its management philosophy
_________________________________________________________________
2-The Accounting System: The focus of the accounting system as one of the
important component of the internal control is on the transactions. The accounting system
should provide a complete audit or transaction trial for each transaction. A transaction trial
is a chain of evidence provided by coding, cross references and documentation concerning
account balances and other summary results with original transaction data.
An effective accounting system should:
 Identify and record all valid transactions
 Describe the transaction in sufficient detail to permit proper classification of
transactions for financial reporting.
 Measure the value of the transactions in a manner that permits recording their proper
monetary value in the financial statements.
 Determine the time period in which transactions occurred to permit recording of
transactions in the proper accounting period.
 Present properly the transactions and related disclosures in the financial statements.
73

In general the accounting system consists of the methods and records established to ,
identify, record, assemble, analyze, classify and report an entity’s transactions and to
maintain accountability for the related assets and liabilities.
3-Control procedures: The control procedures have the following factors:

 Proper authorization
 Segregation of duties
 Documents and records
 Access controls
 Independent checks
Control procedures will be effective if each control procedures are maintained as

follows:
o If management personnel with in the scope of their authority authorize
transactions.
o The assignment of the responsibility for a transaction should enable one
employee to cross check the work of one or more employees. This helps errors
and irregularities to be prevented and detected.
o Segregation of duties is applied upon the following four situations like
responsibility for executing a transaction, recording the transaction and
maintaining custody of assets, resulting from the transactions should be assigned
to different individuals or departments.
o The various steps involved in executing a transaction should be assigned to
different individuals or departments
o Responsibility for certain accounting operations should be segregated.
o There should be proper segregation of duties with in the electronic data
processing and other departments.
74

o Documents should be pre-numbered and properly field and records should be

properly maintained.
o The work performed by the individual or department and valuation of recorded

amounts should be verified or independently checked.
o Verifying transactions and reconciling records with existing assets.
o Comparing and analyzing financial results with budgeted amounts.
Activity-14: Describing the components of internal control
This activity helps you to test understanding of elements of internal control

Assume you have established a new retailing business and you want to install
the internal control with in your organization. Describe the elements of the
internal control system that you should consider in establishing it.
_____________________________________________________________________
4.5-Internal controls and control risk
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Internal controls are all the policies and procedures that a company uses to prevent, detect,
and correct errors and irregularities and frauds that might get in to financial statements. The
auditor’s task is to assess the control risk associated with the control procedures designed
and implemented for the period under audit. Control risk is the probability that a
company’s controls will fail to detect errors, irregularities, and frauds. Control risk is a
characteristic of the client’s controls. Many auditors usually conclude the internal control
risk assessment decision with a descriptive assessment such as maximum or high, moderate
and low.
If the internal control is effective and strong, then the level of control risk will be
assessed as low. This is because due to the effectiveness of the internal control the errors
and frauds can be prevented and detected. Likewise if the internal control is poor, and then
the control risk can be assessed at high. If the auditors assess the control risk as high
(i.e... poor internal control) they will tend to perform a great deal of substantive audit work
with large sample size and gather more and competent audit evidence. On the other hand if
auditors assess control risk as low, (i.e... effective internal control) they can perform a
lesser quantity of substantive –audit work with small sample size. Of course, auditors may
assess control risk between low and high and adjust the substantive work accordingly.
The effective operation of internal control ensures that the accounting records are complete
and accurate. If the auditor is satisfied that the internal control system is functioning, there
is a reduced risk of error in the accounting. Therefore, the auditor has to see what internal
control system exists in the client and then check whether the system is operating properly
as designed.
The client expects the auditor to detect and report on frauds that might exist in the
organization and forward recommendations to management on how to improve the internal
control of their client’s if they find weakness in it.
Q- Explain the relationship between internal control and control risk

____________________________________________________________________
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4.6-Internal Audit and internal control

Internal audit is a means of management control mechanism established internally and
arising out of the need for verification. Internal audit is part of the internal control system
in an organization, which is responsible for evaluating and commenting on the
effectiveness of the internal control system. An internal audit function is established within
an entity to monitor the effectiveness of other control related policies and procedures. For
an internal audit function to be effective, the internal audit staff should be independent of
both the operating and accounting departments, and that it reports directly to a high level of
authority with in the organization.
There are two forms of internal auditing. These are pre-audit and post-audit. The pre-audit
is the examination of transactions before payment is effected. It is a more traditional audit
function. Post-audit represents after the fact examination and is a more recent one.
The purposes of pre-audit are to provide reasonable assurance that:

-Expenditures are not unreasonable or extravagant,
-Sufficient funds are available to enable payments of the invoice, and
-There has been compliance with government proclamations, regulations, and directive,
procedural and budgetary requirements.
Post-audit is conducted to achieve the following objectives:

 To verify the accounting records
 To review the internal control system
 To evaluate the efficiency, effectiveness and economy of operations and
 To evaluate if management objectives are achieved.
The basic limitation of the post-audit is that it concentrates on detection of fraud and error
rather than preventing their occurrence. The existence of an effective internal audit
strengthens the internal control system of the organization under consideration. This
increases the degree of reliance by the external auditor on the internal control system of the
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audit client. This in turn decreases the extent of examination to be made to verify the
reliability of the information included in the financial statements.
Activity-15: Describing the objective of post-audit and pre-audit

There are two forms of internal auditing: post- audit and pre- audit.
Describe the objective of conducting pre-audit and post-audit
_______________________________________________________________
4.7-Internal audit and External audit:

Internal audit is a means of management control mechanism established internally and
arising out of the need for verification. Internal audit is part of the internal control system in
an organization, which is responsible for evaluating and commenting on the effectiveness
of the internal control system. An internal audit function as part of an internal control
system is established with in an entity to monitor the effectiveness of other control related
policies and procedures.
For an internal audit function to be effective, the internal audit staff should be independent
of both the operating and accounting departments, and that it reports directly to high level
of authority with in the organization. External audit is n independent audit made by the
external auditors to attest the fairness of the financial statements presentation.
Thus internal and external audit varies with regard to need, status, scope, qualification,
appointment, responsibility and procedures.
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4.8-Limitations of Internal control

Regardless of how carefully designed, an internal control structure contains inherent
limitations. Of course, management is responsible to establish and maintain an appropriate
internal control system by considering the entity’s size, ownership, nature, characteristic of
employees, nature and complexity of operations, methods of data processing, and
regulations. Management normally seeks reasonable assurance, rather than absolute
assurance. This is because internal control structure has inherent limitations. This shows
that the auditor cannot rely 100% on an internal control system since all internal control
systems have inherent limitations. These weaknesses primarily emanate from the fact that
any internal control system is administered by human beings who are all subject to
temptation and default.
While designing the internal control system, the following two important factors need to be
considered:
-The cost of the structure should not exceed the expected benefits.
-Controls should not have a significant adverse effect on efficiency or profitability
All internal control systems are subject to three major inherent limitations:
Human factors: An employee through misunderstandings of instructions, carelessness, fatigue,
absenteeism, deliberate circumvention, or overriding specific controls can impair the
effectiveness specific controls. In short, incompetent and/or dishonest people can reduce the
system to a shamble.
Scope of controls: Controls may not encompass all transactions, that is non routine
transactions and extraordinary events may not be covered.
Business environment: Changed conditions may necessitate major modifications in the control
structure.
Thus, there is always some level of control risk but detection risk can be reduced when
there is an effective internal control structure.
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Q- List and describe the limitations of internal control?

_____________________________________________________________________
______________________________________________________________________
 Summary
Internal control is a process designed by an entity’s board of directors to provide reasonable
assurance regarding the achievement of organizational objectives. It is the responsibility of
management to ensure that internal control systems are strong. But the auditor must also
examine the system to plan the extent, the nature, and the timing of audit procedures to be
used in the achievement.
A company’s internal control system is classified in to administrative and accounting
controls. Administrative controls do not have direct impact on the financial statements of
the client. Accounting controls, however, directly affect the financial statements of the
client. Thus the auditor is interested in accounting controls. For the purpose of financial
statement audit, internal control system consists of the control environment, accounting
system and control procedures.
The control environment consists of management philosophy and operating styles,
organizational structure, board of directors, methods of assigning authority and
responsibility, management control methods, internal auditing and personnel policies and
practices
A company’s internal control does not provide absolute assurance that the objectives of the
management are met. This is because of its inherent limitations. The inherent limitations of
internal control are related to human factors, scope of control and business environment.
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Part-I: Choose the best answer from the given choices
1. Internal control is a;
a. part of internal audit
b. part of internal check
c. system of controlling employees of the organization
d. none
2. Which of the following is not an element of sound internal control;

a. Segregation of duties
b. Staffing adequately trained employees
c. proper authorization of transactions
d. Computerization of the programs
3. The most important objective of internal audit is?

a. to facilitate final audit
b. early preparation of financial statements
c. early detection of frauds and errors
d. to provide information to external auditors
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4. The part of audit risk which arises due to the inefficiency of internal control is?
a. Detection risk
b. Control risk
c. Inherent risk
d. all
5. If the internal control structure of the organization is too strong then
a. Control risk is high
b. Detection risk is low
c. Control risk is low
d. Detection risk is high
e. c&d
f. a&b
6. Which of the following best describes inherent limitations of an internal control

structure?
a. The benefits expected to be derived from the effective internal control
usually do not exceed the costs of such control
b. The competence and integrity of client personnel provide an environment
conducive to control and provides assurance that effective control will be
achieved.
c. Procedures designed to assurance the execution and recording of
transactions in accordance with proper authorization are effective against
irregularities perpetuated by management.
d. Procedures whose effectiveness depends on segregation of duties can be
circumvented by collusion.
7. Control activities constitute an important part of internal control. Control activities

do not encompass:
a. proper safeguards over access to assets
b. Design and use of documents
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c. An internal audit function

d. Comparison of assets with recoded accountability.
8. Component of audit risk, which is related to the firm’s internal control, is:
a. Audit risk
b. Inherent risk
c. Control risk
d. detection risk
e. none
Part-II: Short answer questions

1. What is internal control?
________________________________________________________________
________________________________________________________________
2. What are the primary objectives of internal c control structure?

_________________________________________________________________
__________________________________________________________________
3. Briefly describe the elements of internal control

_________________________________________________________________
_________________________________________________________________
4. What are the inherent limitations of internal control?

_________________________________________________________________
_________________________________________________________________
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UNIT-FIVE
AUDIT EVIDENCE
 Introduction
As you might remember in previous units, the purpose of financial statement audit is the
expression of an opinion on the fairness of the financial statements. To have a basis for an
opinion, you have to gather and evaluate evidence.
The third standard of field work requires the auditor to obtain sufficient and competent
evidential matter. Audit evidence is any information used by the auditor to determine
whether the quantitative information being audited is stated in accordance with the
established criteria. The information varies widely in the extent to which it persuades the
auditor whether the financial statements are stated in accordance with generally accepted
accounting principles.
In this unit you will study the nature of audit evidence, which will help you to distinguish
between the concepts of competency and sufficiency as they relate to auditing, the financial
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statement assertions provided by management, the different types of audit evidence and
their credibility and the use of audit working papers.
Objectives:

 Understand the objective of conducting an audit of financial statements
 Discuss the five types of management assertions about financial statements.
 State the nature and types of audit evidence
 Explain the auditors’ responsibility to subsequent events
 Describe the purpose of audit working papers.
5.1-Nature of Audit Evidence

The third standard of field work requires an auditor to collect sufficient and competent
evidence, which is the every essence of auditing and forms the basis for issuing audit
opinion. Audit evidence includes all the things that influence the auditor’s judgment in
evaluating whether the financial statements are in conformity with GAAP. Audit evidence
is any information or document that confirms or rejects a premise (a statement or
hypothesis). As an auditor, you, there fore need to obtain sufficient, relevant and reliable
evidence to satisfy your self that the objectives of the individual audit have been met, and
thereby the overall audit opinion can be put forward. Thus most of the auditor’s work
involves obtaining and evaluating evidences.
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Q. What makes audit evidence competent and sufficient?
Competency of evidence is related to its quality and reliability. Evidence is said to be

competent if it is both valid and relevant. The quality of audit evidence is affected by the
source of the audit evidence, the strength of the client’s internal control and the ability of
the auditor to gather firsthand information. A brief discussion of each is given below:
 The source of the audit evidence: Evidence obtained from independent sources outside
the client is more reliable than evidences obtained from the client.
 The strength of the client’s internal control: The quality and reliability of audit evidence
increases if the client has strong internal control
 The ability of the auditor to gather first hand information: Information obtained by
auditors through personal observation, computation or using other techniques increases
the reliability of audit evidence.
Sufficiency of evidence relates to the quantity of evidence auditors should obtain. Though
the sufficiency audit evidence is determined by the auditor’s professional judgment, factors
such as competence, materiality and risk are the determinants of the sufficiency of audit
evidence.
In general, more evidences are needed for accounts that are material to the financial
statements than for accounts that are immaterial. Similarly, more evidences are normally
required for accounts that are likely to be misstated than for accounts that are likely to be
correct. But still, the amount of evidence that is considered sufficient to support the
auditor’s opinion is a matter of professional judgment. The amount of evidence that is
sufficient in a specific situation varies inversely with the appropriateness of the available
evidence. Thus the more appropriate the evidence, the less the amount of evidence that is
needed to support the auditor’s opinion. In short sufficiency and competency of audit
evidences are inversely related.
You might have realized that one of the factors affecting the reliability of the audit
evidence is its source. To clarify more, you may classify evidence as follows: Evidence
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originated by the auditor, evidence created by the third party and evidence created by the
management of the client.
 Evidence created by the auditor: this type of evidence is exceptionally reliable since
there is little risk of being manipulated by management. Analytical review procedures,
physical inspection or observation and re-performance of calculations are some of the
reliable evidences that might obtained by the auditors.
Evidences obtained from third parties: Evidences obtained from third parties independent of
the client are more reliable than evidence produced by the client. Examples may include:
confirmation letter obtained from the client’s customer, confirmation of bank balances, reports
produced by specialists such as property valuations and legal opinions, documents provided by
the client which were issued by third parties such as invoices.
Evidences originated from client’s management: this type of evidence is less reliable than
evidence obtained from outside party. The degree of reliance to be placed on such evidence
depends on the reliability of the client, internal control and materiality of the item. Examples
of such evidence includes the client’s accounting records, supporting schedules, and the
clients oral explanations,
Activity-16.Classifying audit evidences as internal and external

Dear student, evidences can be classified as internal and external.
Assume the auditor gather the following documents to support his conclusions
about the financial statements. Classify each of the following documents as
internal and external
1.Purchase requisitions
2. Bank statements
3.Remitance advices
4. Minutes of board of directors
5. General ledgers
6. Notes receivables
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7. Receiving reports
___________________________________________________________
5.2 Audit objectives and management assertions
 Audit objectives:
The objective of the ordinary examination of financial statements by the auditor is the
expression of an opinion on the fairness of financial statements. The only reason why
auditors accumulate evidence is to enable them to reach conclusions about whether
financial statements are fairly stated and issued as appropriate audit reports. When the
auditors conclude that the financial statements are unlikely to mislead a prudent user, the
auditor gives an audit opinion on their fair presentation and associate his/her name with the
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 the
assertions made by management that are contained in the financial statements. The
auditors’ assertions are closely related to management assertions. This is not surprising,
since the auditor’s primary responsibility is to determine whether management assertions
about financial statements are justified or correct.
Audit objectives are intended to provide a frame work to help the auditor accumulate
sufficient and competent evidence required by the third standard of field work and decide
the proper evidence to accumulate given the circumstances of the management. The
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objective remains the same from audit to audit, but the evidence varies, depending on the
circumstances.
The primary objective of audit evidence is to issue an opinion on the fairness of the
presentations made in the financial statements. To issue an opinion on the fairness of the
financial statements the auditors need to gather sufficient and competent evidence.
 Management’s financial statement Assertions
Financial statements include both explicit and implicit management assertions.

Management assertions are implied or expressed representations by management about all
the transactions and balances appearing in the financial statements. For example, consider
that the current asset section of the balance sheet shows cash of Br. 50,000. In reporting this
item in the balance sheet, management makes the following two explicit assertions: (1) cash
exists and (2) the correct amount of cash is Br 50,000. Management also makes the
following three implicit assertions: (1) all cash that should be reported has been included,
(2) all the reported cash is owned by the entity and (3) there are no restrictions on the use
cash. Therefore, assertions are the representations by management that are embodied in
financial statements. By presenting financial statements, management is stating either
implicitly or explicitly certain things about the company’s financial position and operations.
There are five broad categories of financial statement assertions. These are:
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Existence or Occurrence: Assertions about existence or occurrence deal with

whether assets and liabilities of the entity exist at a given date, and whether recorded
revenues and expense transactions have occurred during a given accounting period. The
auditor’s concern about this category of assertion relates primarily to the overstatement of
financial statement components through the inclusion of items that do not exist or the
effects of transactions that did not occur. But it does not extend to whether items that do
exist and the effects of transactions that did occur have been included at the correct
amounts.
Completeness: Assertions about completeness deal with whether all transactions and
accounts that would be presented in the financial statements are so included. The auditor’s
concern is about completeness assertions relates primarily to the possible understatement of
financial statement components through the omissions of items that exist or omission of
effects of transactions that occurred. But, the issue of correct amounts relates to valuation or
allocation assertion.
Valuation or allocation: Assertions about valuation and allocation are concerned with
whether the asset, liability, revenue and expense components have been included in the
financial statements at appropriate amounts. The reporting of financial statements
component at an appropriate means that the amount has been determined in conformity
with GAAP and is free from of mathematical or clerical errors. Conformance with
GAAP includes appropriate application of the cost, matching, and consistency principles of
accounting.
Rights and Obligations: Assertions about rights and obligations deal with whether
assets are the rights of the entity and liabilities are the obligations of the entity at a given
date. The rights and obligation assertion pertain only to the balance sheet components.
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Presentation and disclosure: Assertion about presentation and disclosure deal with
whether particular components of the financial statements are properly classified, described
and disclosed. This assertion involves determining whether items are included in the correct
accounts and accounts are properly displayed on the financial statements. For example,
assets must be properly separated in to short term and long term. The assertion about
disclosure involves that the balance sheet and income statement accounts and related
information are correctly set forth in the financial statements and properly described in the
body and footnotes of the statements.
Activity-17: Assessing the audit objectives and assertions

Dear students, The following are specific audit objectives applied to the audit
of accounts receivables. Describe the type of assertion involved in each audit
objective
1. There are no unrecorded receivables

2. Allowance for doubtful accounts has been provided for.
3. All accounts recorded are with in the accounting period
4. All the accounts in the list have occurred during the normal business period
____________________________________________________________
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5.3 Types of Audit evidence

When conducting audits, auditors gather a combination of many types of evidences. The
auditor should consider whether the conclusions drawn from different types of evidences
are consistent with one another. Audit evidence is a fundamental concept in auditing and
the major types evidences that are gathered during an audit are classified as follows:
 Physical evidence
 Documentary evidence
 Accounting Records
 Written Representations
 Mathematical evidence
 Oral evidence
 Evidence from analytical procedures.
Physical evidence: physical evidence is obtained from the physical examination or
inspection of tangible assets. This form of is widely used by auditors in the verification of
tangible asset balances. Physical evidence is obtained from the actual physical examination
of the resources. This type of evidence provides the auditor with direct personal knowledge
of the existence of an item. How ever, this type of evidence does not establish the
ownership or valuation of the asset. Physical evidence is also helpful in determining quality
of the asset. The auditor should supplement the evidence obtained through physical
examination by other types of evidence to determine ownership and proper valuation.
Documentary Evidence: This type of evidence includes checks, invoices, contracts,

minutes of the meetings and others. Such documentation is contained in the client’s files
and is available to the auditor on request. The reliability of a document depends on the
manner in which the document is created, the way it was obtained by the auditor and the
nature of the document it self.
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Documentary evidence may be created outside the client organization or within it.
Externally created documents may be sent directly to the auditor by third party; or such
documentation may be held by the client. Externally created documents are viewed as the
highly reliable since the client does not have an opportunity to alter the documents.
The reliability of internally created documents depends on the distribution or circulation of
the documents. Documents originated by the client such as canceled or paid checks that
circulate outside the client organization are considered more reliable than documents that
remain entirely with in the company. Examples of internally created documents include
sales invoices, shipping notices, purchase orders, and receiving reports. The reliability of
such types of documentary evidence depends on the quality of the internal control structure
from which the documents are generated.
Accounting Records: An amount appearing in financial statements may be verified by

tracing it back through ledger, journal, and source documents. When record keeping is
monitored by good internal control, it provides reliable support for financial statements.
When different persons maintain general ledger, subsidiary ledgers and journal, reliability
will be more. However, the auditor must be careful about alteration or misstatements.
Written Representations: A written representation is a signed statement by responsible

and knowledgeable individual about a particular account, circumstances or events. Written
representations are a form of documentary evidence which might originate from with in the
client’s organization or external sources.
The auditor is required by GAAS to obtain certain written representations and such
representations are designed to document management’s replies to inquiries made by the
auditor during the engagement. Management representations commonly presented in the
form of representation letter may reveal information not shown in the accounting records
such as existence of contingencies that may require further investigation. At the end of field
work auditors obtain a written letter of representations from the client, verifying oral
representations falling in to the following categories. All relevant records have been made
available to the auditors, financial statements are complete and prepared in conformity with
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generally accepted accounting principles and all items requiring disclosures have been
disclosed properly.
Auditors may also request written representations from out side experts. An auditor is not
expected to possess expertise of lawyers in evaluating litigation pending against the client
or geologist in estimating the quantity of a mineral oil. When an auditor needs such
evidence, they can use the work of a specialist (lawyer or geologist) to obtain competent
evidential matter.
Mathematical evidence: This type of evidence is results from the auditor’s computations
or re-computations. Computations provide reliable evidence relevant to the auditor
objectives of clerical accuracy and valuation. Mathematical evidence may result from such
routine tasks as checking the footings of journals and ledgers, or from complicated
calculations pertaining to pension plans and earnings per share data.
Oral Evidence: Through out their examination the auditors will ask a great many questions
to the officers and employees of the client’s organization. The answers to the auditors’
questions represent another type of oral evidence. Generally oral evidence is not sufficient
in it self, but it may be useful in disclosing situations that require investigation or in
corroborating other forms of evidence. Oral evidence serves the same audit objective as
written representation.
Analytical evidence: These are used to establish reliability of information by analyzing

relationships among financial and other information. It involves determining an expected or
desired balance and determining the tolerance level. This type of audit evidence involves
the use of ratios and comparisons of the client data with industry trends, general economic
conditions, and prior or expected company results. Analytical evidence provides a basis for
supporting an inference on the fairness of a specific financial statement item or relationship.
Analytical evidence relates primarily to the existence, completeness and valuation audit
objectives. This type of evidence may help to understand client’s strength and weakness in
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comparison to similar companies. How ever, auditors must be careful of comparability such
as size, accounting methods adopted and other business issues.
Activity-17: Describing the different types of audit evidences
Assume you are the senior auditor and one of your junior auditors within the
audit team asks you the types of audit objectives are there and reliability.
Please describe the different types of audit objectives with their relative degree
of reliability
____________________________________________________________
5.4 The Relation ship between evidence and audit risk

There is strong relation ship (high degree of correlation) between the audit risk and the
type's evidence to be collected to form an opinion regarding fairness of financial statements.
While determining competence and sufficiency of evidence, auditors must consider the
audit risk i.e. the possibility of misstatement and their failure to detect it and issuing
inappropriate opinion. The audit risk includes inherent risk (possibility of material
misstatement assuming absence of internal control), and detection risk ( the risk that audit
procedures may lead to a conclusion that there is no material misstatement when in fact the
accounts are materially misstated). While planning the audit and determining the evidence
requirement, the auditor must assess the degree of inherent and control risks for each
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material item. Accordingly they should plan the audit procedures and quantity and quality
of evidence required to minimize detection risk by collection of enough competent
evidence.
Conducting the complete audit i.e. examining each invoice, cheque or other documentary
evidence is not feasible. Therefore it is required to test adequacy and effectiveness of the
methods and procedures adopted by the company to control its accounting process so that
the auditor can do with sample audit. In general the audit risk can be minimized if the
auditor is able to accumulate competent and sufficient evidence and the quality
(competency) and quantity (sufficiency) of evidence to be gathered depends on the internal
control structure of the client.
If the internal control system of the client is strong, then the control risk is low and the
auditor may rely on such strong internal control system and fail to design appropriate audit
procedures. This in turn, may result in high detection risk and vice versa.
5.5 Evidences provided by subsequent events

Evidence not available at the end of the period under audit some times becomes available
before the auditors finish their field work and write their audit report. The auditor’s opinion
on the fairness of the financial statements may be changed considerably by these
subsequent events.
The term subsequent event refers to an event or transaction that occurs after the date of
the balance sheet but prior to the completion of the audit and issuance of the audit
report.
Subsequent events may be classified in to two broad categories:
1)-Those providing additional evidence as to facts existing on or before the balance sheet
date and
2)-Those involving facts coming in to existence after the balance sheet date
The first type of subsequent event provides additional evidence as to conditions that
existed at the balance sheet date and affects the estimates inherent in the process of
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preparing financial statements. These types of subsequent events require that the financial
statement amounts be adjusted to reflect the change in estimates resulting from the
additional evidence.
As an example, assume the large amount of receivable due from the client’s major customer
was regarded as good and collectible at year end, but during the course of the audit
engagement the customer entered bankruptcy. The bankruptcy of the customer shortly after
the balance sheet date indicates that the client was simply in error in believing the
receivables to be good and collectible. Hence, the auditor should insist an increase in the
year end allowance for uncollectible accounts. Another good example is litigations pending
against the client and shortly settled after the balance sheet date. Such litigations are
disclosed in notes to the financial statements and when such litigations are settled it
becomes actual liability and should be reported on the balance sheet date.
The second type of subsequent event involves conditions coming into existence after the
balance sheet date. These types of subsequent events don’t require adjustment to the
financial statements, but they should be disclosed to the financial statements.
For example, if the client sustains an uninsured fire loss destroying most of its plant assets,
shortly after the balance sheet date, but during the course of audit engagement, the carrying
value of plant assets should not be reduced because these assets were correct at the end of
the year. However, the event should be disclosed to the financial statements as foot note.
Other examples:
-Business combination with other competing company
-Death of company’s key official
-Introduction of new product line
-Plant closed by a labor strike.
-Adoption of new retirement pension plan which requires large cash outlays.
Although these events may be significant in the future operations of the company and of
interest to many who read the audited financial statements, none of these occurrences has
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any bearing on the results of the year under audit, and their bearing on future results is not
easily determinable.
In deciding whether a particular subsequent event should result in adjustment to the

financial statements or footnote disclosures, the auditor should carefully consider when the
underlying conditions came in to existence. Closely related to subsequent event is
subsequent period. The subsequent period is the period of time between the balance sheet
date and the last day of field work. During this period the auditors should determine that
proper cutoffs cash receipts and disbursements and sales and purchases have been made and
should examine data to aid in the valuation of assets and liabilities as of the balance sheet
date.
In addition, the auditors should:

 Review the latest available interim financial statements and minutes of the directors,
stockholders and appropriate committees’ meetings.
 Inquire about matters dealt with at meetings for which minutes are not available.
 Inquire appropriate client officials as to loss contingencies, change in capital stocks,
debt or working capital, change in the current status of items estimated in the financial
statements under audit or any unusual adjustments made subsequent to the balance sheet
date
 Obtain a letter from the client’s attorney describing as of the last day of field work,
pending litigation, unasserted claims, or other loss contingencies.
 Obtain a letter of representation from the client concerning subsequent events. This
letter should be dated as of the last day of the field work.
Generally the auditor’s responsibility for performing audit procedures to gather evidence as
to subsequent events extends only through the last day of field work. How ever, even after
completing normal audit procedures, the auditors have the responsibility to evaluate
subsequent that come in to their attention. Suppose, for example, that the auditors
completed their field work for the December 31 audit on February 3 and thereafter began
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writing their report. On February 12, before completing their report, the auditors were
informed by the client that the lawsuit, which had been footnoted as a loss contingency in
the December 31 financial statements, had been settled on February 11 by a substantial
payment by the client. In such cases the auditors should have to insist that the loss
contingency be changed to a real liability in the December 31 balance sheet and that the
footnote be revised to show the settlement of the lawsuit subsequent to the balance sheet
date.
Activity-18: Explaining the auditors responsibility with regard to

subsequent events;
Assume you started audit the financial statements of Fasil company for the
year ended December 31, 2007. The field work of your audit is completed on
February 25, 2008. On march, 2, 2008, pending litigation with Br 250,000 has
been settled and the court has decided that Fasil company to pay it with in 60
days. On March 15, 2008 one of the key officers has left the company
following the decision of the court on the litigation.
Explain your responsibilities with regard to both the events that have occurred
on march 2, 2008 and March 15, 2008. (Hint: how should both events be
reported?)
____________________________________________________________
5.6 Audit working papers

Working papers refer to the papers prepared by the auditor for audit work as well as the
documents, statements, and recorded information obtained by the auditor from his client
and others connected with the business.
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The documentation of audit evidence is provided in working papers. Working papers are
kept by the auditor’s of the procedures applied, the tests performed, the information
obtained, and the pertinent conclusions reached in the audit. Working papers are the written
private materials which an auditor prepares for each audit. It describes the accounting
information which an auditor received from the client, the method of examination,
conclusions and the reasons thereof and the financial statements.
Working papers provide basic evidence of audit conducted in accordance with the standards
audit practices and helps the auditor in writing the report.
Working papers are the connecting links between the client’s accounting records and the
auditor’s report.
Functions of working papers: Audit working papers assist auditors in several ways
1-It provides a means of the assigning and coordinating audit work.
2-It helps the seniors in supervising and receiving the work of assistants.
3-It supports the audit report.
4-It helps the auditor to show his client the weakness of the internal control system
5-It is a permanent record and in case of any suit against him for negligence.
6-It helps for planning and conducting the next audit.
7-It serves as an evidence to show that the audit was made in accordance with GAAS.
Contents of working papers: Working papers normally include:

 the audit plan and programs
 -Copies of the documents received
 Schedules of receivables and payables, fixed assets and investments
 Copies of any correspondences concerning the audit work
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 Contract letter from the client

 Particulars of depreciation
 Copies of the previous audit reports
 Copies of the resolutions passed in the meetings of directors and
shareholders.
 Certificates of management assertions.
 Details of the questions made during the course of audit and their
explanations given
 Understanding of the client’s internal control
 Recommended journal entries necessary to correct the accounts
 Other necessary documents received for the conduct of the audit work.
Ownership of working papers: The audit working papers being the matters
documented and prepared by the auditors are the property of the auditors, not of the client.
The client doesn’t have the right to demand access to the auditor’s working papers. After
the audit, the working papers are retained by the auditors and the custody of working papers
rests with the auditor, and the auditor is responsible for their safe keeping.
To conduct the satisfactory audit, the auditors must be given unrestricted access to all
information about the client’s business. Much of this information is confidential in nature.
The information obtained and documented through the working papers may be confidential
and hence working papers them selves are confidential in nature. Hence auditors shall not
disclose any confidential information obtained in the course of a professional engagement
except with the consent of the client.
Activiy-18 Describing the functions of working papers

After the completion of the audit report, One of the members of the
audit team asks you the importance of keeping the audit working
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papers. Describe to him/her the importance of the working papers

after the issuance of audit report.
_______________________________________________________
Summary
The primary objective of financial statement audit is to examine and express an opinion on
to the reasonableness and fairness of the financial statements. To this end the auditors have
to gather sufficient and competent evidence by applying various techniques. The major
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types of evidences that are gathered during an audit may be classifies as physical evidence,
documentary evidence, written evidence, , oral evidence and analytical evidences.
Auditors should have a detailed record of the activities they have performed during their
engagement. Such records are known as audit working papers. These working papers are
records prepared and kept by the auditors. These working papers are permanent records and
contain the procedures applied, tests performed, the information obtained and the pertinent
conclusions reached by the auditor in the engagement. Working papers provide evidence of
the auditors' technical training and proficiency by showing his/her knowledge of generally y
accepted accounting principles and his/her ability to apply auditing procedures applicable in
the circumstances. Such papers are the properties of the auditor and should be kept
confidentially since they contain confidential information of the client.
Self-test exercises-5
Part-I choose the best answer from the given choices.
1. The principal reason why an auditor gathers audit evidence is to________
a. To detect fraud
b. Evaluate management
c. Form an opinion the financial statement
d. Evaluate internal control
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e. All
2. Audit evidence can come in different forms with different degrees of persuasiveness.
Which of the following is the least reliable type of evidence?
a. Supplier's invoice
b. Bank statement
c. Computations made by auditor
d. Accounting records of the client
e. none
3. Which of the following statements relating to the competence of the evidential matter is
false?
a. Evidential matter gathered by the auditor from outside an enterprise is reliable
b. Evidence obtained from the client is more reliable
c. Oral representations made by the management are additional sources of
Evidence
d. Accounting data developed under strong internal control are more reliable
4. The purpose of gathering competent and sufficient evidence at the planning stage is?
a) Evaluate the effectiveness of internal control
b) Determine appropriate internal control
c) Determine the completeness and accuracy of the an account balance
d) Accept or reject an engagement
5. Which of the following is not the primary purpose of audit working papers?
a) To coordinate the examination
b) To assist in then preparation of audit report
c) To support the financial statements
d) To provide evidence of the audit work performed
e) None
6 Audit working papers are the properties of:
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a) The auditors
b) The client
c) Both
d) none
Part-II short answer questions
1. What factors affect the reliability of audit evidence?
______________________________________________________________
_______________________________________________________________
2. Describe the different types of audit evidences;
______________________________________________________________
______________________________________________________________
3. Describe the relation ship between competency and sufficiency audit evidence
______________________________________________________________
______________________________________________________________
4. Briefly describe the function of audit working papers.
______________________________________________________________
______________________________________________________________
UNIT-SIX
AUDIT REPORTS
 Introduction
Dear student, in this unit you will be introduced with the final output of the auditing
process-audit reports. Audit report is the final step in the audit process. Audit reports are
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usually the only channel of communication between the shareholders of the company
whose financial statements have been subject to audit and the auditors. Dependable
financial information is essential to the very existence of our society. Good accounting and
financial reporting aid the society in allocating its resources in the most efficient manner.
The contribution of independent auditor is to give credibility to financial statements and
then by to make the information dependable to the decision makers. Credibility, in this
usage, means that the financial statements can be believed and relied upon by outsiders
such as shareholders, trade creditors, government, and other interested parties. Audited
financial reports are now the accepted means by which business corporations report their
operating results and financial position. The word audit when applied to financial
statements means that the balance sheet, income statement, retained earnings statements and
statement of cash flows are accompanied by an audit report prepared by independent public
accountants, expressing their professional opinion as to the fairness of the company’s
financial statements.
This unit deals about the scope of audit report, the different types of audit reports and the
circumstances under which the different audit reports are issued.
Objectives
 Describe the nature of audit report
 Identify the components of audit report
 Describe the different types of audit reports.
 Describe the conditions under which each type of audit report is issued
 Describe the concept of materiality on the type opinion auditors express.
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6.1 The nature of Audit report

The audit report is the final step of the audit process. The financial statements on which you
prepare an audit report are the balance sheet, the income statement, the statement of
retained earnings and the statements of cash flow. The auditing profession recognizes the
need for uniformity in reporting as a means of avoiding confusion. To avoid confusion and
misrepresentation of an audit report there should be uniformity in reporting.
The AICPA has developed the following reporting standards.

1. The report shall state whether the financial statements are presented in conformity
with Generally Accepted Accounting Principles.
2. The report shall state whether or not such principles have been consistently
followed or not.
3. Informative disclosures in the financial statements are to be regarded as reasonably
adequate unless otherwise stated in the report.
4. The report shall contain either an expression of an opinion regarding the financial
statements taken as a whole, or an assertion to the effect that an opinion cannot be
expressed. When an over all opinion cannot be expressed, the reasons should be stated. In
all cases where an auditor’s name is associated with the financial statements, the report
should contain a clear-cut indication of the character of the auditor’s examination, if any,
and the degree of responsibility he/she is taking.
The profession recognizes the need for uniformity in reporting as a means of avoiding
confusion. The professional standards have defined and enumerated the types of audit
reports that should be included with the financial statements. The wording of audit reports
is reasonably uniform, but different audit reports are appropriate for different
circumstances.
Q- Explain the four reporting standards of auditing.

____________________________________________________________________
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6.2 Components of the standard Unqualified audit report
Auditors issue different types of reports based on their findings. Later, in this chapter, we
shall see the types of reports issued by auditors. One of the reports auditors issue is the
standard unqualified audit report. The standard audit report contains three paragraphs,
namely the introductory paragraph, the scope paragraph, and the opinion paragraph.
Each part of the auditor report is significant in terms of the information conveyed to the
user and the responsibility assumed by the auditor.
Independent Auditors’ Report
To :The Board of Directors and share holders

ABC Company
We have audited the accompanying balance sheet of ABC company as of December

31, 2007, and the related statement of income, retained earnings, and cash flows for the
year then ended. These financial statements are the responsibility of the company’s
management. Our responsibility is to express an opinion on these financial statements
based on our audit.
We conducted our audits in accordance with generally accepted auditing standards.
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Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatements. 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
principles used and significant estimates made by management, as well as, evaluating the
over all financial statement presentations. We believe that our audits provide a reasonable
basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of ABC company as of December 31, 2007, and
the results of its operations and its cash flows for the year then ended in conformity with
Generally Accepted Accounting Principles (GAAP).
A&B&C
Signature
Date: March 15, 2008
The above standard unqualified report has seven parts.

Report Title: The auditing standard requires that the report be titled and that the title
include the word Independent. The appropriate title would be “Independent auditor’s report,
or Report of independent auditors.” The requirement that the title include the word
“independent” is intended to convey to users that the audit was unbiased in all aspects of
the engagement.
Address: The report is usually addressed to the company, its stockholders or the board of
directors or combinations of these. If you are appointed by the stockholders at the annual
meeting, you have to write the audit report addressing to them.
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Introductory paragraph: This is the first paragraph of the audit report and it does three
things:
 It makes the simple statement that the audit firm has done an audit. This is intended
to distinguish the report from a compilation or review report.
 It lists the financial statements that were audited, including the balance sheet,
income statement, statement of retained earnings and cash flow statements.
 The introductory paragraph states that the statements are the responsibility of
management and that the auditor’s responsibility is to express an opinion on the
financial statements based on an audit.
Scope paragraph: The scope paragraph describes what the auditor has performed during
the audit. Specifically, it states whether the audit was conducted in accordance with
Generally Accepted Auditing Standards (GAAS). It also states that the GAAS requirement
that an audit be planned to provide reasonable assurance that the financial statements are
free of material misstatement. The scope paragraph states that the audit is designed to
obtain reasonable assurance about whether the statements are free of material
misstatements. The inclusion of the word “material” conveys that auditors are responsible
only to search for significant misstatements; not minor errors that do not affect users’
decisions. The use of the term “reasonable assurance” is intended to indicate that an audit
cannot be expected to eliminate completely the possibility that a material error or
irregularity will exist in the financial statements. In other words, an audit provides a high
level of assurance, but it is not a guarantee.
The scope paragraph also discusses the audit evidence accumulated and states that the
auditor believes the evidence accumulated was appropriate for the circumstances to express
the opinion presented. The word test-basis indicates that sampling was used rather than an
audit of every transaction and amount on the statements.
Opinion Paragraph: The final paragraph in the standard report states the auditor’s
conclusions based on the results of the audit examination. This paragraph contains the
auditor’s opinion on whether the financial statements are in conformity with GAAP.
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Management is responsible for preparing the financial statements. The responsibility of the
auditor is to audit them and express an opinion on their fairness. This paragraph describes
the auditor’s findings. These findings are expressed in terms of whether the financial
statements are presented in accordance with generally accepted accounting principles. The
audit report must contain either an expression of opinion or an assertion to the effect that an
opinion can not be rendered and the reasons for this.
Name of the audit firm and signature: The name and the signature identify the audit firm
or practitioner that has performed the audit. Typically, the firm’s name is used, since the
entire audit firm has the legal and professional responsibility to make certain the quality of
the audit meets professional standards.
Date of audit report: The appropriate date of the audit report is the one on which the field
work has been completed. This date is important because it represents the time limit on the
auditors’ responsibility. The auditor does not have any responsibility to make any enquiries
after this date.
Q-Describe the purpose of each paragraph of the unqualified audit report
__________________________________________________________________
Activity-19: Applying the reporting standards
This activity helps you to relate your understanding to practical

situations.
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Assume that on February 30/2008 you completed the fieldwork on the

financial statements for Dashen company for the year ended December,
31, 2007. The audit is satisfactory in all material respects except for the
existence of a change in accounting principles from Straight line to
Double declining methods of depreciation for building, Which results in
an explanatory paragraph to consistency. On march 3/2008, you
completed the final audit report, attached to the financial statements and
delivered to the client on march 8/2008. Which is the appropriate date on
the auditor's report?
___________________________________________________________
6.3 Types of audit report

There are four types of audit reports that might be issued by the auditors. These are:
1) An unqualified opinion
2) Qualified opinion
3) An adverse opinion
4) Disclaimer opinion
The Unqualified report: The most common type of audit report is the standard
unqualified audit report. This report represents a “clean bill of health” and may be issued
when there are no material departures from generally accepted accounting principles, no
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significant scope limitations preventing the gathering of necessary evidence and when no
conditions requiring explanatory language exist.
The unqualified report is issued when the following conditions have been met:
 All statements- balance sheet, income statement, statement of retained earnings and
cash flow statements are included in the audited financial statements
 When all the three general standards of auditing are applied in all respects of the
engagement.
 When sufficient evidence has been accumulated and the auditor has conducted the audit
in a manner that enables him to conclude that three standards of field work have been
met.
 The financial statements are presented in accordance with generally accepted
accounting principles. This also means that the adequate disclosures have been included
in the footnotes and other parts of the financial statements.
 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 their audit. The sample unqualified opinion has been
presented on previous page.
Q-Describe the conditions under which the auditor issues unqualified audit report?
___________________________________________________________________
Activiy-20: Evaluating standard unqualified audit report and explaining
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its deficiencies
Dear student, this activity helps you to relate your understanding of the
content of an audit report with practical situations.
Adonias is an authorized auditor. He has completed the examination of the
financial statements of Z-company as of the year ended December 31/2007.
Adonias has applied the generally accepted auditing standards and has no
scope limitations during the engagement. The financial statements according
to his conclusions are prepared in accordance with GAAP and finally Adonias
drafted the following report.
I have audited the balance sheet, income statement and retained earnings
statement of Z-company as of the year ended December 31/2007. I conducted
my audit in accordance with generally accepted auditing standards. Those
standards require that I plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of misstatements.
I believe that my audit provide a reasonable basis for my opinion. In my
opinion, the financial statements referred to above present fairly the financial
position of Z-company as of December 31/2007, and the results of its
operations fort the year then ended in conformity with generally accepted
accounting principles.
Adonias
Signature
Date
Explain the deficiencies of the above audit report issued by Adonias.
______________________________________________________________________
Q. Identify and discuss the different parts of the standard unqualified audit report
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___________________________________________________________________
Qualified opinion: This type of opinion is still a positive opinion and may result from
limitations on the scope of the audit of failure to follow generally accepted accounting
principles.
Auditors may issue this type of opinion when:

 They do not agree with the accounting principles used in preparing financial statements
or when they believe that the disclosures in the financial statements are inadequate.
 A change in accounting principles is not applied properly as per GAAP and is not
adequately disclosed in the financial statements
 There are limitations on scope of examination
 There is major uncertainty affecting a client’s business.
In general qualified opinion is issued when the auditors’ examination is restricted as to its
scope or the financial statements depart from generally accepted accounting principles.
A qualified opinion is still a positive opinion; it asserts that the presentation in the financial
statements, viewed as a whole is fair. The qualified opinion has a separate explanatory
paragraph before the opinion paragraph disclosing the reasons for the qualification. When
ever the auditor issues a qualified report, he/she must use the term except for in the opinion
paragraph. The implication is that the auditor is satisfied that the overall financial
statements are correctly stated except for a particular aspect of them
Example of qualified opinion
Independent auditors’ report

To: Board of directors and shareholders
RT-Company
115

We have audited the accompanying balance sheet of RT-company as of December

31, 2007 and the related statements of income and retained earnings for the year then
ended.These statements are the responsibility of the company’s management. Our
responsibility is to express an opinion based on our audit.
We conducted our audit in accordance with auditing standards. Those standards
require that we plan and perform the audit to obtain reasonable assurance as to whether
the financial statements are free of material misstatements. An audit includes examining
on test-basis evidence supporting the amount and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant estimates
made by management, as well as, evaluating the overall financial statement presentation
We were unable to obtain audited financial statements supporting the company’s
investment in a foreign affiliate stated at Br 300,000 at December 31, 2007, which is
included in the net income for the year ended and we were also unable to satisfy our
selves as to the carrying value of the investment in the foreign affiliate.
In our opinion, except for the effects of such adjustments, the financial statements
referred to above present fairly, in all material respects, the financial position of RT
company as of December 31, 2004, and the results of its operations for the year then
ended in conformity with generally Accepted Accounting principles.
R&T Public accounting firm

Signature
Date: March 15, 2008.
As it can be seen from the above example, the qualified opinion has explanatory paragraph
before the opinion paragraph.
Activity-21: Differentiating unqualified opinion from qualified opinion

This activity aims at helping you to understand the difference between the
unqualified and qualified audit opinion.
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Compare qualified audit report with unqualified report and write the
circumstances under which each type of audit report is issued.
Adverse opinion: this is a negative opinion, asserting that the financial statements are
not fairly presented. It is issued when the exceptions to the presentations in the financial
statements are so significant that a qualified opinion would be an inadequate warning to the
users of those statements. This is a stronger form of except-for opinion - the disagreement is
so material that the financial statements as a whole are misleading. This type of statement
is used only when the auditor believes the overall financial statements are so materially or
extremely misstated or misleading that they do not present fairly the financial position or
results of operations and cash flows in conformity with generally accepted accounting
principles.
The adverse opinion report can arise only when the auditor has the knowledge, after
adequate and satisfactory investigation, of the absence of conformity. That is when the
auditors express an adverse opinion; they must have accumulated sufficient appropriate
evidence to support their unfavorable opinion. Presumably creditors and stockholders
would not provide debt or equity capital to the client if the auditor issues adverse opinion to
the financial statements of the client. Thus, the client usually will make whatever changes
in the financial statements that the auditors require in order to avoid receiving an adverse
opinion.
The adverse opinion like the qualified opinion has a separate explanatory paragraph, before
the opinion paragraph to state the reasons for issuing an adverse opinion and the principal
effect of the adverse opinion on the client’s financial position and operating results. In the
opinion paragraph of adverse opinion the auditors use the negative word “do not present
fairly”.
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Example of Adverse opinion

Independent auditors report
To: Share holders and board of directors
Akaki Corporation
We have audited the accompanying balance sheet of RT-company as of December

31, 2007 and the related statements of income and retained earnings for the year then
ended. These statements are the responsibility of the company’s management. Our
responsibility is to express an opinion based on our audit.
We conducted our audit in accordance with auditing standards. Those standards
require that we plan and perform the audit to obtain reasonable assurance as to whether
the financial statements are free of material misstatements. An audit includes examining
on test-basis evidence supporting the amount and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant estimates
made by management, as well as, evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
As discussed in Note 2 to the financial statements, the company carries its all plant assets
at appraisal value, and provides depreciation on the basis of such values. More over the
inventories of the company were stated at current fair market value. Generally accepted
accounting principles require that the plant assets should be stated at cost and, reduced by
depreciation based on such amount, and the inventories should be recorded and reported
at acquisition cost. Because of the departures from generally accepted accounting
principles identified above, the total plant assets have been overstated by Br 1,333,000.
In our opinion, because of the effect of the matters discussed in the preceding paragraph
the financial statements referred to above do not present fairly, in accordance with
generally accepted accounting principles, the financial position of Akaki Corporation as
of December 31,2007 or the results of its operations and cash flows for the year then
ended.
Signature
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Date: march 8. 2008
Disclaimer Opinion: This opinion is also called denial opinion. This type of audit
opinion is issued whenever the auditor has been unable to satisfy him self or her self that
the overall financial statements are fairly presented. The necessity for disclaiming an
opinion may arise under the following conditions:
 If there has been a severe scope limitation that prevents you from obtaining sufficient
and competent audit evidence;
 If the auditor cannot satisfy him self or herself by applying other procedures;
 If the effect of the scope limitation is so significant that the auditor can not form an
opinion as to the fairness of the financial statements.
Either of these situations prevents the auditor from expressing an opinion on the financial
statements as a whole. 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 the factors beyond the
control of the client or the auditors, rather than by restrictions imposed by the client.
A disclaimer is distinguished from an adverse opinion in that it can arise only from a lack
of knowledge by the auditor, where as to express an adverse opinion the auditor must have
knowledge that the financial statements are not fairly stated.
When the auditor expresses a disclaimer of opinion, he/she has to make sure that the
following conditions are met:
 An introductory paragraph is modified

 The scope paragraph is omitted-since the auditor does not undertake auditing.
 An explanatory paragraph is included after introductory paragraph
 A third paragraph contains a denial of opinion.
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The audit report below is an example of a disclaimer of opinion.
Independent auditors report
To: Board of directors

XYZ company
We were engaged to audit the accompanying balance sheet of XYZ company as of

December 31, 2007 and the related statements of income, retained earnings and cash
flows for the year then ended.
The company did not make a count of its physical inventory in 2007, stated in the
accompanying financial statements at Br 580,000 as of December 31, 2007. Further,
evidence supporting the cost of property and equipment acquired is no longer available.
The company’s records do not permit the application of other audit procedures to
inventories and plant assets.
Since the company did not take physical inventories and we were not able to apply other
auditing procedures to satisfy ourselves as to inventory quantities and the cost of plant
assets, the scope of our work was not sufficient to enable us to express an opinion, and
we do not express an opinion on these financial statements.
Signature
Date:
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Activity-21: Understanding the four basic audit reports.

Dear student, by exercising this activity you should able to understand the
four basic types of audit reports.
Assume, your classmate only knows the four types of audit reports but does
not know under what situations each report can be issued by the auditors.
Explain in detail to your classmate the situations that drive the auditors
towards issuing unqualified, qualified, adverse and disclaimer types of
opinions.
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Summary
Audit reports are the final outputs of the auditing process. After completing the audit, the
auditor has to issue an audit report expressing his opinion about the financial statements
The type of report issued by the auditors depends on their findings. The auditors may issue
any of the four basic types of audit opinions. These are:
 An unqualified opinion-standard report.
 A qualified opinion
 An adverse opinion and
 A denial of opinion.
Materiality is an essential consideration in determining the appropriate type of report for a
given set of circumstances. The standard unqualified audit report contains three paragraphs-
the introductory paragraph, the scope paragraph and the opinion paragraph. This type of
audit opinion is issued when the client has prepared the financial statements based on
generally accepted accounting principles and when the auditor has applied generally
accepted auditing standards during his audit engagement.
The qualified and the adverse opinions contain the four paragraphs- the introductory
paragraph, the scope paragraph, the explanatory paragraph and the opinion paragraph.
Depending on the degree of materiality and deviation from generally accepted accounting
principles and the scope limitation imposed on the application of the generally accepted
auditing standards the auditor may issue either a qualified or an adverse opinion.
When the auditor fails to accumulate sufficient and competent audit evidence to back his
opinion, the appropriate type of opinion issued by the auditor is denial of opinion. In this
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type of opinion the auditor is not giving an opinion, rather he is saying I could not apply
generally accepted auditing standards to assess the fairness of the financial statement and I
am not providing an opinion. The denial type of opinion has introductory paragraph, the
explanatory paragraph and the opinion paragraph. Since the auditor could not apply
auditing standards and could not conduct an audit, the scope paragraph is usually omitted in
the denial opinion
Self- Test Exercises-6

Part-I choose the best answer from the given choices
1. The date of the auditor's opinion on the financial statements of his client should be the
date of;
a. Closing of the client's books
b. Submission of the audit report
c. Completion of the fieldwork
d. Completion of audit report
e. Receipt of the client's letter of representation
2. All of the following audit reports have a separate explanatory paragraph, except
a. Unqualified audit report
b. Qualified audit report
c. Adverse audit report
d. Disclaimer audit report
e. none
3. When the auditor believes that the financial statements are misleading or do not reflect
the proper application of generally accepted accounting principles, the report will contain
a. Unqualified opinion
b. qualified opinion
c. adverse opinion
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d. disclaimer opinion.
4. What is the most suitable opinion if an auditor conducts the engagement in accordance
with generally accepted auditing standards and financials statements are in accordance with
generally accepted accounting principles applied on a consistent basis and includes all
informative disclosures?
a. unqualified opinion
c. adverse opinion
d. disclaimer opinion
5. The except for opinion is:

a. unqualified opinion
c. adverse opinion
6. It would be appropriate to address the audit report to:

a. The board of directors and share holders
b. The president of the company
c. The creditors of the company
d. All
7. The audit report is signed by:

a. The leader of the audit team
b. By all members of the audit team
c. By the audit firm
d. Client representative
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e. none
8. 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
9. 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
e. unknown
10. Which of the following does not refer to the standards of reporting?
a. compliance with GAAP
b. Consistence in the application of GAAP
c. Adequacy of informative disclosure
d. emphasis on Accountability
11. One of the following audit opinions does not contain a separate explanatory paragraph.
a. Unqualified opinion
c. adverse opinion
e. none
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12. Under which of the following circumstances might an auditor provide disclaimer
opinion?
a. When the financial statement contain a departure from GAAP
b. When there ate significant uncertainties affecting the financial statements
c When the principal auditor decides to make reference to the reports of
another auditor who audited a subsidiary.
d. When there has been a material change between periods in the method of
application of accounting principles.
Part-II: Short answer questions

1. Discuss the components of the qualified audit report
______________________________________________________________________
______________________________________________________________________
2. Under what circumstances do auditors issue the standard unqualified report?

______________________________________________________________________
______________________________________________________________________
3. Distinguish between qualified opinion, adverse opinion and disclaimer opinion, and
explain the circumstances under which each is issued.
______________________________________________________________________
______________________________________________________________________
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UNIT-SEVEN
OVERVIEW OF AUDITING AND AUDITORS IN ETHIOPIA
 Introduction
In Ethiopia, there are three bodies that are providing auditing services. These are the Office
of the Auditor General, the Audit Service Corporation and Private auditors. Besides these
there are internal revenue auditors and government auditors employed by local, regional
and federal government agencies. At each regional state, there is an Office regional of audit
bureau, which is responsible to audit the office of regional government offices and usually
perform compliance audit and operational audit. The internal revenue auditors have the
responsibility for the enforcement of the tax laws. A major responsibility of the internal
revenue auditors is to audit the returns of tax payers to determine whether they have
complied with the tax laws.
The first of this unit focuses on the establishment, duties and responsibilities of the Office
of the Auditor General. You will also study the types of services offered by the audit
service corporation. Finally the role of privet audit firms will be discussed.
After completing this unit, you will be able to:

 Describe the objectives of the office of the Auditor General
 Identify the duties and responsibilities of the office of the Auditor General
 Identify the professional, auditing and ethical standards issued by the office of the
Auditor General
 Describe the objectives and types of services offered by the Audit Service Corporation
127

 Identify the Articles of the Commercial Code of Ethiopia that are relevant to Auditing
 Describe the role of private audit firms in Ethiopia.
7.1 The Office of Auditor General (OAG)
In 1942, a financial regulation was issued prescribing modern financial and accounting
responsibilities of government ministries and audit of government receipts and payments
including budgeting. Subsequent to this requirement, the audit and control department was
established by proclamation Number 68/1946, under the prime minister headed by the
Auditor General.
A separate Auditor general’s Office was established in 1958. This proclamation has been
revised continuously with the change in government, the last being the 1997 proclamation.
According to this proclamation Number 68/1997, the office of the Auditor general is
established with the following objectives:
 To strengthen an audit system required for reliable information necessary for the proper
management and administration of the plans and budget of the federal government
 To ascertain that all receivable money and property of the federal government are
allocated, preserved and used properly in accordance with the laws and regulations of
the federal government, and report same to the council.
 To undertake financial and performance audits of the offices and organizations of the
federal government.
 To make efforts in cooperation with concerned organs to promote and strengthen
accounting and audit profession.
 To give professional assistance and advice to regional and federal civil servants and
organizations engaged in accounting and audit professions.
 To draw up a standard of auditing by which accounts of the offices and organizations of
the federal government shall be examined and follow up the implementation of the
same.
128

The Federal Auditor General is appointed by the council of Peoples’ Representatives upon
the recommendation of the Prime Minister. The Deputy Auditor general is also appointed
through the same procedures. The federal auditor general is accountable to the Council of
Peoples’ Representatives. Each regional state has also its own Audit Bureau.
According to Art 7 of proclamation Number 68/1997, the federal office of the auditor
general has the following authorities and duties.
 Audit or cause to be audited the accounts of the federal government offices and
organizations
 Audit or cause to be audited accounts involving budgetary subsidies and any special
grants extended by the federal government to regional governments.
 Audit the accounts of private contractors relating to the federal government contractual
work, which involves a sum exceeding Br 500,000.
 Carry out or cause to carry out as may be necessary program and efficiency audit or
performance audit in order to ensure that the performance of Federal government
offices and organizations is in accordance with the law, economically sound, and has
attained the desired objectives.
 Report audit findings to the head of the audited federal government office and
organization
 Issue directives in cooperation with other offices concerned, regarding accounts and
property auditing procedures and standards.
 Issue certificates of competence to internal auditors to be employed by any federal
government offices and organizations.
 Give necessary advice on the financial and accounting regulations to be prepared by the
Ministry of finance.
 Promote the accounting and auditing profession, take appropriate measures to ensure
that the development of the accounting and auditing profession of the federal
government is in the right direction.
129

 Issue, renew, suspend and cancel certificates of the competence of private auditors and
accountants who provide auditing and accounting services.
Charges fee for the issuance and renewal of such certificates in accordance with regulations
issued by the council of peoples' Representatives.
The federal auditor general is also required to submit a consolidated annual report to the
council of peoples’ representatives. Moreover, the office of auditor general is entrusted with
the responsibility of reviewing the annual report which the ministry of finance submits
concerning the federal government receipts and expenditures, assets and liabilities as well
as the financial statistical data. In addition to its regular activities, the courts and other
agencies frequently request the office of federal auditor general to audit and review
complex financial information.
The main objective of the Office of auditor general is to conduct operational and
compliance audit. The auditors of the office of the auditor general perform their duties in
accordance with international auditing standards and according to the financial audit
manual prepared by the office.
Q-Explain the duties and responsibilities of Office of the auditor general

______________________________________________________________
Professional standards: The existence of professional standards helps to measure the

quality of performance of auditors. Recognizing this fact, the office of auditor general has
established accounting, auditing and ethical standards.
The accounting standards classify accounts as commercial type accounts and government
accounts. The commercial type accounts should be prepared in accordance with the
commercial accounting standards. These standards include going concern concept, the
accrual concept, the consistency concept, and the prudence concept. The government
130

accounts are prepared in accordance with the government accounting standards. These
standards focus on the principle of accountability based on budgetary appropriations.
One of the auditors’ responsibilities in auditing either the commercial type entities or the
central government accounts would be to ensure that the financial statements are prepared
in accordance with the accounting standards.
Auditing standards –all the audit staff of the office of auditor general are required to plan,
control, and record their work. Moreover, auditors have to evaluate the internal control
system of the client to determine the extent of reliance they could place on such internal
controls. To arrive at reasonable conclusions, auditors should gather sufficient, relevant and
reliable audit evidence using the various techniques including the review of the financial
statements.
Ethical standards- The office of the auditor general require all the auditors to be
professionally independent, to possess the professional knowledge, skills and disciplines
necessary for the proper performance of audit. The standards of due care and professional
secrecy or confidentiality are also included in the ethical standards of office of auditor
general
The office of the federal auditor general has issued Ethiopian code of ethics for
professional accountants in January 2004. This code consists of rules of conduct
applicable to all professional accountants and authorized auditors.
The code of conduct applicable to all authorized auditors are rule of independence,
professional competence and responsibilities, fees and commissions, activities
incompatible with the practice of accountancy and advertising and solicitation.
Rule-9: Independence.
A professional accountant member of the assurance team sand firms should be independent
both in mind and in appearance in the performance of professional service for the client.
Rule-10: professional competence and responsibilities regarding the use of non
accountants
131

Professional accountants should refrain from agreeing to perform professional services

which they are not competent to carry out unless competent advice and assistance is
obtained so as to enable them to satisfactorily perform such services.
Rule-11: fees and commissions

Professional accountants, who undertake professional service for a client, assume the
responsibilities to perform such services with integrity and objectivity and in accordance
with the appropriate technical standards. That responsibility is discharged by applying the
professional skill and knowledge which professional accountants have acquired through
training and experience. For the services rendered the professional accountants are entitled
to remuneration. This rule further emphasizes that the professional fees should be a fair and
reflection of the value of the professional services performed for the client.
Rule-12: Activities incompatible with the practice of public accountancy

Professional accountants should not concurrently engage in any business, occupation or
activity that impairs or might impair integrity, objectivity or independence, the full
reputation of the profession and there fore would be incompatible with the rendering of
professional offices.
Rule-13: Relations with other professional accountants

This rule contains several articles explaining how the auditor should handle new audit
assignments and advisory services and his relationship with other professional accountants.
Rule-14: Advertising and solicitation
According to this rule of conduct, advertising and solicitation should be aimed at informing
the public in an objective manner and should be decent, honest, truthful and in good taste. It
is clearly desirable that the public should be aware of the range of services available from
professional accountant. Accordingly, there is no objection to a member body
communicating such information to the public on an institutional basis.
132

Activity 22 Briefly describe the duties and responsibilities of the Office

of the auditor general
This activity helps you to test your understanding of the duties and
responsibilities of the office of the auditor general
___________________________________________________________
7.2 The Audit service corporation
As stated earlier the office of the auditor general was given the responsibility to audit or
cause to be audited all the federal government offices. How ever, the 1974 revolution, when
the then Ethiopian government nationalized a number of private enterprises, the office
could not satisfy the need for audit with in the country due to the limited number of
manpower. Thus, there was a need to establish a semi-independent audit services
corporation. As a result, audit Service Corporation was established in 1977 pursuant to
proclamation 126/1977.
According to the proclamation 126/1977, the objectives of the corporation were:
 To render audit service to production, distribution and service giving organization, of
which the government is the owner or major shareholder.
 To render management consultancy services to the organizations specified above
 To find way and means for further development of audit profession and try to make
Ethiopia self-sufficient with in a short-period, with respect to audit profession.
133

The corporation was established as an independent entity with powers to sue and be sued,
enter in to contracts, determine terms and conditions of recruitment as well as to charge fees
for its services.
The objective of audit rendered by the audit service corporation is the same as that of
private auditing firms. The audit service corporation audits public enterprises on a fee basis,
to examine if their financial statements present fairly the true picture of their activities.
Thus, the type of audit rendered by the service audit corporation is a financial statement
audit.
Q-describe the responsibility of the audit service corporation

_______________________________________________________________
7.3 The private auditing firms in Ethiopia.
The private auditing practice was started in Ethiopia with the opening of a branch office of
Price Waterhouse peat &co in Addis Ababa following the establishment and growth
multinational British companies like A. Bessie and Co.,, Mitchell Cots Ltd and the issuance
of the Commercial code of Ethiopia in 1960. The demand for commercial audit has
increased as the commercial code of Ethiopia required the multinational companies to
present audited financial statements for renewal of trade license.
As discussed earlier, the office of auditor general audits or cause to be audited the accounts
of the federal government offices and organizations. On the other hand, the audit service
corporation provides auditing services to public enterprises. The private businesses also
need audited financial statements for various purposes such as for bank loan and for tax
purposes. Thus private auditing firms provide auditing, accounting, tax services and
management advisory services on fee basis primarily to the private businesses. The type of
audit conducted by private auditing firms is financial statement audit.
134

Activity-23 Identify the difference between the office of the federal

auditor general and the audit service corporation.
Dear student, this activity helps you to differentiate between office of the
auditor general and audit service corporation, and to understand the types of
audits being conducted by each.
7.4 commercial code of Ethiopia:
The commercial code of Ethiopia contains articles that are related to duties and
responsibilities of auditors in Ethiopia. The commercial code of Ethiopia contains
provisions requiring partnership and corporation to keep books and accounts, related to
corporations specifically about appointment of auditors, competency of auditors,
professional secrecy and liabilities of auditors.
Further more, the code specifies persons who are founders and beneficiaries of a company
or its subsidiary, persons related by blood to the fourth degree or persons who receive
remuneration from company founders and persons who act as directors of the company are
not to engage in auditing that company (principles of independence).
In addition, according to the code, an auditor is liable for breach of professional secrecy, for
negligence in the performance of professional services and for breach of contract.
According to the commercial code auditors are liable to client and third party beneficiary
for losses they cause, for issuing inappropriate report, for failure to inform the laws for any
offences that they knew were committed by the client that affects the public.
135

Relevant articles from commercial code of Ethiopia
Art.368: appointment of auditors

The following points are included in this article:
 The general meeting of every company limited by shares shall elect one or more
auditors and one or more assistant auditors.
 Shareholders representing not less than 20% of the capital may appoint an auditor
selected by them
 Where there is more than one auditor, they may exercise their duties jointly or
separately.
 A body corporate may act as auditor.
Art 369: Nomination and term of appointment

According to this article, auditors are elected by the meeting of subscribers and thereafter
by the annual general meeting. Auditors elected by the meeting of subscribers would hold
office until the first annual general meeting. But auditors elected at annual general meeting
may hold office for three years.
Art 310: persons not competent

As per Art 310 the following persons may not be elected as auditors.
 Founders, contributors in kind, beneficiaries holding special benefits, directors of the
company or of its subsidiaries or of its holdings company
 Spouses or relatives to the fourth degree inclusive, of founders, contributors in kind,
beneficiaries holding special benefits, directors of the company or of one of its
subsidiaries or of its holdings company.
136

 Persons who receive salary or periodical remuneration in connection with duties other
than those of an auditor from the founders, contributors in kind, beneficiaries holding
special benefits, directors of the company or of one of its subsidiaries or of its holdings
company.
Auditors may not be appointed as directors or managers of the company, which they audit,
nor of one of its subsidiaries or its holding company with in three years from the date of the
termination of their company.
Art 372: Remuneration

The remuneration of auditors shall be fixed by the general meeting on their appointment.
Where the general meeting fails to agree on the remuneration of the auditors, the Ministry
of commerce and industry may on the application of any interested party fix the
remuneration.
Art 373: Professional secrecy

Auditors shall be liable to the penalties prescribed in Art 407 of the Pe4nal Code for
breaches of professional secrecy.
Art 374: Duties of the auditors

The auditors shall have the following duties:
 To audit the bond and securities of the company
 To verify the correctness and accuracy of the inventories, balances sheets and profit
and loss accounts
 To certify that the report of the board of directors reflects the correct state of the
company’s affairs.
 To carry out such special duties as may be assigned to them
Art 375: Report to general meetings
137

According to this article, the auditor has to submit to the annual general meeting a written
report that show how they have carried out their duties and their comments on the report of
the board of directors.
Art 378: Auditors to inform directors of irregularities

According to this article, the law requires the auditor to inform the dire4ctors when they
find irregularities or breaches of legal or statutory requirements. If they find serious
irregularities or breaches, they have to inform the general meeting. The auditor has also the
legal responsibility to inform the public prosecutor of any matter which would appear to
disclose the commission of an offense.
Art 378: Powers

As per this article the auditors have the powers to make audits and check at any time as may
be necessary, and may request for nay information, agreement, books, accounts, minutes
books and such other documents as may be required for the proper execution of auditors’
duties.
Art 380: Liability of the auditors
According to this article, the auditors are liable to the company and third parties for any
fault in the exercise of their duties which resulted in loss. The auditor will also be punished
under Art 438 or Art 664 of the penal code, if they knowingly give or confirm an untrue
report concerning the position of the company or if they fail to inform the public prosecutor
of an offense which they know to have been committed.
Activity-24 Identify the articles of commercial code of Ethiopia that are

relevant to the profession of accountancy and auditing.
The purpose of this activity is to help you identify the relevant articles from
138

the commercial code of Ethiopia

____________________________________________________________
Summary
The three parties that are rendering auditing and other related service are the Office of the
Auditor General, Audit Service Corporation and the private auditing firms. The office of
the federal auditor general is established to conduct efficiency and operational audits of the
various offices of the federal government. More over, it issues certificate of competence to
private auditors and accountants. The audit service corporation is government owned
organization that audits public enterprises on a fee basis. In addition to these organizations,
the private auditing firms are also playing a significant role in the auditing service in the
country. They provide financial statement audit to the public on a fee basis. They also
provide accounting, tax, and management advisory services.
The Office of the auditor general has issued Ethiopian code of ethics for professional
accountants. This code consists of rules of conduct applicable to all professional
accountants and authorized auditors.
The code of conduct applicable to all authorized auditors are rules of independence,
professional competence and responsibilities, fees and commissions, activities incompatible
with the practice of accountancy and advertising and solicitations.
Self test Exercises-7

Part-I choose the best from the given alternatives
1. Which of the following audit is not conducted by the office of the auditor general?
a. Efficiency audit
b. Financial audit
c. Regulatory audit
139

d. All
e. None
2. According to the accounting standards of the office of the auditor general,
Accounts are classified as_____ and ________
a. government and non government
b .commercial and government
c. accounting and non –accounting
d. Profit and not for profit
3. The office of the auditor general primarily audits the account of:
a .private enterprises
b. public enterprises
c. government offices
d. both public and private enterprises
e. none
4. When was the audit service corporation established?
a. in 1974
b. in 1977
c. in 1946
d. in 1942
5. The audit service corporation conducts audit on_______

a. fee basis
b. salary basis
c. free of charge
d. none of the above
6. According to the commercial code of Ethiopia, which one of the following can not be an
auditor?
a. Founder of the company
140

b. A person related by blood to a 4th degree

c. A person who receives remuneration from the company
d. All of the above.
7. According to the Commercial code of Ethiopia, auditors are liable for_______

a. Issuing inappropriate opinion
b. Receiving professional fee for their work
c. Auditing an organization for several years
d. None of the above
Part II: Short answer questions.

List the three main auditing bodies in Ethiopia
_________________________________________________________
_________________________________________________________
1. What are the main objectives of the office of the auditor general?
___________________________________________________________
___________________________________________________________
2. What are the main functions of the audit service corporation?
___________________________________________________________
___________________________________________________________
3. Discuss the difference between the office of the auditor general and audit Service
Corporation.
_____________________________________________________________
______________________________________________________________
141

Answer Kew to Self –Test- Exercises

Self-test-exercise-1
Part-I:
1. A
2. B
3. C
4. B
5. C
Part-I:
1. D
2. B
3. A
4. A
5. D
6. A
7. A
8. A
9. C
Part-I:
1. B
2. A
3. A
4. D
5. D
6. C
7. B
142

Part-I:
1. A
2. D
3. C
4. B
5. C
6. C
7. B
8. C
Part-I:
1. C
2. D
3. B
4. D
5. C
6. A
Part-I:
1. C
2. A
3. C
4. A
5. B
6. A
7. C
8. C
143

9. A
10. D
11. A
12. B
Part-I:
1. B
2. B
3. C
4. B
5. A
6. D
7. A
144

Glossary
 Accounting: is the process of recording, classifying, summarizing and communicating
economic events in a logical manner for the purpose of providing financial information for
decision-making
 Accounting Controls: These are controls related to the accounting system.
 Adverse opinion report: is a negative opinion issued when generally accepted accounting
principles have not been followed in the preparations of the financial statements and/or the
financial statements are materially misstated.
 Administrative controls: These controls emphasize on the effectiveness and efficiency of the
management decision-making process.
 Audit evidence: is any information or document that confirms or rejects a premise (a

statement or hypothesis).
 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.
 Breach of contract: is failure of one or both parties to a contract to perform in accordance

with the contract’s provisions.
 Compliance Audit: a type of audit which helps to determine whether the auditee is
following specific procedures or rules set out by some higher authority such as management,
government, board of directors etc.
 Contributory negligence: is negligence on the part of the plaintiff that has contributed to his
or having incurred a loss.
 Control risk: is the risk that a material misstatement will not be prevented or detected on a
timely basis by the company’s internal control.
 Detection risk: is the risk that the auditor’s procedures will lead them to conclude that a
material misstatement does not exist in an account balance, when in fact the account is
materially misstated
145

 Disclaimer Audit report: an opinion issued when there is no sufficient information to

conclude as to whether the financial statements present fairly the financial position of the
organization
 Engagement letter: is the written contract summarizing the contractual relationship between
auditor and client.
 Field work standards: Auditing standards related to the accumulation and evaluating
evidence sufficient for the auditors to express an opinion on the financial statements.
 Forensic audit: An audit conducted for the purpose of the detection of a wide variety of
fraudulent activities.
 Fraud: is defined as misrepresentation by a person of material fact known by that person to

be untrue or made with reckless indifference as to whether the fact is true, with the intention
of deceiving the other party and with the result that the other party is injured.
 General standards: Auditing standards related to the personal integrity and professional
qualifications of the auditors.
 Gross negligence: It is a substantial failure on the part of the auditor to comply with
generally accepted auditing standards.
 Inherent risk: refers to the possibility of a material misstatement occurring in an account

assuming that there are no related internal controls.
 Internal control: is the process, designed by an entity’s board of directors, management and
other personnel.
 Materiality: refers to the magnitude of the an omission or misstatement of accounting

information that makes it probable that the judgment of a reasonable person relying on the
information would have been changed or influenced by the omission or misstatement.
 Operational audit: is a review of any part of an organization’s operating procedures and

methods for the purpose of evaluating efficiency and effectiveness.
 Ordinary negligence is violation of a legal duty to exercise a degree of care that any other
prudent person would exercise under similar circumstances.
 Physical evidence: evidence which is obtained from the physical examination or inspection
of tangible assets.
 Plaintiff: is the party claiming damages and bringing suit against the defendant.
146

 Professional Ethics: professional ethics refers to the basic principles of right action for the
member of a profession.
 Qualified opinion: An opinion issued when the auditor finds exceptions, or when the auditor
cannot follow all generally accepted auditing standard requirements or when there are
limitations on the scope and extent of his work, and the exceptions do not overshadow the
fairness of the financial statements.
 Sampling risk: is the risk that the auditor’s conclusion based on the sample might be
different from the conclusion they would reach if they examined every item in the entire
population.
 Subsequent event: refers to an event or transaction that occurs after the date of the balance
sheet but prior to the completion of the audit and issuance of the audit report.
 Unqualified opinion: an opinion issued when the financial statements reflect fairly the
financial position of the firm for stated period.
 Working papers: refer to the papers prepared by the auditor for audit work as well as the
documents, statements, and recorded information obtained by the auditor from his client and
others connected with the business.
147

REFERENCES
 Robert F. Meigs, Walter B. Meigs, O. Ray Whittington, and Kurt Pany

(1989) “Principles of Auditing” 9th Edition, R.R Donnelley and sons
Company.
 Jack C. Robertson, (1990) “Auditing”, 6th Edition. Richard D. Irwin, Inc.
 Hermanson, and Strawswer (1989) “Auditing theory and practice, 5th Edition, USA.
 Kell, Waltaier G. and Boynton William C. ( 1992) “ Modern Auditing, 5ht
 Edition , John Wiley and Sons Inc. USA
 Whittington and Pany (1995) “Principles of Auditing”, Irwin, USA.

 The Commercial code of Ethiopia, 1960
148

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Principles of Auditing

Faculty of Managements Sciences and Economics

Principles of Auditing-I Module for Distance Education

Prepared by Gardachew Worku

Reviewed by P.L. Madhava Rao

University of Gondar, Faculty of management sciences and Economics/ Distance education

Unit -Two: The auditing profession:………………………………..…………….25

Unit-Three: Planning and conducting an audit…………………………….……46

Unit-Four: Internal control…………………………………….…………………70

University of Gondar, Faculty of management sciences and Economics/ Distance education

4.4 Components of internal control……………………………………….…75

Unit-Five: Audit evidence:………………………………………………………..88

Unit-Six: Audit reports…………………………………………………………..110

University of Gondar, Faculty of management sciences and Economics/ Distance education

University of Gondar, Faculty of management sciences and Economics/ Distance education

After studying this unit, you will be able to:

University of Gondar, Faculty of management sciences and Economics/ Distance education

1.1 Meaning and nature of auditing

Auditing is the accumulation and evaluation of evidence about information to

Accounting principles Board (APB): According to APB, Auditing is an exercise whose

International Federation of Accountants (IFA): An audit is an independent examination

The American Accounting Association (AAA) defines auditing as follows:

University of Gondar, Faculty of management sciences and Economics/ Distance education

University of Gondar, Faculty of management sciences and Economics/ Distance education

Q-Dear student, Define what auditing is about?

1.2 Need for Audit

University of Gondar, Faculty of management sciences and Economics/ Distance education

University of Gondar, Faculty of management sciences and Economics/ Distance education

Q- Explain the advantages of auditing and its inherent limitations.

Activity-1 Answer the following questions as per the

D-Explain how auditors add credibility to the financial statements?

1.3 Distinction between Auditing and Accounting

University of Gondar, Faculty of management sciences and Economics/ Distance education

Certified Public Accountants (CPA) which is given to individuals performing an audit

Accounting is the process of recording, classifying, summarizing and communicating

Table1.The comparison of Accounting and Auditing

Basis of comparison Accounting Auditing

University of Gondar, Faculty of management sciences and Economics/ Distance education

Primary responsibility Preparation of Audit of

Its nature Constructive Analytical

End product Financial statements Audit reports

Activity-2 Differentiating accounting and auditing

This activity helps you to identify the similarities and differences

University of Gondar, Faculty of management sciences and Economics/ Distance education

1.4 Types of audits

1.4.1 Financial statement audit:

 Unqualified audit report: Unqualified opinion is issued when the financial

University of Gondar, Faculty of management sciences and Economics/ Distance education

 Qualified opinion report: An auditor issues qualified opinion when he finds

University of Gondar, Faculty of management sciences and Economics/ Distance education

 Suggesting corrective actions, where needed , and

University of Gondar, Faculty of management sciences and Economics/ Distance education

1.5 Types of auditors

Independent Auditors: An independent auditor, also known as Certified Public

University of Gondar, Faculty of management sciences and Economics/ Distance education

perform financial statement audit. In addition, The Audit Service Corporation, a

The following table provides a comparison of internal and external auditor

Internal Auditor External auditor

University of Gondar, Faculty of management sciences and Economics/ Distance education

efficiency fairness of financial statements