NATURE AND PURPOSE OF AN AUDIT

NATURE AND OBJECTIVES

An audit is the independent examination of an expression of an opinion on the
financial statements of an economic entity by appointed auditor in pursuance of that
appointment and in compliance with any relevant statutory obligation
The objective of an audit is to enable the auditor express an opinion whether
financial statements show a true and fair view of the company state of affairs in
accordance with an identified financial reporting framework.
The purpose of an audit is not to provide additional information but rather it is
intended to provide the users of the accounts with assurance that the information
provided to then by directors is reliable. However, the users should not assume the
auditor’s opinion is one to efficiency with which management has conducted the
affairs of the e n t i t y .
Financial statement: According to the Companies Act, the company accounts refers
to the balance sheet and the profit and loss account but due to development in
business practice and shareholders information needs, these are inadequate as to the
information regarding financial position and performance of the company. Since
most balance sheets and profit and loss accounts are summarized statements
amplified by notes to the statements, the business community and the accountancy
profession require that a cash flow statement as well as a statement of changes in
equity be prepared. The terms company accounts and financial statements have the
same meaning.

Scope of-the Audit

Aspect Internal Auditing External Auditing

Objectives The main objective is to advice The objective is to
management on whether organization provide an opinion as to
has sound internal control systems to whether or not the
protect it against loss. financial statements
show a true and fair view
Of the company’s state
affairs.
Legal basis Internal auditing is not a legal It is a legal requirement
requirement but corporate for limited liability
governance advises and recommends companies and public
that a company should have an bodies to have their
internal audit department. accounts audited.
 Scope It covers all areas of organization i.e. It has a purely financial
operational as well as financial. focus.
Approach It is increasingly risk based. The Its increasingly risk based
approach is to assess risks, evaluate as it only tests underlying
systems of control and test operation transactions that form
of the systems and finally make having of financial
recommendations for improvement. statements.
Responsibilit The responsibility is to advise and The Responsibility is to
y
make recommendations on form an opinion on
internal controls and corporate whether financial
governance statements show a true
and fair view.

Scope & Objectives of Internal audit function

This depends on the size and structure of the entity and the responsibility assigned to
it by management. Ordinarily these would include:
• review of accounting internal control systems. The management is
responsible for establishing internal control system. The system requires
proper attention and continuous review, a function usually assigned to
internal audit. Internal audit function designs a plan on areas and control
procedures that will be reviewed during the financial year.
• Carrying out examination of financial and operational information. This may
include detailed
testing of transactions and operation procedures.
• Review of the economic efficiency and effectiveness of operations including
non-financial controls of the entity.
• review of company’s compliance with external laws and regulation.
The internal audit functions checks whether procedure are in place to ensure
that all relevant laws and regulations are adhered to.
• Review of entity’s compliance with management policies and other
internal requirements.
• Carrying out independent investigations into company affairs as required by
management
e.g. investigation areas of suspected fraud or misuse of company’s resources.
Similarities between internal audit and external audit
• Both auditors are concerned about the strength and proper functioning of the
internal control system. The internal auditor is concerned it is his or her
responsibility while the external auditor is concerned as he or she relies on
the strength of internal control system to carry out systems based audits.
• Both auditors have as part of their duties to ensure that the company adheres
to all relevant laws and regulations.
• Both auditors interested in ensuring that the company keeps proper books of
 records. The internal auditor uses the company accounts to appraise the
functioning of the internal control system while external auditor uses them to
collect audit evidence to corroborate his audit opinion.
• Both auditors are concerned about prevention and detection of errors and
frauds. The internal auditor ensures errors or frauds are prevented and
detected by having strong internal control system while the external auditor
has the incidental duty of detecting and preventing material errors and frauds
which would otherwise distort the true and fair view of the financial
statements.
• Both auditors have interest in safeguarding company assets. The internal
auditor through strong internal control system ensures safety of company’s
assets while external auditor must ensure that company assets are
safeguarded against theft and misuse so that the true of fair view of financial
statements is maintained.
External auditor’s reliance on work of internal auditor
Before deciding on whether to rely on work of internal audit function with the
intention of reducing audit procedures, the external auditor should evaluate the
internal audit function to determine the scope of the function its independence and
the extent to which its work can be relied on. in evaluating internal audit function,
the external auditor considers the following factors:
• Organization status. Since internal audit function is part of the entity, it
cannot be totally independent. To aid in its independence, the internal audit
function should report to the highest level of management. The internal
auditor should also be free from duties such as accounting functions which
may bring about conflict of interest. The internal auditor should not have any
restrictions upon him or her from management which could impair
effectiveness of doing his or her work.
• Scope of the function. The external auditor should ascertain the nature and
depth of coverage of internal audit assignments. Also to be considered are the
management actions on the recommendations of internal auditor. In case the
management does not follow up on the recommendations, the external
auditor must reduce his reliance on work of internal audit function as this
means it is weak.
• Technical competence. The external auditor should assess the competence
experience, qualifications, technical training and proficiency of the staff
members in the internal audit function.
• Due professional care. The external auditor should ascertain whether due
professional care has been observed in doing the work of the internal audit
function e.g. whether there were work plans, supervision and documentation
of audit evidence in executing internal audit functions.
• Availability of resources. The external auditor should consider whether the
 internal audit function has adequate resources to enable it carry out its
functions as expected e.g. adequate staff and time.
DEVELOPMENT OF AUDIT (EARLY AUDIT AND MODERN AUDIT)
A review of the historical development of auditing has shown that the objective of
auditing and the role of auditors are constantly changing as they are highly
influenced by contextual factors such as the critical historical events (e.g. the
collapsed of big corporations), the verdict of the courts, and technological
developments (e.g. advancement of computing systems and CAATs). It can be
observed that any major changes in these contextual factors are likely to cause a
change in the audit function and the role of auditors. As a result, auditing is seen
to be evolving at all times.
However, it is important to note that the change in society's expectation and the
response of the auditing profession towards these changes are not always at the
same pace. Hence there is a natural time gap between the changing expectation of
the users and the response by the profession and due to this time gap there arises
what has been stated as the expectation gap or audit expectation gap. Even though
the existence of such a natural time gap is inevitable, auditors should be sensitive
to the changing expectation of the relevant groups while at the same time
containing these expectations within the constraints of what is possible. There are
inevitably economic and practical limitations on what an audit can do, and this is
something which those who wish the benefit must understand.
The evolution of auditing practices

prior to 1840
Generally, the early historical development of auditing is not well documented
(Lee, 1994). Auditing in the form of ancient checking activities was found in the
ancient civilizations of China, Egypt and Greece. The ancient checking activities
found in Greece (around 350 B.C.) appear to be closest to the present-day
auditing.
Similar kinds of checking activities were also found in the ancient Exchequer of
England. When the Exchequer was established in England during the reign of
Henry 1(1100-1135), special audit officers were appointed to make sure that the
state revenue and expenditure transactions were properly accounted for. The
person who was responsible for the examinations of accounts was known as the
"auditor". The aim of such examination was to prevent fraudulent actions.
1840s-1920s
The practice of auditing did not become firmly established until the advent of the
industrial revolution during the period 1840s-1920s in the UK. According to
Brown (1962), the large- scale operations that resulted from the industrial
revolutions drove the corporate form of enterprise to the foreground. Large
factories and machine-based production were established. As a result, a vast
amount of capital was needed to facilitate this huge amount of capital expenditure.
The emergence of a "middle class" during the industrial revolution period
provided the funds for the establishment of large industrial and commercial
undertakings.
However, the share market during this period was unregulated and highly
speculative. As a consequence, the rate of financial failure was high and liability
was not limited. Innocent investors were liable for the debts of the business. In
view of this environment, it was apparent that the growing number of small
investors was in dire need of protection (Porter, et al, 2005). Hence, the time was
ripe for the profession of auditing to emerge (Brown, 1962).
In response to the socio-developments in the UK during this period, the Joint
Stock Companies Act Was passed in 1844. The Joint Stock Companies Act
stipulated that "Directors shall cause the Books of the Company to be balanced
and a full and fair Balance Sheet to be made up". In addition the Act provided the
appointment of auditors to check the accounts of the company. However, the
annual presentation of the balance sheet to the shareholders and the requirement of
a statutory audit were only made compulsory in .1900 under the Companies Act
1862 (UK).
According to Porter, et al (2005) the accountant particularly in the early years of
this period, was normally the company manager and his duties were to ensure
proper use of the funds entrusted to him. The auditors during this period were
merely shareholders chosen by their fellow members. The auditors during this
period were required to perform complete checking of transactions and the
preparation of correct accounts and financial statements. Little attention was paid
to internal control of the company.

1920s-1960s
The growth of the US economy in the 1920s-1960s had caused a shift of auditing
development from the UK to the USA. In the years of recovery following the
1929 Wall Street Crash and ensuing depression, investment in business entities
grew rapidly. Meanwhile, the advancement of the securities markets and credit-
granting institutions had also facilitated the development of the capital market in
this period. As companies grew in size, the separation of the ownership and
management functions became more evident. Hence to ensure that funds
continued to flow from investors to companies, and the financial markets function
smoothly, there was a need to convince the participants in the financial markets
that the company's financial statement provided a true and fair portrayal of the
relevant company's financial position and performance. In view of the economic
 condition, the audit function was mainly to provide credibility to the financial
statements prepared by company managers for their shareholders. Consensus
were generally achieved that the primary objective of an audit function is adding
credibility to the financial statement rather than on the detection of fraud and
errors.
The concept of materiality and sampling techniques were used in auditing during
this period. The development of material Concept and sampling technique was due
to the voluminous transactions involved in the conduct of business by large
corporations operating in widespread locations. It is no longer practical for
auditors to verify all the transactions.
Consequently, sampling and the development of judgment of materiality were
essential.
The major characteristics of the audit approach during this period i n cl u d ed :
 Reliance on internal control of the company and sampling techniques were used;
 Audit evidence was gathered through both internal and external source;
 Emphasis on the truth and fairness of financial statements;
 Gradually shifted to the audit of Profit and Loss Statement but
Balance Sheet remained important; and
 Physical observation of external and other evidence outside the "book of
account"

1960s to 1990s
The world economy continued to grow in the 1960s-1990s. This period marked an
important development in technological advancement and the size and complexity of
the companies. Auditors in the 1970s played an important role in enhancing the
credibility of financial information and furthering -the operations of an effective
capital market. The duties of auditors among others were to affirm the truthfulness
of financial statements and to ensure that financial statements were fairly presented.
Hence, the role of auditors with regard to the audit of financial statement generally
remained the same as per the previous period.
Despite the overall audit objectives remaining similar, auditing had undergone some
critical developments in this period. In the earlier part of this period, a change in
audit approach can be observed from "verifying transaction in the books" to "relying
on system". Such a change was due to the increase in the number of transactions
which resulted from the continued growth in size and complexity companies where
it is unlike for auditors to play the role of verifying transactions. As a result, auditors
in this period had placed much higher reliance on companies' internal control in their
audit procedures. Furthermore, auditors were required to ascertain and document the
accounting system with particular consideration to information flows and
identification of internal controls. When internal control of the company was
effective, auditors reduced the level of detailed substance testing. In the early 1980
there was a readjustment in auditors' approaches where the assessment of internal
control systems was found to be an expensive process and so auditors began to cut
back their systems work and make greater use of analytical procedures. An
extension of this was the development during the mid-1980s of risk-based auditing.
Risk-based auditing is an audit approach where an auditor will focus on those areas
which are more likely to contain errors. To adopt the use of risk-based auditing,
auditors are required to gain a thorough understanding of their audit clients in term
of the organization, key personnel, policies, and their industries. Hence, the use of
risk-based auditing had placed strong emphasis on examining audit evidence derived
from a wide variety of sources, i.e. both internal and external information for the
audit client. Most of the companies in this period had introduced computer systems
to process their financial and other data, and to perform, monitor and control many
of their operational and administrative processes. Similarly, auditors placed heavy
reliance on the advanced computing auditing tool to facilitate their audit procedures.
In addition to the auditing of financial statement, auditors at the same time were
providing advisory services to the audit c li e n ts
1990s-present
The auditing profession witnessed substantial and rapid change since 1990s as a
result of the accelerating growth at the world economies. It can be observed that
auditing in the present day has expanded beyond the basic financial statement attest
function. Present-day auditing has developed into new processes that build on a
business risk perspective of their clients. The business risk approach rests on the
notion that a broad range of the client's business risks are relevant to the audit.
Advocates of the business risk approach opined that many business risks, if not
controlled, will eventually affect the financial statement. Furthermore by
understanding the full range of risks in businesses, the auditor will be in a better
position to identify matters of significance and relevance to the audit profession on a
timely basis. Since the early 1990s, the audit profession began to take increased
responsibility to detect and report fraud and to
assess, and report more explicitly, doubts about an auditor’s ability to continue in
conformance with society's and regulators' increasing concern about corporate
governance matters.
Adoption of the business risk approach in turn enhances auditor's ability to fulfill
these responsibilities. Presently, the ultimate objective of auditing is to lend
credibility to financial and non-financial information provided by management in
annual reports; however, audit firms have been largely providing consultancy
services to businesses
Although the overall audit objectives in the present period remained the same, i.e.
lending credibility to the financial statement, critical changes have been made to the
audit practice as a result of the extensive 'reform in various countries. Such reform
has implicated the auditing profession in the following ways:
• The role of auditors is expected to Converge: refocusing on the public
interest, redefining -audit relationship, ensuring integrity of financial
reports, separation of non- audit function and other advisory services;
• The audit methods revert to basics i.e. risk attention, fraud awareness,
objectivity and independence, and.
• Increase attention on the needs of financial statement users"

Users of Audited Financial Statements

The annual accounts and report are primarily prepared by the
directors to the shareholders. However, the following parties need
financial statements.

1. Those parties with vested interests in a business.

- Employees.
- Creditors or suppliers
- Lenders and debenture holders
- The management
- The shareholders to whom the financial statements are addressed.
- Credit rating agencies.

2. Those with potential interests

- Potential shareholders
- Trustees
- Suppliers Customers

3. Those with representative interests

- Lawyers
- The government
- The general public.

4. Others
- Competitors
- Stock brokers
- Statisticians
- Financial journalists
- Trade unions.
  Present and potential investors. These risk capital providers and
their advisors are concerned with the risk that is inherent in their
investment. They need information to help them determine
whether they should buy more shares, hold on to the shares they
have or sell the shares they have.
 Employees. These and their representative groups such as trade unions are
interested in information about the stability and profitability of their
employers. They are also interested in information which enable them assess
the ability of the company to provide adequate remuneration, retirement
benefits and employment opportunities.
 Lenders. These are interested in information that enables them determine
whether their loans and interests arising from the loans will be paid back
when due.
 Suppliers and other trade creditors. These users are interested in
information that enables them determine whether the amounts owing to them
will be paid when due. Their interest in the company is of shorter period than
lenders while they are dependent upon the continuation of the company as a
major customer.

 Customers. These have interest in information about the continuance of the

company especially when they have long term involvement and or are
dependent as the
company.
 Government. The main interest of the government is allocation of resources.
It also requires information in order to regulate the activities of the enterprise,
determine taxation policies and obtain national income statistics.
 Public. A company affects public in a variety of ways. A company may
make substantial contribution to the local economy by employing people
and obtaining supplies locally.
 Financial statements assist the public in information on trends
and recent developments of the company in the economy.

FEATURES OF AUDITS
There are five elements that must all be present in order to qualify the
engagement as an assurance engagement.
 A three-party relationship involving a practitioner, a responsible party, and
intended users;
  An appropriate subject matter;
 Sufficient appropriate evidence;
 Suitable Criteria;
 A written assurance report in the form appropriate to a reasonable assurance
engagement or a limited assurance engagement.
Appropriate Subject Matter
The subject matter and the subject matter information of an assurance
engagement can take many forms, such as:
 Financial performance or conditions

 Non-financial performance or conditions

 Physical characteristics

 Systems and Processes

 Behavior
An appropriate subject matter is;
 Identifiable and capable of consistent evaluation or measurement

against the identified criteria

 Capable of being subjected to procedures for gathering sufficient

appropriate evidence to support a reasonable assurance or limited

assurance conclusion, as appropriate
Sufficient Appropriate Evidence
 Sufficiency is the measure of the quantity of evidence

 The quantity of evidence needed is affected by the risk of the

subject matter being materially misstated.

 Appropriateness is the measure of the quality of evidence,

that is, its relevance and reliability

 The reliability of evidence is influenced by its source and by its
nature, and is dependent on the individual circumstances under
which it is o b t a i ne d .
 Generalization about the reliability of evidence – evidence is more reliable
if:
 Obtain from independent source outside the entity
 Generated internally when the related controls are effective
 Obtained directly by the practitioner than indirect or by inference

 Exist in documentary form

 Provided by original documents

 Merely obtaining more evidence may not compensate for its poor quality

 The auditor should consider the cost of obtaining the usefulness of the
evidence.

Suitable Criteria
The following are the characteristics of criteria to be considered suitable:
 Relevance – contribute to conclusions that assist decision-making by the
intended users
 Completeness – the relevant factors that could affect the conclusions are not
omitted. Includes benchmarks for presentation and disclosure
 Reliability – allows reasonably consistent evaluation or measurement of the
subject matter including where relevant, presentation and disclosure, when
used in similar circumstances by similarly qualified practitioners
 Neutrality – free from bias
 Understandability – contribute to conclusions that are clear, comprehensive,
and not subject to significantly different interpretations.
Distinction between Audit and Accounting
Financial accounting entails provision of information about a business or
company in form of financial statements which are then made public. These
statements are generally prepared on an annual basis and used by management
and other interested parties to make decisions. The information contained in
these financial statements must give a true and fair view of the state of affairs in
the organization.
Auditing is a check carried out by an independent auditor to make sure that what
a company is saying about its financial statement is true. Auditing therefore
adds credibility to the financial statements by ensuring the availability of
accurate and reliable financial information.
Differences between Auditing and Financial Accounting
i) Accountants are usually employees of the company whereas external auditors are
employees of the audit firm who perform an independent appraisal of the books of
accounts. An internal auditor is an employee of the company but is not part of the
accounts department. They do not report to anyone in the finance department to
avoid a conflict of interest.
ii) Accounting is governed by Generally Accepted Accounting Principles and
international accounting standards. In contrast, an auditor’s check for
material misstatements and their auditing processes are governed by
auditing standards.
iii) Accounting is a day-to-day process, while an audit takes place after a fixed
period of time or after the occurrence of an extraordinary event, like fraud.
iv) Accounting is a 'must have' for all businesses whereas some companies choose
to do without audits.
v) Accountants provide financial management and other information necessary for
effective decision making in the company. By contrast, auditors are not involved
in the management’, of the company and clearly state in their report that the
financial statements are the responsibility of the directors of the company.
vi) After the end of the financial year, accountants produce the financial
statements. After the audit, auditors issue an opinion on whether the financial
statements present a true and fair picture of activities of the company.
 Auditors can also claim to have failed to reach an opinion on the accounts due
to lack of sufficient information.
vii) Accountants work in their given offices whereas auditors move from
company to company doing their work.
viii) Accounting is more detailed financial work whereas auditors sample financial
information to come to a professional opinion.

Similarities between Auditing and Financial Accounting

Both auditing and accounting are statutory requirements i.e. that companies must
maintain
proper books of accounts at that their financial statement must be audited

Objectives & General principles of an Audit

ISA 200 (objectives and General principles Governing an audit of Financial
accounting) states that the objective of an audit of financial statement is to enable
auditors give an opinion on financial statements taken as a whole thereby provide
reasonable assurance that the statements give a true and fair view and have been
prepared in accordance with relevant accounting and other requirements.
The auditor’s opinion is not a guarantee that the financial statements actually show
true and a fair view but that in his or her opinion, they show a true and fair view as to
the state of affairs of the company.
Classification of audit
• Audits can be classified into two broadways.
• According to terms of engagement i.e. nature of work done.
• According to the approach to the work to be done/ timing.
TYPES AUDIT
Statutory audits
These are carried out as per the requirements of various statutes e.g. Companies
act Cap 486 requires that all public limited companies to have their financial
statements subjected to an independent audit. The objective of the audit is to
enable the auditor express an opinion whether the financial statements have a true
and fair view of the company’s state of affairs. The rights and duties of the auditor
are laid down in the relevant statute. The powers of appointment of the auditors are
vested on the shoulders.
Private audits
These are not governed by statutes. They are performed by independent auditors
because the owners, members or interested parties require them carried out. Private
audits are carried out for organizations such as non-governmental organizations,
partnerships and clubs and among others. Appointment of auditors is carried out as
a private contract between the auditor and the relevant shareholder. The scope and
objective of the work as well as rights and duties of the auditor are determined by
the agreed terms between the auditor and the client. The auditor is not liable to third
parties.
According to approach of the work to be done, audits can be continuous,
interim or final
Continuous audits
This is an approach whereby an audit is carried out throughout the financial period
usually at predetermined intervals. This approach is ideal for large organizations
with tight reporting deadlines e.g. multinational banks. The approach ensures
accounts are kept up to date, errors and frauds are discovered in early stages and
better audit reports are developed since more time is taken. However, this approach
is expensive considering amount of time taken, has frequent interruptions of client
work and auditors’ independence may be affected by their continuous presence at
clients premises.
Interim audits
This is an audit carried out halfway through the financial period. It usually precedes
the final audit and is a preparation for the final audit. It is ideal for dynamic
businesses, cheaper compared to continuous audits and enhances keeping of up to
date records.

Final audits
These are usually done at the end of the year as either a continuation of the interim
audit for large and medium size companies or as a single audit for small companies
at end of financial period.
Procedural audits. These require examination of procedures or records for
reliability and accuracy. They usually relate to company’s internal control
systems, laid down guidelines and procedures and records of the company.
Management audits. These involve investigation of the company’s entire
management to ascertain whether the directors are running the company in the
most optimal way for the benefit of the shareholders. It improves quality and
efficiency of management in addition to checking the budgetary system.
Balance sheet audits. This tests the strength of internal control system by
working backwards to get the initial transactions using assertion methodology.
Similarities between internal audit and external audit

 Both auditors are concerned about the strength and proper functioning of the
internal control system. The internal auditor’s concerned it is his or her
responsibility while the external auditor’s concerned as he or she relies on the
strength of internal control system to carry out systems based audits.
 Both auditors have as part of their duties to ensure that the company adheres
to all relevant laws and regulations.
 Both auditors interested in ensuring that the company keeps proper books of
records. The internal auditor uses the company accounts to appraise the
functioning of the internal control system while external auditor uses them to
collect audit evidence to corroborate his audit opinion.
 Both auditors are concerned about prevention and detection of errors and
frauds. The internal auditor ensures errors or frauds are prevented and
detected by having strong internal control system while the external auditor
has the incidental duty of detecting and preventing material errors and frauds
which would otherwise distort the true and fair view of the financial
statements.
 Both auditors have interest in safeguarding company assets. The internal
auditor through strong internal control system ensures safety of company’s
assets while external auditor must ensure that company assets are safeguarded
against theft and misuse so that the true of fair view of financial statements is
maintained.
Advantages of auditing

 Dispute resolution. A partnership business with a complex profit sharing

agreement may require an independent examination of those accounts to
ensure accurate assessment and division of those profits.
 Significant changes in ownership and structure can be easily effected if past
accounts contain unqualified audit reports. E.g. in mergers.
 Auditors have access to the corporate strategy of the company thus are able to
give advice on gaining competitive advantage and on improvement of business
efficiency.
 Borrowing of finances from third parties is enhanced with availability of
unqualified audit report on the company’s financial statements.
 Auditing protects the interests of the shareholders who are separated from the
management of their savings invested in the company.
 Auditing assists in prevention and detection of fraud and error in financial
statements although this is not the primary objective of an audit.

Disadvantages of auditing

• Audit fees are normally high since auditors are highly qualified professionals
hence small firms such as sole proprietorships may not afford their financial
statements to be audited.
• The audit exercise interrupts the clients operations because client staff have to
spend time in availing the required information to the auditors.
• Company secrets may leak to competitors since all company information is
accessible to the auditors
Internal Audit
Management upon realizing the advantages of an audit have established within the
company an independent activity to examine and evaluate the organizations risk
management process and systems of control and to make recommendations for the
achievement of the company’s objective‟. This activity is called internal auditing.
The duties of internal audit personnel are:

• Reviewing the economic efficiency and effectiveness of the company’s

operations.
• Reviewing the company’s compliance with external laws and regulations and
internal policies and procedures.
• Reviewing and advising the management on development of key organizational
systems and implementation of major changes.

The focus of internal auditing is adding value to an organization through

improvement in risk control.
In 1999, the institute of internal auditors (IIA) defined internal auditing as,an
independent objective assurance and consulting activity designed to add value and
improve an organization’s operations, help it achieve its objective and improve the
effectiveness of risk management, control and governance process.

Scope & Objectives of Internal audit function

This depends on the size and structure of the entity and the responsibility assigned
to it by management. Ordinarily these would include:
 Review of accounting internal control systems. The management is responsible
for establishing internal control system. The system requires proper attention and
continuous review, a function usually assigned to internal audit. Internal Audit
function designs a plan on areas and control procedures that will be reviewed
during the financial year.
 Carrying out examination of financial and operational information. This
may include detailed testing of transactions and operation procedures.
 Review of the economic efficiency and effectiveness of operations including
non- financial controls of the entity.
 Review of company’s compliance with external laws and regulation. The
internal audit functions checks whether procedure are in place to ensure that
all relevant laws and regulations are adhered to.
 Review of entity’s compliance with management policies and other internal
requirements.
 Carrying out independent investigations into company affairs as required by
management e.g. investigation areas of suspected fraud or misuse of
company’s resources.
Advantages of Internal Audit function
 It reinforces application of internal controls thus enables the company to operate
in an orderly and efficient way.
 It prevents and detects errors and frauds through periodic comparison of
budgets, routine and surprise checks.
 Assists management in implementation of company policies through reporting
on adherence or non-adherence to laid down policies of the company.
 Assists external auditor in highlighting areas of weaknesses in internal control
system. This reduces audit time for the external auditor and thus there is a saving
on audit fees.
 Assists the company in achieving its objective by ensuring that all laid down
rules, procedures and policies are followed e.g. adherence to budgets and
forecasts assists in decision making.
 The internal audit function guards company’s resources against theft and misuse
through proper functioning of the internal control system and periodic
verification of assets.

Limitations of an Internal Audit

 The cost of installing and maintaining an internal audit function is high and in
particular for large companies as they may require highly qualified staff while
for small companies the department may not be justifiable.
 If management ignores the recommendations of internal audit function,
members of internal audit function may be frustrated as errors and frauds may
continue being undetected.
 Management may deny the internal audit function its due independence by
assigning it accounting duties or even management responsibilities.
 If company operations are few or has complex technical aspects may limit the
proper functioning of the internal audit function.
 The internal audit department may fail e.g. if it points out problems without
giving solutions or ignoring some departments within the company.
 The internal audit may lack the necessary support from top level management if
top management views the function as not important.

Factors necessitating growth in Internal Audit

• Increase in business size. As business grow, it becomes more and more
necessary to have a function that checks all the increasing levels of internal
control and operation.
• Dynamic technology– the frequent changes in technology has made some
companies to have their controls updated on a continuous basis. This calls for
constant feedback on controls requiring updating through use of expert advice
for internal audit function.
• Legislation and regulatory requirements. As the concept of corporate governance
becomes necessary in business management, the need of internal audit has
increased. Companies are now required by regulations to have audit committees
 to oversee operation of controls within the company and to which the internal
audit function reports.
• Competition. High competition in business calls for efficient operations by
companies so as to survive. This can be achieved through strong controls and
cost effectiveness which is enhanced by internal audit.

Risk and Materiality (ISA 320 Materiality)

ISA 320 discusses the concepts of risk and materiality. An audit risk is the risk that
an auditor may give an inappropriate opinion i.e. an opinion that contradicts the true
nature of the financial situation of the company. Materiality plays a role in each of
the following two stages.

a. Planning stage. (in planning what audit work should be done)

b. Reporting stage (in deciding what opinion to give.)

The international auditing and assurance standards board (IAASB) in its framework
for preparation and presentation of financial statement defines materiality as follows;
Information is material if its omission or misstatement could influence the decision of
users taken on basis of the financial statements.‟ Therefore materiality provides a
threshold or cut off point rather than being a primary qualitative characteristic which
information must have if it is to be useful.

ISA 320 further states a number of audit principles as follows:

The auditor should consider materiality and its relationship to audit risk when
conducting an audit. If the auditor assesses the risk associated with an account
balance or internal control system to be high, it will be reflected in a lower level of
materially thus additional testing will be required.
The objective of an audit is to enable the auditor express an opinion whether financial
statements are prepared in all material respects and in accordance with the identified
financial reporting framework. The auditor needs to establish an appropriate
materiality level so that quantitatively, material misstatements which are likely to
destroy the true and fair view of financial statements are identified.
Materiality at planning stage is usually set at lower level than necessary in order to
reduce risk of undiscovered misstatements and to deal with the problem of having to
adjust materially at later date in light of evidence obtained.
Materiality should be considered by the auditor when;
• Determining nature, timing and extent of audit procedures
• Evaluating effect of misstatements
The auditor should plan sufficient audit procedures so that he or she has reasonable
expectation of detecting material misstatements in financial statements. Any
immaterial item will not affect the truth and fair view of the financial statement and
thus can be ignored.
Materiality and judgment
Auditors consider the following before appropriately testing whether an item is
material or not.
1. Qualitative aspects: these may include inadequate or inaccurate descriptions of an
accounting policy.
2. Cumulative effect of small amounts: small errors at a month end procedure could
individually be immaterial but continuous errors of this kind throughout the
financial year could be material.
3. Relatively of materiality. A figure of Kshs. 100,000 may be absolutely
immaterial for a large company but absolutely material for a small company. An
amount must be considered in relation to:

 Items on the overall financial statements level.

 Items at individual account balance or transaction level
 Legal and other disclosure requirements which may require disclosure
regardless of the monetary value e.g. director’s fees.
 The corresponding amount in the previous year

4. The degree of latitude allowable in deciding on the amount attributable to a

particular item. While some items such as director’s fees are capable of an exact
definition, others such as depreciation and allowance for doubtful debts are at best
an intelligent estimate. In some countries e.g. US, the security exchange
commission estimate materiality as follows;
• Errors greater than 10% are material
• Errors between 5% and 10% may be material
• Errors below 5% are not material

5. In evaluating the true and fair presentation of financial statement, the auditor
should assess whether the aggregate of uncorrected misstatements that have been
identified in the audit is material. The auditor should reconsider all uncorrected
misstatements and check whether this total is material.

True and fair view

The true and fair view is a concept of the Companies Act. However, the Companies
Act does not define or even describe what is true and fair view. The companies Act
requires that all limited liability companies to appoint an auditor whose task is to
express an independent opinion as to whether financial statement show true and fair
view of the financial performance and position of the company. True and fair view
implies that the financial statements are not prejudicial to any user of the financial
statements.
Financial statements will present a true and fair view if:
• They contain in all material respects with the disclosure requirement of the
Company Act and other relevant regulations.
• They contain material matter and not full of needless details.
• They are complete in every respect within the constraints of materiality and the
 inevitable estimation of some items.
• The values attributed to the items in the financial statements are reasonable
amounts within a range in which if a major decision was taken on their basis the
user would not make a material error.
• The information contained therein is presented and disclosed without bias and all
relevant information for evaluation and decision making is available.
Assertion Methodology

In preparing financial statements which show true and fair view of the company’s
financial position and performance, the management explicitly or implicitly makes
certain assertions. These assertions are categorized as:
o Existence
o Completeness
o Occurrence
o Rights & obligation
o Measurement
o Valuation, presentation and disclosure.
o Classification
o Cut-off
o Accuracy
o Allocation

Existence
This is the assertion that an asset or liability exists at a given date. It is either true
or not true that an asset or liability reflected in the balance sheet was in existence
at the balance sheet date.

Rights and obligation

This is the assertion that an asset or liability in financial statements pertains to the
entity at a given date i.e. an asset is a right of the entity and a liability a genuine
obligation of the entity.

Occurrence
This is the assertion that a transaction or event took place which pertains to the entity
during the financial period or that a recorded event or transaction actually took place
as recorded and it is a valid transaction pertaining the entity. It is either the
transaction took place as recorded or not.

Completeness
This is the assertion that there are no unrecorded assets, liabilities, transactions or
undisclosed items. It would suggest 100% completion and accuracy however, this is
impossible under accrual basis of accounting. The users of the financial statements
do not expect 100% completeness in financial statements but completeness within a
certain range such that they can still make justifiable decisions. This assertion is
therefore assessed for reasonableness as some transactions may be excluded if they
are not material.

Valuation
This is the assertion that an asset or liability is recorded at an appropriate carrying
value. It is the most crucial assertion of all the assertions. In arriving at appropriate
carrying value of an asset or liability, the management considers.
1. Overall valuation basis. The management must consider the entity as a whole and
make an assessment whether it is appropriate to apply the going concern
assumption in preparing the financial statements. The basis of preparing financial
statement when entity is going concern is radically different from preparing
financial statement on basis that the entity is not a going concern.
2. Suitable accounting policies. In determining carrying amount of an asset or
liability appropriate accounting policies must be followed. The accounting
policies must be in line with the generally accepted accounting principles
(GAAPs), appropriate to the circumstances of the entity, applied consistently, be
in conformity with entity’s industry practices and be adequately disclosed.
3. Desirable qualitative characteristics. The suitable accounting policy adopted must
be applied after taking into consideration the qualitative characteristics of
materiality, prudence and substance over form. Since it may subjective whether
an entity is a going concern or not, the accounting policy adopted can be
subsequently subjective thus the assertion of valuation can only be assessed for
reasonableness.

Measurement
This is the assertion that a transaction or an event is recorded and proper amounts of
revenue and expense are allocated to the proper period for proper reporting purposes.
Whether a transaction brings into being an asset or liability, revenue or expense
depends largely on the capitalization policy of an entity i.e. the guidance as to what
items are revenue items and capital items.

The period in which a transaction took place may be influenced by management’s

desire to reflect a given financial position. However, where revenue or expense of an
item is spread over more than one accounting period is called allocation rather than
measurement and is a component of valuation.

Presentation and disclosure

This is the assertion that an item is disclosed, classified and described in accordance
with the applicable financial reporting framework. The information in financial
statements should be presented without bias, be relevant to the needs of the users and
meet qualitative characteristics of understandability, relevance, reliability and
comparability. This assertion is not assessed for truth but rather adequacy or
reasonableness.

In conclusion, truth and fairness of financial statements can be assessed on these

seven assertions i.e. the financial statements will reflect a true and fair view of
company’s financial position and performance if the seven assertions are used as
guidelines in preparing the financial statements.

Classification
Are transactions recorded in appropriate accounts?

Cut-off
Are transactions recorded in appropriate period?
Accuracy
Are the amounts disclosed in the financial statements appropriate?

Allocation
Are account balances included in appropriate accounts?