ATD – Principles of Auditing Notes

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TOPIC 1

 NATURE AND PURPOSE OF AN AUDIT

 

Nature of an audit

According to General Guidelines on Internal Auditing issued by the ICAI, “Auditing is defined as a systematic and independent examination of data, statements, records, operations and performances (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognises the propositions before him for examination, collects evidence, evaluates the same and on this basis formulates his judgement which is communicated through his audit report.”

The nature of the propositions which an auditor is called upon to review varies. Thus an auditor may review the financial statements of an enterprise to ascertain whether they reflect a true and fair view of its state of affairs and of its working results. In another situation, he may analyse the operations of an enterprise to appraise their cost-effectiveness and in still another, he may seek evidence to review the managerial performances in an enterprise. In yet another type of audit, the auditor may examine

whether the transactions of an enterprise have been executed within the framework of certain standards of financial propriety. However, the variations in the propositions do not change the basic philosophy of auditing, though the process of collection and evaluation of evidence and that of formulating a judgment thereon may have to be suitably modified.

According to AAS-1 on “Basic Principles Governing an Audit”, “An audit is independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon.” The person conducting this process should perform his work with knowledge of the use of the accounting statements discussed above and should take particular care to ensure that nothing contained in the statements will ordinarily mislead anybody. This he can do honestly by satisfying himself that:

  • The accounts have been drawn up with reference to entries in the books of account;
  • The entries in the books of account are adequately supported by underlying papers and documents and by other evidence;
  • None of the entries in the books of account has been omitted in the process of compilation and nothing which is not in the books of account has found place in the statements;
  • The information conveyed by the statements is clear and unambiguous;
  • The financial statement amounts are properly classified, described and disclosed in conformity with accounting standards; and
  • The statement of accounts taken as an integrated whole, present a true and fair picture of the operational results and of the assets and liabilities.

The aforesaid definition is very authoritative. It makes clear that the basic objective of auditing, i.e., expression of opinion on financial statements does not change with reference to nature, size or form of an entity. The definition given in AAS-1 is restrictive since it covers financial information aspect only.

However, the scope of auditing is not restricted to financial information only but, today, it extends to variety of non-financial areas as well. That is how various expressions like marketing audit, personnel audit, efficiency audit, production audit, etc. came into existence. Students may note that study material deals with various aspects of financial audit only unless otherwise specified.

 

The auditor: The person conducting audit is known as the auditor; he makes a report to the person appointing him after due examination of the accounting records and the accounting statement in the form of an opinion on the financial statements. The opinion that he is called upon to express is whether the financial statement reflect a true and fair view. Auditing, especially of companies and for public purposes has become the preserve of persons having recognised professional training and qualification.

 

Objectives of an audit: The objective of an assurance engagement will depend on the level of assurance given. First we will consider a reasonable assurance engagement, where a high, but not absolute, level of assurance is given.

ISAE 3000 (Revised) Assurance engagements other than audits or reviews of historical financial information was revised in September 2013 and applies to assurance reports dated on or after 15 December 2015. The revised ISAE distinguishes between two forms of assurance engagements:

  • Reasonable assurance engagements
  • Limited assurance engagements

The objective of a reasonable assurance engagement is a reduction in assurance engagement risk to an acceptably low level in the circumstances of the engagement as the basis for the assurance practitioner’s conclusion. The conclusion would usually be expressed in a positive form.

In order to give reasonable assurance, a significant amount of testing and evaluation is required to support the conclusion.

Limited assurance is a lower level of assurance. The nature, timing and extent of the procedures carried out by the practitioner in a limited assurance engagement would be limited compared with what is required in a reasonable assurance engagement. Nevertheless, the procedures performed should be planned to obtain a level of assurance which is meaningful, in the practitioner’s professional judgement.

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For a limited assurance engagement, the conclusion conveys whether, based on the procedures performed and evidence obtained, a matter(s) has come to the practitioner’s attention to cause the practitioner to believe the subject matter information is materially misstated. This would usually be expressed in a negative form of words.

For both reasonable and assurance engagements, the revised ISAE requires the practitioner to provide a summary of the procedures undertaken within the assurance report.

 

The principles and processes of an audit

Auditing is a systematic and independent examination of books, accounts, statutory records, documents, and vouchers of an organization to ascertain how far the financial statements present a true and fair view of the concern. The process is guided by fundamental principles to ensure the reliability and credibility of the audit opinion.

 

1.2.1 Integrity, Objectivity, and Independence

These are foundational ethical principles for auditors.

  • Integrity: Auditors must be straightforward and honest in all professional and business relationships. This means conducting the audit with honesty, fairness, and a commitment to truth.
  • Objectivity: Auditors must not allow bias, conflict of interest, or undue influence of others to override professional or business judgments. The audit opinion must be based on objective evaluation of evidence, not personal feelings or external pressures.
  • Independence: This is the cornerstone of auditing. Auditors must be independent in both mind and appearance.
    • Independence of Mind: The state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, objectivity, and professional skepticism.
    • Independence in Appearance: The avoidance of facts and circumstances that are so significant that a reasonable and informed third party would be likely to conclude that an auditor’s integrity, objectivity, or professional skepticism has been compromised.
    • Factors that can impair independence include financial interests, family and personal relationships, employment relationships, and gifts/hospitality.

1.2.2 Confidentiality

  • Auditors must respect the confidentiality of information acquired as a result of professional and business relationships and must not disclose any such information to third parties without proper and specific authority, unless there is a legal or professional right or duty to disclose.
  • This principle applies even after the termination of the relationship between the auditor and the client.
  • It is crucial for building trust with clients and ensuring the free flow of necessary information for the audit.

1.2.3 Skills and Competence

  • Auditors must possess the necessary professional competence and due care. This means having the required knowledge, skills, and experience to carry out the audit engagement effectively.
  • Professional Competence: Maintaining professional knowledge and skill at the level required to ensure that clients receive competent professional service based on current developments in practice, legislation, and techniques.
  • Due Care: Acting diligently and in accordance with applicable technical and professional standards. This involves careful planning, supervision, and review of the audit work.
  • Auditors are expected to undertake continuous professional development (CPD) to keep their skills up-to-date.

1.2.4 Work Performed by Others

  • Auditors often rely on the work performed by internal auditors, experts (e.g., valuers, actuaries), or even other external auditors for components of the financial statements.
  • When relying on others’ work, the primary auditor remains solely responsible for the audit opinion.
  • The auditor must assess the competence, objectivity, and professional due care of the individual or firm whose work is being used.
  • Adequate review procedures must be in place to ensure the reliability and appropriateness of the work performed by others in the context of the overall audit.

1.2.5 Documentation

  • Audit documentation (working papers) is a critical part of the audit process. It provides evidence of the auditor’s basis for a conclusion about the overall financial statements and evidence that the audit was planned and performed in accordance with ISAs (International Standards on Auditing) and applicable legal and regulatory requirements.
  • Purpose:
    • To aid in the planning and performance of the audit.
    • To facilitate supervision and review of the audit work.
    • To provide evidence of the audit work performed to support the auditor’s opinion.
    • To retain a record of matters of continuing significance to future audits.
  • Documentation should be sufficiently complete and detailed to enable an experienced auditor, having no previous connection with the audit, to understand the nature, timing, and extent of the audit procedures performed, the results of the procedures, and the audit evidence obtained, and significant matters arising during the audit and the conclusions reached thereon.

 

1.2.6 Planning

  • Planning an audit involves establishing the overall audit strategy for the engagement and developing an audit plan.
  • Key aspects of planning:
    • Understanding the Entity and Its Environment: Gaining knowledge of the client’s business, industry, regulatory environment, and internal controls to identify potential risks.
    • Assessing Risk: Identifying and assessing risks of material misstatement, both at the financial statement level and at the assertion level, whether due to fraud or error. This involves understanding the client’s accounting policies and significant estimates.
    • Determining Materiality: Establishing the materiality level for the financial statements as a whole, and performance materiality. Materiality guides the scope of audit procedures.
    • Developing the Audit Strategy and Plan: Outlining the scope, timing, and direction of the audit and determining the required resources. The audit plan details the nature, timing, and extent of audit procedures.
    • Consideration of Laws and Regulations: Identifying applicable laws and regulations that could affect the financial statements.
  • Effective planning helps ensure that sufficient appropriate audit evidence is obtained and that the audit is conducted efficiently.

 

1.2.7 Audit Evidence

  • Audit evidence is the information used by the auditor in arriving at the conclusions on which the auditor’s opinion is based.
  • Nature of Evidence: Can be financial (e.g., invoices, bank statements, ledgers) or non-financial (e.g., minutes of meetings, internal control manuals, confirmations). It can be obtained from internal or external sources.
  • Sufficiency: Refers to the quantity of audit evidence. It is influenced by the assessment of the risks of material misstatement and the quality of such audit evidence. More evidence is needed for higher risks.
  • Appropriateness: Refers to the quality of audit evidence; that is, its relevance and reliability in providing support for the conclusions on which the auditor’s opinion is based.
    • Relevance: The logical connection with, or bearing upon, the purpose of the audit procedure and, where appropriate, the assertion under consideration.
    • Reliability: Influenced by its source and nature. Generally, evidence is more reliable when obtained from independent external sources, when internal controls are effective, when obtained directly by the auditor, or when it is in documentary form.
  • Auditors use various audit procedures to gather evidence, including inquiry, observation, inspection, recalculation, re-performance, and analytical procedures.

 

1.2.8 Accounting System and Internal Control

  • Accounting System: The series of tasks and records of an entity by which transactions are processed as a means of maintaining financial records. It includes procedures and controls that ensure that transactions are properly recorded, classified, summarized, and reported.
  • Internal Control: The process designed, implemented, and maintained by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations.
  • Auditor’s Responsibility: The auditor obtains an understanding of the entity’s accounting system and internal controls relevant to the audit. This understanding helps the auditor to:
    • Identify types of potential misstatements.
    • Consider factors that affect the risks of material misstatement.
    • Design the nature, timing, and extent of further audit procedures (e.g., tests of controls, substantive procedures).
  • While the auditor is not primarily responsible for internal controls, a weak internal control environment generally leads to higher assessed risks of material misstatement and requires more extensive substantive testing.

1.2.9 Audit Conclusions and Reporting

  • After gathering and evaluating sufficient appropriate audit evidence, the auditor forms an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.
  • Forming the Conclusion: Involves:
    • Reviewing the financial statements for consistency with the auditor’s understanding of the entity.
    • Evaluating whether the financial statements are presented fairly in all material respects.
    • Assessing the appropriateness of accounting policies used and the reasonableness of accounting estimates.
    • Considering the adequacy of disclosures.
  • Audit Report: The formal document that communicates the auditor’s opinion to the users of the financial statements.
    • Types of Opinions:
      • Unmodified (Unqualified) Opinion: States that the financial statements present fairly, in all material respects, the financial position, financial performance, and cash flows of the entity in accordance with the applicable financial reporting framework. This is issued when the auditor concludes that the financial statements are free from material misstatement.
      • Modified Opinion: Issued when the auditor concludes that the financial statements are materially misstated or when unable to obtain sufficient appropriate audit evidence.
        • Qualified Opinion: Financial statements are materially misstated, but the misstatements are not pervasive to the financial statements, or the auditor is unable to obtain sufficient appropriate audit evidence for a specific area, but the possible effects on the financial statements are not pervasive.
        • Adverse Opinion: Financial statements are materially misstated and the misstatements are pervasive to the financial statements.
        • Disclaimer of Opinion: The auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, and the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive.
      • The report also includes the basis for opinion, key audit matters (for listed entities), responsibilities of management and those charged with governance, and auditor’s responsibilities.

 

Users of audited financial statements and auditor reports

Audited financial statements and the accompanying auditor’s report provide credible and reliable financial information about an entity. This information is crucial for various stakeholders in making informed economic decisions. The auditor’s report adds credibility by providing an independent opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.

SAMPLE WORK

Complete copy of Principles of Auditing is available in hard copy at Ksh 600

Phone: 0728 776 317

Email: info@masomomsingi.com

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