Auditing.rtf - CHAPTER 1 OVERVIEW OF AUDITING Objectives After studying this chapter you will be able to know about the basic features of auditing types

Auditing.rtf - CHAPTER 1 OVERVIEW OF AUDITING Objectives...

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Unformatted text preview: CHAPTER 1 OVERVIEW OF AUDITING Objectives After studying this chapter, you will be able to know about the: basic features of auditing types of audits and auditors nature of external auditing in Ethiopia Introduction Without question, the independent audit function plays an important role in both business and society. Numerous third parties, including investors, creditors, and regulators, depend on the competence and professional integrity of independent auditors. Economic decisions are typically based upon the information available to the decision maker. To obtain the most benefit, users should have economic information that is both relevant and reliable. This need for relevant and reliable financial information creates a demand for accounting and auditing service. Basic Features of Auditing Auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria. Auditing should be done by a competent and independent person. Auditing enable the auditor to express opinion whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework. This framework (criterion) might be generally accepted accounting principles (GAAP), or the national standard of a particular country. Financial statements include balance sheet, income statement, statement of cash flow, notes and explanatory material that are identified as being part of financial statements. The phrases used to express the auditor’s opinion are that the financial statements ‘give a trued and fair view’ or ‘present fairly in all material respective’. Note that the auditor does not certify the financial statements or guarantee that the financial statements are correct, he reports that in his opinion they give a ‘true and fair view’, or present fairly’ the financial position. Demand for Audit There is a need for auditing when ownership is separated from control. At a practical level, it helps prevent or detect misstatements-errors or fraud. It may prevent or detect misstatements on the part of 1) the employees who actually handle the money, or 2) management. Auditing is needed to enhance the credibility of financial information prepared by an entity. The independent audit requirement fulfils the need to ensure that those financial statements are objective, free from bias and manipulation and relevant to the needs of users. Control Mechanism Audits whether internally or externally performed are valued as important control mechanisms for accountability the overall need for monitoring activities, especially financial activity includes the need for auditing to provide credibility for reported and unreported information. Conflict of Interest The agency relationship that exists between an owner and manager produces a natural conflict of interest because of the information asymmetry that exists between the manager and the absentee owner. Information asymmetry means that the manager generally has more information about the "true" financial position and results of operations of the entity than the absentee owner does. If 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. Whenever there is a conflict of interest between parties, the need for an arbiter or a non-partisan view is obvious. In financial affairs there are natural grounds for conflict of interest between information preparer and user, which can result in the production of a biased information data. Thus an audit is required for an objective review of the information. Consequences The ultimate objective and function of accounting is to provide information for economic decision-making. Information is used for decisions that have serious and substantial economic consequences. Thus the need for an audit for verifying the accuracy of information before they are used in decisions that may bring damaging consequences. Remoteness Because of the separateness of the management from the owners; information is prepared in a place far from the user. The user is prevented from directly assessing the quality of information he obtains. Thus the need for auditor services to assess the information on the users' behalf. Regulatory Requirements Many business laws, memorandum of association and regulatory agencies acts make audits annual requirements to be complied with for renewal of license or permit. For example the security exchange commission (SEC) in the US; the Commercial Code of Ethiopia (1966), and latter the Public Financial Regulation of Procl 163/1999 in Ethiopia make the filing of audited financial statements annually. Disaster Prevention and Preparedness Commission (DPPC) requires NGOs to prepare and submit their annual financial statements. Thus compliance requirements create a very large demand for auditing services. Accounting versus Auditing Accounting is the collecting (recording, classifying), summarizing, reporting and interpreting of financial data. Auditing is the testing of those accounting records for fairness, appropriateness. An accountant only needs to know generally accepted accounting principles (GAAP). The auditor needs to know GAAP, plus how to select and evaluate evidence related to the assertions of financial statements. Accounting is constructive. It starts with the raw financial data to process and produce financial statements. Auditing on the other hand is analytical work that starts with financial statement to lend credibility and fairness of the measurements. In addition to understanding accounting, the auditor must also possess expertise knowledge in the accumulation and interpretation of audit evidence. Determining the proper audit procedures, sample size, particular items to examine, timing of the tests, and evaluating the results are unique to the auditor. It is these expertise that distinguishes auditors from accountants. Types of Audits and Auditors A. Types of Audits Audits are often viewed as falling into three major types: 1) Audits of financial statements, 2) Operational audits, and 3) Compliance audits. 1. Audits of financial statements: - The goal is to determine whether the financial statements have been prepared in conformity with generally accepted accounting principles. 2. Operational audits: - An operational audit is study of some specific unit of an organization for the purpose of measuring its performance. The operation of a unit can be evaluated for its effectiveness and efficiency. 3. Compliance audits: - Compliance audit determines whether the specified rules, regulations, or procedures are being carried out or followed. B. Types of Auditors The most known types of auditors are 1. Independent auditors, 2. Internal auditors, 3. Government auditors. 1. Independent (external auditors): - Independent auditors have no connection to the firm as an owner or employee/manager. The basic task of independent auditor is to confirm to the owners that the employees are correctly reporting on their financial position and performance. 2. Internal auditor: - An internal auditor is paid salary as employee on the organization that is being audits. He/she is responsible to appraise and investigation the performance of unit and/or units within the organization and give recommendation to top management. 3. Government audit: - The government auditor is paid a salary by the government. He/she is responsible to the legislature or executive. The Nature of External Auditing In Ethiopia In Ethiopia audits seem to be done primary on account of government regulation. For example, NGOS are audited because the assets of the NGO S are deemed a “national asset,” the use of which is ultimately accountable to the government of Ethiopia. Auditing in Ethiopia could be viewed in five main areas. 1. The office of the auditor general (OAG) (OAG) The powers and functions of the office of the OG are circumscribed through the proclamations that established it, its sphere of activity lies in government audit. 2. The audit service corporation. corporation. The duty and functions of this entity involve mostly commercial audits of commercial and productive enterprises wholly or partially owned by government. 3. Private audit firms. 4. Ministry of finance audit and inspection. inspection. Auditing activity in this area includes audit of ministries and government departments by MF auditors and inspectors, including tax audit by Inland Revenue authorities. 5. State corporations’ and enterprises’ auditors.These auditors.These are audits performed by internal auditors within enterprise. Activity 1. Why auditors cannot provide absolute assurance? ________________________________________________________________ 2. What is the contribution of internal auditor in the audit of annual financial statements? ___________________________________________________________________ Summary This unit should have given you good understanding on the nature of the audit. The objectives of an audit have also been covered and need to borne in mind at all times. It has also covered the three major types of audits and auditors. It has dealt with the basic areas of auditing in Ethiopia. Answer To Activity Questions 1 Auditors can provide only reasonable assurance. They cannot provide absolute assurance due to the inherent limitation of auditing principles and standards, inherent limitations of accounting principles, use of samples in auditing, and the existence of human error. 2 The contribution of internal auditor in the audit of annual financial statements is to assist the external auditors. CHAPTER 2 AUDITING PROFESSION Objectives This chapter covers the basic codes of professional conduct, which the auditors need to bear in mind in carrying out their duties. The main source of material for code of professional conduct in this unit is the AICPA’s code of professional ethics. This chapter also covers the duties and legal liabilities of auditors. Broadly defined, the term ethics represents the moral principles or rules of conduct recognized by an individual or group of individuals. Ethics apply when an individual has to make a decision from various alternatives regarding moral principles. In addition to understanding accounting, the auditor must also possess expertise knowledge in the accumulation and interpretation of audit evidence. Determining the proper audit procedures, sample size, particular items to examine, timing of the tests, and evaluating the results are unique to the auditor. It is these expertise that distinguishes auditors from accountants. Independence The AICPA code of professional conduct requires a member in public practice to be independent in the performance of professional services as required by standards promulgated by bodies designated by council. The requirement is stated in terms of “standards promulgated by bodies designated by council” to conveniently permit inclusion or exclusion of independence requirements for certain types of services provided by CPA firms. For example, independence is required for audits of annual financial statement but a CPA firm can do tax return and provide management services without being independent. Independence in auditing means an unbiased viewpoint in the performance of audit test, the evaluation of results, and the issuance of the audit report. Independence has two distinct aspects. First, the public accountants must in fact be independent toward any enterprise they audit. Second, the relationships of public accountants with audit clients must be such that they will appear independent to third parties. Independences in fact refer to the auditor’s ability to maintain unbiased and impartial mental attitude or state of mind in all aspects of work. As such independence in fact is not subject to objective measurement and therefore can be judged only by the auditor. Independence in appearance refers to the auditor’s freedom from conflict of interest, which third parties may infer from circumstantial evidence. The following paragraphs illustrate some of the common situations, which may impair independence: Investment interest in audit client: - An auditor’s investment in shares, bonds, mortgage, and notes of an audit client or its associates, either direct or indirect, may impair independence. In this situation, an auditor may be in a position to issue an opinion or to influence the client’s financial statements for personal financial gains at the expense of his/her capacity as auditor. Such an investment is not limited to the auditor but also applies to his or her immediately family and to partners and their immediate families. Non audit functions and services: - Certain functions are incompatible with the auditing function. These include functioning as a director, officers or employee of an audit client. The auditor’s involvement in these functions and services creates a conflict of interest. Litigation between CPA firm and client: When there is a lawsuit or intent to start a lawsuit between a CPA firm and its client, the ability of the CPA firm and client to remain objective is questionable. Hospitality or goods and services: - This will affect independence unless it is modest. Undue dependence on income: - If the amount of income from a client is very large as compared to the total annual income of the audit firm, independence will be impaired since the auditors want to maintain this financial interest. Professional Requirements A professional accountant should perform professional services with due care, competence and diligence and has a continuing duty to maintain professional knowledge and skill at a level required to ensure that a client or employer receives the advantage of competent professional service based on up-to-date development in practice, legislation and techniques. Auditing standards require auditors to have adequate educational requirement as well as other moral and legal criteria fulfillment. The educational requirements are composed of theoretical knowledge and practical experience. Professional Ethics All recognized professions have developed codes of professional ethics. Professional ethics refer to the basic principles of right action for the member of a profession. Professional ethics may be regarded as a mixture of moral and practical concepts. Thus the professional ethics of an accountant would signify his behavior towards his fellows in the profession and other professions and towards members of the public. The fundamental purpose of such codes is to provide members with guidelines for maintaining a professional attitude and conducting themselves in a manner that will enhance the professional stature of their discipline. The AICPA code of professional conduct considers the following to be followed by auditors (accountants) in the conduct of professional relations with others. Integrity: - An accountant should be straightforward, honest and sincere in his approach to his professional work. Objectivity: - An accountant should be fair and should not allow bias to override his objectivity. When reporting on financial statements, which come his review, he should maintain an impartial attitude. Independence: - When in public practice, an accountant should both be and appear to be free of any interest which might be regarded, whatever its actual effect, as being incompatible with integrity and objectivity. Confidentiality: Confidentiality: - A professional accountant should respect the confidentiality of information acquired in the course of his work and should not disclose any such information to a third party without specific authority or unless there is a legal or professional duty to disclose. Technical standards: - An accountant should carry out his professional work in accordance with the technical and professional standards relevant to that work. Professional competence: - An accountant has a duty to maintain his level of competence throughout his professional career. He should only undertake works, which he or his firm can expect to complete with professional competence. Ethical behavior: - An accountant should conduct himself with a good reputation of the profession and refrain from any conduct, which might bring discredit to the profession. Contingent fess: - The AICPA code of professional conduct prohibits a CPA firm from rendering any professional services on a contingent fee basis. Responsibilities to colleagues: - The auditor should promote cooperation and good relations with other members of the profession. Advertising: - The advertising should not be false or misleading,” should not contravene “professional good taste,” should not make “unfavorable reflection on the competence or integrity of the profession,” and should not” involve a statement the contents of which” cannot be substantiated. Legal Responsibility and Liability Of Auditors The auditor is responsible for his report. The auditor then has certain duties to fulfill to the users of the financial statements that he reports on. Responsibilities impose liabilities if things go wrong. Liability The CPA can be sued under the following legal concepts a. Prudent man concept: - The auditor is responsible for exercising due professional care, and he is subject to lawsuit if he fails to do so. b. Liable for acts of others: - The partners are jointly liable for civil actions against a partner. c. Lack of privileged communication: - CPAS do not have the right under common law to withhold information from the courts on the grounds that the information is privileged. Definition of Terms Negligence: Negligence: is violation of legal duty to exercise a degree of care that an ordinary prudent person would exercise under similar circumstances with resultant damages to another party. Gross negligence: negligence: is lack of event slight care. Many jurisdictions consider gross negligence equivalent to constructive fraud. Fraud: is defined a misrepresentation by a person of a material fact, known by that person to be untrue. Constructive fraud: fraud: differs from fraud as defined above in that constructive fraud does not involve a misrepresentation with the intent to deceive. Privity: is the relationship between parties to a contract. Breach of contact: contact: is failure of one or both parties to a contract to perform in accordance with the contract’s provisions. Proximate cause: cause: exists when damage to another is directly attributable to a wrongdoer’s act. Contributory negligence: negligence: is negligence on the part of the client that has contributed to his or her having incurred a loss. A. Auditors’ liability to their clients When CPAS take on any type of engagement, they are obliged to render due professional care. This obligation exists whether or not it is specifically set forth in the written contract with the client. Thus, CPAS are liable to their clients for any losses proximately caused by the CPA’ S failure to exercise due professional care. That is to recover its losses, an injured client need only prove that the auditors were guilty of negligence and that the auditors’ negligence was the proximate cause of the client’s losses. C. Auditors’ liability to third parties Bankers and other creditors or investors who utilize financial statements covered by an audit report can recover damages from the auditors if it can be shown that the auditors were guilty of fraud or gross negligence in the performance of their professional duties. Moreover, the auditors can be held liable for negligence to a limited class of third parties if the auditors have actual knowledge of such third parties or if there exists a special relationship between the auditors and the third parties. The clients (plaintiffs) must prove that they sustained losses, that they relied on the audited financial statements, which were misleading, that this reliance was the primate cause ...
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  • Fall '17
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