AUDITING - AFU 07305

NATURE, PURPOSE AND SCOPE

LECTURE 1

Dr. Mwiga Wiljonsi Mbesi

 Origin and Evolution of Audit

 The term audit was derived from the Latin term ‘audire,’ which means to hear.

 In early days an auditor used to listen to the accounts read over by an

accountant as a way to check and balance

 Auditing is as old as accounting

 Auditing was in use in all ancient countries such as Mesopotania, Greece,

Egypt, Rome, U.K. and India.

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

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 Cont……

 Auditing evolved and grew rapidly after the industrial revolution in the 18th
century. With the growth of the joint stock companies the ownership and
management became separate.

 The owners needed a report from an independent expert on the accounts of the
company managed by the board of directors who were the employees.

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

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 Definitions

 Auditing is an independent examination of, and expression of opinion on the financial

statements of an entity by an appointed auditor in pursuance of that appointment and in
compliance with any relevant statutory or other provisions including International
Standards on Auditing (ISAs).

“An audit is a systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events to ascertain the degree of correspondence
between these assertions and established criteria and communicating the results to
interested users.”
American Accounting Association

Auditing enable auditors to express opinion whether the financial statements give a true
and fair view, and have been prepared in accordance with the applicable reporting
framework.
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 Cont….

 Financial statements audit refers to an independent examination of

financial statements by an auditor and an expression of opinion on whether
such financial statements present a true and fair view.

 This means that both the Examination of Financial statements and the
expression of opinion on them have to be fulfilled for an audit to be
completed.

 NB: Auditors do not certify or guarantee the correctness of financial

statements; they report whether in their opinion they give true and fair view
of the financial position.

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 Comparison between auditing and accounting
Accounting Auditing
1 Subject matter Accounting is the process of recording, Auditing is concerned with examination or
classifying, and summarising business review of financial information.
transactions in monetary terms. It provides
information for decision making.
2 Object The main object of accounting is to know the The object of the audit is to judge the
trading results and state of affairs of an business correctness and reliability of financial
during the accounting period statements.

3 Hierarchy Accounting begins before auditing Auditing begins where accounting ends. There
can be no auditing without the prior existence
of accounting data.

4 Nature Accounting is constructive in nature as it Auditing is analytical and critical aspect of

measures business events in terms of profit or accounting as it review the measurement of
loss and communicate the financial position in and communication of financial results and
the financial statements condition of business.

5 Expertise required An accountant An auditor

6 Process It is a Four-steps process that involves It included Three principal steps Audit
collection and recording, classification, planning, performing the audit work, and
summarizing, and communication of reporting the findings. However separation
accounting information of these steps is not clear.

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Relationship between Accounting and Auditing

Analyses events and transactions Obtain and evaluate evidence

Measure and record transactions Determine fairness of financial statements in

conformity to the standards

Classify and summarizes transactions Prepare audit reports on findings

Prepare financial statements Deliver audit report to the client

Exit

Distribute financial statement s and auditors

reports to stakeholders

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 Stewardship and Stewardship Accounting

 Stewardship is the name given to the practice by which productive resources

owned by one person or group are managed by another person or group of
persons.

 The role of Auditor can be traced back to hundreds of years ago when the
stewardship role started to receive more attention.

 Historically, e.g. in the middle ages, great landowners would not manage their
own land but would appoint persons called stewards to manage the land.

 Today most business is operated by limited companies which are owned by

their shareholders and managed by directors appointed by the shareholders.
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 Cont………
 Stewardship accounting : Is the process whereby the managers of a business
account or report to the owners of the business.

 Owners who appoint managers to look after the owner’s property will be
concerned to know what has happened to their property through steward ship
accounting.

 A famous example of this is in St. Mathew’s Gospel (chapter 25), rich man
and servants. When a rich man went on journey and delivered his goods to
his servants to look after while he was away. On his return he asked each of
his servants to account for the goods with which he had been entrusted. He
was not pleased with the servant who did not profitably used the goods he
had managed in his master’s absence.
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 Agency Theory
 The relationship between various interested parties in the firm is often
described in terms of agency theory.

 Agency relationships occur when one party, the principal employs another
party, the agent to perform a task on their behalf.

 For example, Directors can be seen as the agents of shareholders, employees

as the agents of directors and auditors as agent of shareholders.

 Principals need to recognize that although they are employing the agent,
agents will have interests of their own to protect and thus may not carry out
fully the requirements of the principal
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 Cont………

 Principals need to recognize that although they are employing the agent, agents will
have interests of their own to protect and thus may not carry out fully the requirements
of the principal.

 The directors have a duty of stewardship of the company’s assets. However they are also
interested in their level of remuneration and if this increases, the assets of the company
go down.

 The auditors report their opinion to the shareholders. However, auditors know the
decision to re-appoint them is effectively in the hands of the directors. They therefore
have a potential conflict of interest in carrying out their function and also remaining on
good terms with directors.

 Despite that, agency theory predicts that matters can be organized so that, by behaving
rationally, the agent will not act against the interest of the principal.

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 Cont………
 The theory assumes that shareholders will only buy shares if safeguards are in place to
protect their interests.

 The legal requirement for audited accounts is one example of a necessary precondition.
If shareholders are suspicious of the quality of an audit, they will not be prepared to
invest. Management therefore will arrange for a proper audit as it in their self-interest to
do so.

 The management of large companies will pay high fees for extensive and sophisticated
audits as they have the greatest need to convince shareholders of the management’s
honesty. In contrast a small company where the management and shareholder are largely
the same group will not pay high fees for an audit.

 However small companies may necessarily need satisfy other users of the accounting
information such as lenders and tax authorities.

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 Users of financial statements

• Shareholders

• Employees

• Vendors (suppliers)

• Customers

• The government

• Society as a whole

• Lenders

• Prospective investors

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 Why auditing?
 Generally, the objective of an audit of financial statements is to enable the audit or to express an
opinion whether, the financial statement of an entity gives a true and fair view

 It gives assurance whether the financial statements are prepared, in all material respects, in
accordance with the applicable financial reporting framework.

 The phrases used to express the auditor’s opinion are "give a true and fair view of" or “present
fairly, in all material respects” which are equivalent terms.

 Audit is designed to reduce the possibility of a material misstatement in the financial statement of
any entity not being detected.

 Auditing increases credibility of the financial statement s to the company 's stakeholders (interested
parties).

 The principal stakeholders of a company are typically its shareholders, but other parties such as tax
authorities, banks, regulators, suppliers, customers and employees may also have an interest in
ensuring that the financial statements are accurate.

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 Primary objectives of auditing
 The primary objective of an audit of financial statements is to enable the auditor to
express an opinion whether, the financial statement of an entity gives a true and fair
view

 To ensure that adequate information required to be disclosed in the financial statements

is disclosed

 To ensure compliance with statutory requirements.

 Accuracy and reliability of books of account and underlying records from which the
financial s statements have been prepared.

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 Secondary objectives of auditing

 To advise the management of any defects or problems with their accounting

system and to suggest ways of improving it.

 To detect errors and fraud

 To prevent errors and fraud

 To provide spin-off effects: The auditor will be able to assist their clients with
accounting, systems, taxation, financial, risk management and other problems.

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 The need for an audit therefore originates
from the following factors
 Requirement of unbiased and relevant financial information to guide investment
decisions of stakeholders

 Complexity of Financial information

 Financial and Economic consequences of using unreliable information

 There is a possibility that financial statements may contain errors

 The financial statements may not disclose fraud

 The reports may be deliberately or inadvertently misleading

 Financial statements may fail to disclose relevant information

 The preparation of financial statements may fail to conform to regulation

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 Reasonable Assurance as opposed to
Absolute assurance
Reasonable Assurance:

 This is a concept relating to accumulation of the audit evidence necessary for

the auditor to conclude that there are no material misstatements in the financial
statements taken as a whole.

 The Auditor cannot obtain Absolute assurance because there are inherent
limitations in an Audit that affect the auditor’s ability to detect material
misstatements.

 It indicates that an auditor is not an insurer or guarantor of the correctness of

the financial statements.

 It is presumably less than certainty or absolute assurance.

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 Cont………

Absolute assurance:

 It is a measure of the level of certainty that the auditor has obtained at the
completion of the audit.

 Absolute means the level of certainty is 100 percent correct.

 The question remain that how can 100 percent certainty be obtained in an
uncertain environment?

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.
Limitations to achieve absolute assurance

The following are the limitations that affect the auditor’s ability to obtain Absolute
assurance:

 The use of testing and samples

 The inherent limitations of internal control (for example, the possibility of

management override or collusion).

 The fact that most audit evidence is persuasive rather than conclusive

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 Scope of an audit
 Audit scope, defined as the amount of time and documents which are involved
in an audit. This is an important factor in all auditing.

 Scope of Audit is the determination of the range of the activities and the period
of records that are to be subjected to an audit examination.

The scope of an audit of financial statements will be determined by the auditor

having regard to:
 The terms of the engagement;

 The requirements of relevant legislation; and

 The pronouncements of the accounting professional bodies

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 Professional Skepticism

 Professional scepticism is an attitude that includes a questioning mind, being

alert to conditions which may indicate possible misstatement due to error or
fraud, and a critical assessment of audit evidence.

 The auditor should plan and perform an audit with an attitude of professional
skepticism recognizing that circumstances may exist that cause the financial
statements to be materially misstated.

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 Assurance Engagements

 An assurance engagement means an engagement in which a practitioner express a

conclusion designed to enhance the degree of confidence of the intended users other
than the responsible party about the outcome of the evaluation or measurement of a
subject matter against criteria.

 Not all engagements carried out by professional accountants are assurance engagements.
For example, giving general tax or accounting advice to a client, or compiling (i.e.
drawing up) a set of financial statements from information provided, are not assurance
engagements since no conclusion or direct assurance is provided.

 In giving positive assurance, an accountant reports that financial statements do give a

True and Fair view. In giving negative assurance, an accountant reports that nothing
has come to his attention to suggest that the financial statements do not give a True and
Fair view.

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 Advantages of an Audit

 It help to identify weak area in the internal control system which helps management to take
corrective measures.

 Audited financial statements are considered more reliable to compare the financial performance of a
business concern over time.

 Dispute between management may be more easily settled.

 Major changes in ownership may be facilitated if past accounts contain an unqualified audit report,
for instance, where two sole traders merge their business to form a new partnership.

 Applications to third parties for finance (loan application) may be enhanced by audited accounts.

 The audit is likely to involve an in-depth examination of the business and so may enable the auditor
to give constructive advice to management on improving the efficiency of the business.

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 Limitations of audit
 An auditor has to depend on books of accounts and records prepared by the management to be
audited. Management could have incentive to maneuver the information. Auditors may not be in a
position to uncover all the manipulations.

 Influence of management is another major limitation. Although auditors are appointed by

shareholders, audit fee is paid by the management therefore auditors can be working under pressure.

 The Audit fee: Clearly the services of an auditor must be paid for. It is this reason that few
partnerships and even fewer sole traders are likely to have their accounts audited, unless such an
audit is required by the local statute.

 The audit involves the client’s staff and management in giving time to providing information to the
auditor. A professional auditor should therefore plan his audit carefully to minimize the disruption
which his work will cause.

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 The concept of True and fair

True and fair view in auditing means that the financial statements are free from material
misstatements and faithfully represent the financial performance and position of
the entity

True suggests that the financial statements are factually correct and have been prepared
according to applicable reporting framework such as the IFRS and they do not
contain any material misstatements that may mislead the users.

Fair implies that the financial statements present the information faithfully without any
element of bias and they reflect the economic substance of transactions rather than just
their legal form

Auditors, in their report, do not say that the financial statement do show a true and faire
view. They can only say that in their opinion the financial statement show a true and
fair view

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 Cont………
The concept of true and fair view as stated in the companies act: Every company
financial statements must give a true and fair view of the state of affairs
and of the profit or loss.

That means that the auditor must report to members of the company whether
financial statements show a true and fair view. It means:
 To comply with accounting standards

 Reasonable care

 In accordance with correct principles

 Relevance

 Objectivity

 Freedom from bias

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 Fundamental accounting principles
The following fundamental accounting principles should be considered:
 Going concern,

 Consistency,

 Accrual)
 Accounting policies, rules, methods, procedures, conventions and bases
adopted by reporting entities to be most appropriate to their circumstances
in preparing their financial statements E.g.
 Materiality concept,
 prudence or conservatism concept
 substance over form concepts (Transactions recorded in the
financial statements must reflect their economic substance rather
than their legal form)
 Keep proper accounting records
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 END OF PRESENTATION

THANK YOU FOR LISTENING

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