Course Title Auditing I

1.The Nature, Purpose, Scope of Audit and 4. Client Acceptance and Planning the Audit
Assurance Services
4.1 Client Acceptance and Continuance
1.1 Meaning Of Audit
4.2 Planning the Audit
1.2 Assurance Services: Overview
1.3 Why Audits are Conducted 4.3Appointment, Remuneration, and Removal of Auditors
1.4 Types of Audit and Auditors 5. Audit Responsibility, Objectives, Evidence and Recording th
2. The Auditing Profession Audit
2.1 The Regulatory Framework Governing 5.1 Audit Responsibility
Auditing 5.2 Management Assertions
2.2 International Standards on Auditing (ISA) 5.3 Audit Objectives
2.3 Professional Ethics: Fundamental
Principles, Threats and Safeguards 5.4Audit Evidence
2.4 Legal Liability of Auditors 5.5 Audit Documentation
2.5 Rights and Duties, Appointment, Dismissal 6. Internal Control
and Resignation of an Auditor 6.1 Meaning and Objectives
3. Materiality and Risk Assessment 6.2 The Basic Elements
3.1 Audit Risk
6.3 Recording Internal Control System
3.2 Materiality
6.4 Internal Control and External Auditor
6.5 Internal Control and Internal Auditor
6.6 Inherent Limitations
7. Audit Reports
7.1 Types of Audit Reports
7.2 Basic Contents of a Standard Audit Report
7.3 Audit Opinion
Chapter-one
1.AN OVERVIEW OF AUDITING
1.1. Historical Background of Auditing Practices
Auditing in the form of ancient checking activities was found
in the ancient civilizations of China, Egypt and Greece.
The word ‘audit’ was derived from the Latin word ‘audire’
meaning “to hear”, “listen” or “give credence to”. Ever since
control and accountability for money was entrusted to third
parties it becomes necessary to account for the transactions
and subject them to some sort of an independent checking.
 Definition of auditing
 A 1973 study by the American Accounting Association entitled,
“A Statement of Basic Auditing Concepts, defined auditing as, ‘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’.
From the definition we can understand the following concepts:-
 An audit is a systematic approach- By systematic we mean that
all audits follow certain steps, namely
(1)planning,
(2) fieldwork, and (3) reporting.
 The audit follows a structured, documented plan (audit plan)
whereby objectives are set and audit programs are developed
that guide the field work. The audit must be planed and
structured in such a way that those carrying out the audit can
Cont…
analyze all important evidence. In the fieldwork of the audit,
accounting records are analysed by the auditors using a variety of
generally accepted techniques. Finally, results are developed in to
reports and communicated with users.
 An audit is conducted objectively –an audit is an independent,
objective and expert examination and evaluation of evidence.
Auditors are faire and do not allow prejudice or bias to override
their objective. They maintain an impartial attitude.
 The auditor obtains and evaluates evidence – the auditor assesses
the reliability and sufficiency of the information contained .in
the underlying accounting records and other source data by:
a) Studying and evaluating accounting system and internal control
on which he wishes to relay and testing internal controls to
determine the nature, extent and timing of other auditing
procedure ;and
b) Carrying out such other testes, inquiries and other verification
procedure of accounting transaction and account balances as he
considers appropriate in the particular circumstances
Cont..
 The evidence obtained and evaluated by the auditor concerns assertions about
economic actions and events. Assertions are representations by management,
explicit or otherwise, that are embodied in the financial statements. One
assertion of management about economic actions is that all the assets reported
on the balance sheet actually exist at the balance sheet date. The assets are real,
not fictitious. This is the existence assertion. Furthermore, management
asserts that all these assets are owned by the company. They do not belong to
anyone else. This is the rights and obligations assertion.
 The five assertions of clients’ financial statements are:
1. Existence and occurrence: a claim regarding existence of asset and liability,
and occurrence of recorded transactions;
2. Completeness - All transactions that actually occurred and accounts that
should have been recorded in the financial statements were recorded;
3. Rights and Obligations – a claim that assets are actually rights of the client
and recorded liabilities are actually owed by the entity
4. Valuation or Allocation - assets, liabilities, revenues, and expenses are
appropriately valued and allocated to the proper accounting period; and
5. Presentation and Disclosure – financial statement components are
properly presented and disclosed in conformity with IFRS or applicable
GAAP.
Cont..
 The auditor ascertains the degree of correspondence
between assertions and established criteria. The
auditor examines the evidence for the assertion
presentation and discloser to determine if the accounts are
described in accordance with the applicable financial
reporting frame work, such as international accounting
standards, local standards or regulations and laws.
 The goal, or objective, of the auditing is communicating
the results to interested users. The audit is conducted
with the aim of expressing an informed and credible
opinion in a written report. The purpose of the
independent expert opinion is to lend credibility to the
financial statement. The communication of the auditor’s
opinion is called attestation, or the attest function. In
an audit this attestation is called the ‘audit report’.
Cont..
 An audit is…
 A logical series of steps (planning, evidence
obtaining, analysis, reporting)
 Performed without bias (objectively)
 To determine if certain representations
(assertions) of management (i.e., mgmt’s f/s)
 Correspond to established standards (IFRS).
 The results of the audit
 are communicated in writing (audit report)
 to people who will rely on the findings (the
“users”).
 Nature of Auditing
 An audit is a systematic examination of books, accounts, documents and reliability of accounting
statements.
 It is not only to see the arithmetical accuracy of the books of accounts but it also goes further
and finds out whether the transaction entered in the books of original entry are correct or
not. An auditor has to go behind the books.
 The purpose of auditing lies in ascertaining whether the working result (financial
performance) and financial position as shown by the income statement and balance sheet for
a particular period are truly determined and presented by those responsible for their
compilation.
 Auditing does not mean the preparation of accounts. It is the verification of accounts by an
independent person who examine and checks them and makes best use of the information
supplied to him.
 An auditor is required to direct his efforts towards proving and establishing the authenticity of
the transaction by vouching all the information supplied.
Auditing, thus primarily involves
 Testing the reliability, competency and adequacy of evidence in support of monetary
transaction of an organization. Reliability of Audit Evidence:
 External evidence is usually more reliable than internal evidence.
 Internal evidence will be more reliable, when related internal controls are satisfactory Evidence
obtained by the auditor himself is more reliable than evidence obtained from entity.
 Documentary evidences are more reliable than oral representations.
 It is the process of testing (the reliability) and weighing (competence and adequacy) of
evidence.
 Cont.…
 Auditing is analytic, critical and investigative.
 It has its principle roots not in accounting which it reviews
but in logic on which it leans heavily for ideas and methods.
 The function of reporting is the end-product of auditing.
 A well laid out and implemented audit program helps an
auditor to arrive at proper conclusion regarding the
accounting statements and thus helps him to formulate his
opinion
 Assurance Services: Overview
 An assurance service is an independent professional service that improves the quality
of information for decision makers. Such services are valued because the assurance
provider is independent and perceived as being unbiased with respect to the
information examined. Assurance services can be done by CPAs or by a variety of
other professionals. For example, Consumers Union, a nonprofit organization, tests a
wide variety of products used by consumers and reports their evaluations of the
quality of the products tested in Consumer Reports.
 The organization provides the information to help consumers make intelligent
decisions about the products they buy. Many consumers consider the information in
Consumer Reports more reliable than information provided by the product
manufacturers because Consumers Union is independent of the manufacturers.
Other assurance
 One category of assurance services provided by CPAs is attestation services. An
attestation service is a type of assurance service in which the CPA firm issues a report
about the reliability of an assertion that is made by another party. Attestation services
fall into five categories:
1. Audit of historical financial statements
2. Audit of internal control over financial reporting
3. Review of historical financial statements
4. Attestation services on information technology
5. Other attestation services that may be applied to a broad range of subject matter.
 Demand for Audit
 The essence of demand for audit refers to the question “why do organizations
request an audit?” the answer to this question can be described as follows:
 Control mechanism: audit is important as control mechanisms to ensure
accountability. The auditors’ role is determining whether the reports prepared
by management are in conformity with the responsibility and duties provided
in the organization policies.
 To resolve conflict of interest between management and the owners:
The Agency relation ship that exists between the owner and manager produces
a natural conflict of interest. Because, the manager has more information
about the “True financial position and results of operations of the entity than
the owner who is absentee. It both parties seek to maximize their own self
interest, it is likely that the manager will not act in the best interest of the
owner.
 To reduce damaging Consequences: Even though, the function of
accounting is to provide information for economic decision making.
 To simplify complexity: In our age, financial information and translation
has become complex in preparation, content, and format.
 Regulatory requirements: many business laws, memorandum of association
and government regulation, make requirements’ for annual audits.
 Rationale for an Audit
 The objective of an audit of financial statements is to enable the
auditor to express an opinion whether, apart from representing
a true and fair view of an entity’s finances; the financial
statements are prepared, in all material respects, in accordance
with the applicable financial reporting framework.
 The underlying objective is to add credibility and enhance the
degree of confidence of Users of management’s financial
statements. Access to capital markets, mergers, acquisitions,
and investments in an entity depend not only on the
information that management provides in financial statements,
but also on the assurance that the financial statements are free
of material misstatements. This assurance is provided, to a
considerable extent, by an audit. While an audit does not
guarantee financial statements’ accuracy, it provides users with
a reasonable assurance that an entity’s financial statements give
a true and fair view in conformity with the applicable financial
reporting framework.
Cont…
 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
 Remoteness of the users from the financial
information generating system and processes
 Financial and Economic consequences of using
unreliable information
Accounting and Auditing
 Many financial statement users and members of the general
public confuse auditing with accounting. The confusion results
because most Auditing is usually concerned with accounting
information and many auditors have considerable expertise in
accounting maters.
 The function of accounting is to provide certain types of
quantitative information that management and others can use
to make decisions.
 In auditing accounting data, the concern is with determining
whether the recorded information properly reflects the
economic events that occurred during the accounting period.
 Accounting is the recording, classifying, summarizing and
reporting of economic events for the purpose of providing
financial information used in decision making.
 Auditing is determining whether recorded information properly
reflects the economic events that occurred during the
accounting period.
 Types of Audits and Auditors
1. Types of Audits
Using different parameters we can classify audits in to different types. Such
parameters include organizational structure, time, scope, and objective.
Accordingly, audits are often viewed as falling in to three major categories:
1. Financial statement audit
2. Compliance audit
3. Operational audits
1. financial statement audit
Audit of financial statements covers the balance and related statements of income,
retained earning, and cash flows.
 The goal is to determine whether these statements have been prepared in
accordance with GAAP.
 This audit normally performed by CPA (Certified Public Accountants)
 Users of Audit reports include management, investors, bankers, creditors,
financial analysts and government agencies.
2. compliance audit Is carried out to determine if entities are complying with
applicable laws, regulations, policies and regulations.
 It is performed by GAO (General Accounting Officer) or compliance officers
 The audit is an appraisal activity which measures the extent to which
organizational objectives are meat.
3. Operational Audit
 An operational audit is a study of a specific unit of
organization for the purpose of measuring its performance.
 Operational audit is concerned with the operating
efficiency and effectiveness of functional areas of an
organization. It takes into consideration
 Inefficient operations both from the time and cost angles;
 Wastage of resources through lack of propriety in expense;
and
 Effectiveness in achieving goals, objectives and plan set for
the functional area.
 It is aimed at improving the profitability of the
organization and simultaneously at achieving the other
organizational goals.
 It is difficult to identify established criterion for
operational audits the only criterion to be used is good
business common sense, best practices etc.
Types of auditors 2. External Auditors (independent
There are three basic types of auditors these auditors)
are:  They are independent of the
1 . Internal auditor organizations whose representations
2 . External auditors (independent auditors) are being audited.
and
 They offer their audit services on a
3 . Government auditors
contractual bases .
1. Internal auditor
 The independent auditor is paid a fee
 Internal auditors are employed by the
organizations they audit. These auditors by the audited, and is responsible
may review. primarily to third parties.
 Employee performance; Compliance with  The majority of audits performed by
company regulations; and Financial and external auditors are financial
accounting systems. statement audits.
 Internal auditors allow company leaders to 3. Government auditors
be informed of what is happening within
the company and to address issues or  They are auditors representing local,
concerns early. Internal auditors have the state and federal Government entities.
following features:  Government auditors perform financial
 They are full-time employees of private or statement audit, compliance audit and
public organizations who are hired to operational audit.
conduct audits of those organizations.
 They often report to the audit committee of
the board of directors and also to the
president or another high executive.
 Internal auditors perform both compliance
and operational audits for there companies.
 CHAPTER TWO
THE AUDITING PROFESSIONAND LEGAL LIABILITY
 The work of an independent auditor is to express an
objective opinion on financial statements of an
organization.
 To have this objectivity an auditor needs to have an
independent physical and mental attitude at all time
in his work. This is one of the major ethical issues that
auditors have to deal with and need guidance on.
 GENERALLY ACCEPTED AUDITING STANDARDS (GAAS)
 Auditing standards are measures of the quality of the auditor's performance.
 The American Institute of Certified Public Accountants (AICPA) first issued
the ten generally accepted auditing standards (GAAS) in 1947 and has
periodically modified them to meet changes in the auditor's environment.
 The GAAS are composed of three categories of standards:
 General standards of qualification and conduct;
 Standards of fieldwork; and
 Standards of reporting.
 Auditing standards must be viewed and interpreted in at least two deferent
ways.
 First auditing standards need to be viewed as the minimum level of
performance standards required to be observed by auditors in performing
their duties. The auditor must understand and recognize that most
professional auditing standards are broad and seldom specifically address the
actual problems that arise in individual audit engagement.
 Second professional auditing responsibilities are achieved if the independent
auditor performs an audit in accordance with GAAS. Therefore, the auditor
meets professional.
 Cont…
 auditing responsibilities in the context of existing professional auditing standards that requires
the constant exercise of professional judgment.
 auditing experts believe that professional auditing standards should be viewed in the latter
context because there is simply no way to establish standards in such detail that professional
judgment is minimized or eliminated. Since professional auditing standards seldom provide the
exact answer, they should be viewed as minimum guidelines that set the tone for the auditing
profession.
 General Standards of Qualification and Conduct
1. The audit is to be performed by a person or persons having adequate technical training and
proficiency as an auditor.
2. An auditor must maintain an independent physical and mental attitude.
3. An auditor must exercise due professional care in his work.
o Standard of Fieldwork
1. Auditor's work must be properly planned and supervised.
2. Auditor's must study and evaluate internal control.
3. Auditor must gather sufficient and competent evidence.
 Standards of Reporting
1. The audit report must state whether financial statements have been prepared in accordance
with Generally Accepted Accounting Principles (GAAP).
2. The audit report must state whether the GAAP has been consistently applied with that of the
preceding period.
3. The audit is to be presumed to have adequate information disclosure unless and otherwise
stated so.
4. The audit report must maintain an expression of opinion on the financial statements as a whole
 General Standards of Qualification and Conduct

 The three general standards are concerned with the auditor's qualification
and the quality of his or her work.
Technical training and proficiency of an auditor
 The first general standard recognizes that an individual must have adequate
training and proficiency as an auditor.
 This is gained through formal education, continuing education programs, and
experience.
 It should be recognized that this training is on going with a requirement on the
part of the auditor to stay up to date with current accounting and auditing
pronouncements.
 Auditors should also be aware of developments in the business world that may
affect the auditing profession.
 Auditors independence in physical and mental attitude
 The second general standard requires that the auditor always maintain an
attitude of independence on an engagement.
 This standard is related with assurance service of the profession and hence it
is unique to the auditing profession;
 The need for independence is a result of the auditor’s responsibility to users of
the financial statements;
 Independence precludes relationships that may impair the auditor's
objectivity;
 A distinction is often made between independence in fact and independence
in appearance. An auditor must not only be independent in fact but also avoid
actions that may appear to affect independence in appearance.
 If an auditor is perceived as not being independent, users may lose confidence
in the auditor's ability to report truthfully on financial statements.
 Lack of independence by auditors put the integrity and fairness of the
financial statements in to question;
 Public confidence is impaired if an auditor is found to lack independence.
 Due professional care in his work
 Due professional care is the focus of the third general
standard.
 In simple terms, due professional care is that the auditor
performs his or her duties with a degree of skill commonly
possessed by others in the profession.
 The third general standard imposes an obligation on the
members of the audit team to observe the standards of
field work and reporting, and to perform the work at the
same level as any other professional auditor who offers
such services to clients could.
Standards of Field Work
 The standards of fieldwork relate to the actual conduct of
the audit.
 There are three standards under this category. They provide
the conceptual background for the audit process.
1. Planning and supervision
 The first standard of fieldwork deals with planning and
supervision. This standard gives recognition that successful
completion of an audit engagement requires proper planning.
 Adequate planning of an audit encompasses features such as
client orientation, determination of man power requirements
and efficient utilization of a firm’s resources;
 Proper planning can lead to a more effective audit that is
more likely to detect material misstatements if they exist;
 Proper planning also assists in completing the engagement in
a reasonable amount of time.
 Additionally, the standard requires that assistants on the
engagement be properly supervised. When two or more
auditors are involved in engagement, there must be system of
review and supervision
 The degree of supervision will deepened upon a variety of
factors such as the background of the assistant and the
nature of the work being performed by the assistant
2. Study and evaluate internal control
 The second standard of fieldwork requires that the auditor gain sufficient understanding
of the audit's internal control to plan an audit.
 The internal control over financial reporting provided in the accounting policies and
procedures of an organization should be in a manner that enables the entity to process,
record, summarize, and report financial data consistent with assertion reflected in its
financial statements.
 The auditor’s responsibility is to understand a client’s internal control structure to a
degree that allows the auditor to determine the nature ,extent, and timing of audit
procedures in a manner that assure the audit will be both effective and efficient.
 Internal control is a process, effected by an entity's board of directors, management and
other personnel that is designed to provide reasonable assurance regarding the
achievement of the following objectives:
 Reliability of financial reporting. Financial Reporting” relates to preparation of
reliable published financial statements. This includes periodical reporting and annual
report. Examples of internal control over financial reporting includes segregation of
duties, authorization limit, dual signatory, physical count of stocks and cash, periodic
reconciliation of balances, documentation of transaction supporting files.
 Compliance with applicable laws and regulations.Compliance” relates to the entity’s
compliance with applicable laws and regulations. This may include: Securities and
Exchange Commission (SEC), Federal Deposit Insurance Corp. (FDIC), Environmental
Protection Agency (EPA), Internal Revenue Service (IRS). Effectiveness of Internal
Controls over Compliance can be judged effective if: The Board of Directors and
 Effectiveness and efficiency of operations. This is related to the effective
and efficient use of the entity’s resources such as fixed assets, people, money,
reputation, production capabilities. Thus, effectiveness of Internal Controls
over Operations can be judged effective if: The Board of Directors and
management has reasonable assurance that they understand the
extent to which the entity’s operations are being achieved.
 The degree to which the auditor relies on the auditee's internal control
directly affects the nature, timing, and extent of the work performed by the
independent auditor.
3 Sufficient and competent evidence
 and confirmation to afford reasonable bases for an opinion regarding the
Sufficient, competent evidence is the focus of the third fieldwork standard.
 Sufficient competent evidential matter is to be obtained through inspection,
observation, inquiries financial statements under examination.
 The standard requires that the auditor collect sufficient and competent
evidential matter as a base for drawing a conclusion about the reliability of a
client’s financial statement.
 The sufficiency of evidential matter relates to the quantity of evidence
acquired through confirmation, observation, inquire, and the use of other
audit techniques.
 Competent evidential matter refers to the quality of the evidence gathered.
Ultimately, what constitutes sufficient and competent evidence is a matter of
professional judgment
Standards of Reporting
 The four standards of reporting are presented below:
1. The report shall state whether the financial statements are presented in
accordance with general accounting principles.
2. 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.
3. Informative disclosers in the financial statements are to be regarded as
reasonably adequate unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding the financial
statements, taken as a whole, or an assertion to the effective that an opinion
cannot be expressed.
 Generally Accepted Accounting Principles: In preparing his/her report, the
auditor should state whether the financial statements are in accordance with
generally accepted accounting principles or not. Generally accepted accounting
principles, as used in the standard of reporting, indicate the application of such
principles in the preparation of financial statements. But you have to note that the
auditor should not state the financial statements are in accordance with GAAP if
they are not actually so.
 Consistency: the auditor should demonstrate in his/her report a consistent
application of GAAP in the preparation of financial statements. Consistency as it is
applies to standards of reporting requires the auditor to state in his/her report if
there is a change in the accounting principles that materially affect the
comparability of the financial statements.
 Informative Discloser: the auditor has to evaluate whether
all information that will have material effect on the
statements is disclosed.
 Expressing opinion: the auditor‘s opinion indicates
whether the financial statements are fairly presented or not.
It is for this reason that the standard of reporting requires
the auditor to express his/her opinion on the financial
statements based on his/her findings. If the auditor is
unable to from opinion due to various reasons, she/he has to
state the reasons clearly. 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.
 Independence audit
 The development of auditing as a profession is tied to the importance of
independence in audit. Independence is the corner stone to professional audit which
is the reason for naming professional auditing as independent audit.
What do we mean by independence and objectivity?
 Independence is freedom from situations and relationships which make it probable
that a reasonable and informed third party would conclude that objectivity either is
impaired or could be impaired.
 Independence is related to and underpins objectivity. However, whereas objectivity is
a personal behavioural characteristic concerning the auditor’s state of mind,
independence relates to the circumstances surrounding the audit, including the
financial, employment, business and personal relationships between the auditor and
the audited entity and its connected parties.
 objectivity is a personal behavioural characteristic concerning the auditor’s state of
mind or situation that influences auditor’s formation of opinion or conclusions.
 Auditors are expected to form their opinion and conclusion based on facts and
evidences they obtained and tested in the audit process.
 Other definitions of independence and objectivity have been provided as follows:
 Independence is the ability to resist client pressure;
 Independence is a function of character with characteristics of integrity and
trustworthiness being essential;
 AICPA, 1997defines independence as an absence of interests that create an
unacceptable risk of bias;
 Defines of objectivity as a free mental attitude which auditors should
maintain in performing audit engagements. Auditors are not to subordinate
their judgment on audit matters to that of others; and
 AICPA requires auditor in their performance of audit to maintain their
objectivity and integrity. Defines objectivity as a state of mind or
conditions in which auditors are free of conflict of interest and they do not
knowingly misrepresent facts or subordinate their judgment to others.
Why Do Auditors Need Independence?
 The very demand for audit calls for integrity and objectivity in the person
who performs the audit so that users of the audit could put trust and
confidence in the auditor and the audit work.
 How can independence, integrity and objectivity be best provided or
guaranteed in the auditor's function or personality is a constant
challenge of the profession. Thus, the auditing profession has tried to
delineate these within the framework of:
1. Professional qualification,
2. Ethics, and
3. Legal liability and responsibility requisites.
 characteristics of a profession
 The most important characteristics of a profession include: a responsibility
to serve the public, a complex and specialized body of knowledge, standards
of admission, and a need for public confidence.
Specialized body of knowledge
 A profession has a specialized body of knowledge that member of the
profession should acquire through formal education. To practice public
accounting, you have to study accountancy at a university. Besides, the
auditor needs to be knowledgeable of new pronouncements issued by
the concerned professional association. The body of knowledge is
dynamic and in constant development and growth and not static.
Standard of Qualification for Admission
 A profession to be a profession must have well-recognized and accepted
predetermined criteria of qualification for admission into the
profession.
 The standards include educational requirement as well as other moral
and legal criteria fulfillment. The education requirements are composed
of theoretical knowledge and practical experience.
 Usually the fulfillment of these requirements is measured through tests of
qualifying examinations to prove the consumption of the accumulated
body of knowledge that exist in the profession and competence in it.
Standards of conduct of behavior
 A professional needs to have standards of conduct that governs the behavior and
activities of the members of the profession.
 The code of professional conduct is a means by which the public measures and judges the
professional quality of the members of the audit profession. To this end auditing
profession has developed a code of professional conduct that has two parts which are
principles and rules of conduct.
Need for public confidence
 A profession will be successful if it gains public trust and confidence. This is an
extremely important quality expected of the independent as it leads to increased credibility.
The demand for audited financial statements is a proof confidence to the auditor.
Responsibility to serve the public
 In financial statements audit, the auditor is the representative of the public in the financial
reporting process. Thus, the role of the independent auditor is to insure that financial
statements are fair to all parties and not biased to favor a certain group.
 To play their role effectively, auditors must maintain a high degree of independence from
their client. This shows the auditors’ responsibility to the public in other words, the
auditors’ acceptance of responsibility for the consequences of theirs action.
 This does not mean only legal responsibility which arises out of the contractual
obligation, but also moral responsibility to the profession itself. Auditor has a
responsibility to assure the society with the quality of services demanded and accept
sanction for failure to do so.

 The role of professional associations in the development of these is crucial. An

association is a body of professionals and it is this body that plays important
role in prescribing the professional standards and guiding their
implementation
 PROFESSIONAL QUALIFICATION REQUIREMENTS
 The professional qualification requirements for auditors or
qualified public accountants (CPA) in various countries are
more or less the same. The most common elements are:
 Minimum educational background which nowadays is
being pushed higher and higher completion of required
specialized body of knowledge as prescribed by the
profession and proved through the passing of qualifying
examinations;
 Fulfilment of prescribed practical experience;
 Moral and ethical requirements invoked through character
reference; and
 Age limit for determining legal personality and
responsibility.
 PROFESSIONAL ETHICS OF AUDITING
 A code of ethics is a comprehensive statement of the values and principle which guide;
 The daily work of auditors,
 Professional attitude; and
 Encourage high level of performance.
 The enforcement of code of ethics assures the general public and the audited entities that
the auditor‘s work is fair and impartial. The purpose of professional ethics in the auditing
profession as well as in other professions is to
 build the public confidence,
 to judge the quality of audit work, and
 provide grounding guidance‘s of conduct for practitioners..
The advantages of prescribing professional ethics are to emphasize positive activity and encourage
high level of performance while preventing mal-practices. However, there is difficulty in
concretize them.
 First they can only be prescribed in general terms to avoid prescribing unacceptable behavior, and
it is difficult to enforce general ideas of behavior.
 Second it is difficult to interpret behavior without reference to specific at which point it requires
interpretation of rulings according to circumstances.
Important parts of ethics in auditing are in relation to:
 Maintenance of mental and physical independence, integrity and objectivity
 General competence and technical standards
 Responsibility to client and colleague
 Other responsibility and practices that have bearing on ethical conduct include acts discreditable
to the profession, i.e. commission, incompatible occupation, soliciting, forms of practice, etc.
As an e.g. of a highly developed professional ethics of auditing the student should refer to the AICPA
code of professional ethics. Most important elements to note in such code of ethics are
Independence, Integrity and Objectivity
 An auditor’s objectivity must be beyond question if he/she is to report as an auditor and this
objectivity can only be assured:
 if the auditor is in fact independent, and
 If the auditor is seen to be independent.
The threat to independence may be reduced by the nature and extent of the precautions taken by
the practitioners to guard against loss of objectivity.
 An auditor must maintain an independent mental and physical attitude. He must be free from
any
 Financial and positional interests, and
 Family relation in assuming a position of an auditor
 Otherwise his independence will be impaired in terms of physical and mental attitude.
 Threats to Independence of an Auditor
 Undue dependence on an audit client
 Objectivity may be threatened by undue dependence on any audit client or group of connected
clients. The recurring work paid by one client or group of connected clients should not exceed
15% of the gross practice income.

 Overdue fees
 The existence of significant overdue fees from an audit client or group of association clients can
be a threat to objectivity akin to that of a loan. Audit firms must therefore ensure that overdue
fees, along with fees from current work, could not be construed as a loan.
  Actual or threatened litigation
 A firm's objectivity may be threatened or appear to be threatened when it is involved in, or even threatened
with litigation in relation to a client. Litigation of certain sorts will represent a 'breakdown of the relationship
of trust' between auditor and client. This would impair the independence of the auditor or cause the directors
of the client to become unwilling to disclose information to the auditor.
 Family or other personal relationships
 An auditor's objectivity may be threatened as a consequence of a family or other close personal
or business relationship.
 Problems arise if an officer or senior employee of an audit client is closely connected with the
partner or senior staff member responsible for the conduct of the audit. In this context, closely
connected people include adult children and their spouses, siblings and their spouses, any
relative to whom regular financial assistance is given or who is indebted to the staff members or
partner.
 Beneficial interest in shares and other investments
 An auditor's objectivity may be threatened where he/she holds a beneficial interest in the shares
or other forms of investment in a company upon which the practice reports.
 Staff or partners should not have share holdings in client businesses. (This includes beneficial
shareholdings held by a spouse or minor children).
 Loans
 Objectivity may be threatened by a loan to or from an audit client.
 No loans or guarantees should be undertaken unless they are with client financial institutions in
the normal course of the business
Goods and Services Hospitable
 Objectivity may be threatened by acceptance of goods,
services or hospitality from an audit client. Acceptance
on normal commercial terms, or with only modest
benefit, is acceptable.
Provision of other services to audit clients
 There are occasions where objectivity may be
threatened or appear to be threatened by the provision
to an audit client of services other than the audit. Care
must be taken to avoid performing executive functions
or making executive decisions
 General and Technical Competence
 An auditor must possess professional competence necessary to provide competent
services that meet clear and acceptable standards and avoid the use of his/her name
in an unintended activity that is,
 Preparation of technical statements that is beyond the capacity and ability of the
auditor,
 Issuance of unaudited financial statements due to lack of competence.
 Auditors should not accept or perform work, which they are not competent to
undertake unless they obtain such advice and assistance as will enable them
competently to carry out the work.
Responsibility to Clients
 The auditor’s responsibility to their client requires:
 Auditor to be responsible for maintaining confidential information forwarded to
him/her by a client as a result of his/her privileged position.
 Auditor to provide his services on contingent or conditional fee bases.
 In addition auditor’s responsibility to their client includes responsibility that was
developed through common law cases that relate to 'due professional care'.
Thus, auditors must employ reasonable care in all they do, in particular:
 Auditors must use generally accepted auditing techniques when seeking to satisfy
themselves that the matters upon which they report accurately reflect the true
financial state of his client's business.
 If auditors come across any matter, which puts them upon inquiry then they have a
duty to investigate such a matter until they are able to resolve it to their own
reasonable satisfaction. Auditors should not accept any explanation unless they have
first carried out such investigations as will enable them properly to assess whether the
explanation offered a reasonable one.
 LEGAL LIABILITY AND RESPONSIBILITY
The auditor is responsible for his report;
 Auditors are not responsible for the financial statements, which
are the representations of management.
 However, the auditor can be sued for causing damage to users of
his audit report if he doesn't carry out his work properly.
 In other words, auditors face legal liability if they conduct their
work negligently.
 Legal liability means the probability that an auditor would be
liable to a legal (court) action for not performing his duties well.
In order to understand this section, you have to know the meaning
of the following words as they are used in the context of auditor's
legal liability.
 Breach of Contract: when the auditor/client fails to meet the
terms and obligations stated in the contract for audit.
 Ordinary Negligence: an absence of reasonable or due care in
performing an audit. An auditor is negligent when he/she fails to
do what other professional accountants would have done under
similar circumstances. E g. Failure to detect that there was an
error in computing depreciation.
 Gross Negligence: an extreme deviation from professional
standards of due care.Eg. Discovering but taking no action
about management theft or fraud because of carelessness.
 Fraud: wrongful actions taken with the intent of deceiving
client, the one whose financial statements are being audited.
 Third Party: the contract for the audit is signed by the auditor
and the client others who have interest are referred to as third
partiesEg. Creditors, investors, potential investors etc
 The following table summarized the auditor's legal liability
 The auditor can be charged by For
 Client for Breach of contract Negligence (gross and ordinary
negligence) Negligence (gross and ordinary negligence
 A third party known to rely on the auditor's report for a
particular purpose Fraud Gross negligence
 Foreseen third parties Fraud Gross negligence
 Reasonably foreseeable third parties for Fraud
 For any of the above parties to be able to successfully sue the auditor,
they should be able to show that:
 The auditor had a duty to do something
 He did not perform his duty
 The plaintiff (person suing the auditor) relied on the work of the
auditor.
 The plaintiff suffered a loss as a result of relying on the auditor's work.
Possible Charges by a Client
 For breach of contract
 The auditor would be seud for breach of contract if he fails to
complete the service agreed to in the contract with the client. Eg. If
the auditor discontinues an audit without adequate cause, or fails to
submit the audit report before or on the deadline, he may be asked to
repay a part or the entire fee.
 For ordinary or gross negligence Auditors can be sued for negligence
by their clients when they fail to show due care, i.e, a level of
carefulness usually possessed by others in the profession. For
example, the client may charge the auditor for not detecting a major
fraud by one employee or for letting a confidential information leak
out
 Possible Charges by Third Parties
 The auditor can be charged by third parties that the auditor is well informed of that
they would rely on his report for negligence and fraud.
 For example, XYZ Co. engaged ABC auditing firm, to audit its financial statements
telling him that they need the report to obtain a loan from a bank. In this case, ABC
auditing firm can be held liable for both ordinary and gross negligence to the bank in
case the bank suffers a loss as a result of relying on the auditor's opinion.
 On the other hand, third parties that the auditor doesn't know would use his report
can charge the auditor and recover any losses only for gross negligence and fraud. But,
the question would be how is ordinary negligence differs from gross negligence?
 Say financial statements have been deliberately overstated by management to deceive
users. The auditor has a duty to discover this. If the auditor applies GAAS properly
and simply doesn't suspect the fraud, he can only be accused of ordinary negligence.
However, if the auditor suspected that there was fraud but did not do additional
investigation to try to uncover the fraud, he can be accused of gross negligence.
 If the auditor actually discovered the fraud and did not mention this in his audit
report, in this case he is participating in the fraud himself (i.e., constructive fraud).
The Auditor's Responsibility for other Illegal Acts
 The auditor has a duty to uncover and report on illegal acts committed by the client or
any one as long as they are related to the financial statements.
 So the auditor can be charged for not reporting illegal acts unrelated to the financial
statement only if he/she knows about them.