City University College Department of Accounting & Finance

1. THE NATURE, PURPOSE AND SCOPE OF AUDITING

Definition of Auditing
There are different definitions of auditing forwarded by different authors.
The following, by serves our purpose more.
“[Auditing is] the independent examination of financial statements of any
entity, whether profit oriented or not, and irrespective of its size and legal
form, when such an examination is conducted with a view to expressing
an opinion thereon.” International Federation of Accountants (IFAC)
The following are also cited as essential features of auditing:
 To make a critical review of the accounting and internal control
systems
 To make such tests and enquiries as considered necessary to form
an opinion as to the reliability of the records as a basis for the
preparation of accounts
 To compare the financial statements with underlying records in
order to see whether they are in accordance there with
 To make a critical review of the financial statements so as to report
whether, the opinion of the auditors, they show a true and fair
view of the state of affairs of the auditee.
The following comprehensive definition is given by Gupta and Arora:
“Auditing is a process of collection and evaluation of evidence for the
purpose of reporting on economic information”
Three key phrases from the above definition are noted and elaborated as
follows:
Economic information
The term includes:
 Financial statements like balance sheet, profit and loss account,
costing statements, tax returns, internal management reports,
stock records and the like.

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Asrat Bekele
City University College Department of Accounting & Finance

Reporting
 The auditor examines the information under audit and expresses
his opinion on the same by way of a written report.
 The audit report is the end product of the audit process.
Collection and Evaluation of Evidence
The auditors’ report stated above is formed by collecting and evaluating
evidence.
The auditor collects information employing techniques like:
 Physical examination
 Examination of documents
 Obtaining certificates, confirmations and statements, etc.
According to Arens and Loebbecke, “auditing is the process by which a
competent, independent person accumulates and evaluates evidence
about quantifiable information related to a specific economic entity for the
purpose of determining and reporting on the degree of correspondence
between the quantifiable information and established criteria.”
This definition is also comprehensive like the one seen above but
stresses competence and independence of the auditor as well as
significance of established criteria or set of rules, regulations and
guidelines governing activities of the economic entity under audit,
against which actual performance is checked.
Distinction between Accounting and Auditing
Many users confuse auditing with accounting. The confusion is caused
as:
 Most auditing is concerned with accounting information
 Many auditors have considerable expertise in accounting
 Individuals primarily responsible for the audit function are titled
‘Certified Public Accountants’
Proper descriptions of the two functions follow:

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Asrat Bekele
City University College Department of Accounting & Finance

Accounting is the process of recording, classifying, and summarizing

economic events in logical manner for the purpose of providing financial
information for decision making.
To provide relevant information, accountants must have thorough
understanding of principles and rules of preparing the information and
develop a system that ensures proper and timely recording of economic
events of the entity at a reasonable cost.
Auditing is concerned with determining whether recorded information
properly reflects the economic events occurred during the accounting
period.
 The auditor involved with the accounting information must
thoroughly understand the accounting rules viz. generally accepted
accounting principles, against which the accounting records are
evaluated.
 The auditor must also possess expertise in the accumulation and
interpretation of audit evidence.
Types of Audit and Auditors
Types of Audits
Three types of audit are considered in this section
 Operational audits
 Compliance audits
 Audit of financial statements
Operational Audits
An operational audit is a review of any part of an organization’s operating
procedures and methods for the purpose of evaluating efficiency and
effectiveness. Recommendations for improvement are normally expected
upon completion of the audit.
 It is difficult to characterize the conduct of a typical operational
audit as different areas of operation can be evaluated.

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Asrat Bekele
City University College Department of Accounting & Finance

 The reviews are not limited to accounting but can also include
evaluation of organizational structure, computer operations,
production methods, marketing and the like.
 Efficiency and effectiveness of operations are difficult to evaluate
objectively and establishing criteria for evaluating quantifiable
information in an operational audit is an extremely subjective
matter.
 Thus, operational auditors are usually more concerned with
making recommendations for improving performance than with
reporting on the effectiveness of existing performance.
 Operational auditing, in this sense, is more similar to management
consulting than to what is generally regarded as auditing.
Compliance Audits
The purpose of compliance audit is to determine whether the auditee is
following specific procedures or rules set down by some higher authority.
There are prescribed policies, contractual agreements, and legal
requirements that call for compliance auditing in virtually every
organization.
For a private business a compliance audit may include:
 Reviewing minimum wage rate for compliance with minimum
wage law
 Examining various contractual agreements to ensure whether
the company is complying with relevant legal requirements
There is increased compliance auditing in government units due to
extensive regulations by higher government authorities.
Results of compliance audits are generally reported to someone within
the organizational unit being audited. Management, as opposed to
outside users, is the primary group concerned with the extent of
compliance. Hence, a significant portion of this type of work is done by
auditors employed by the organizations themselves.

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Asrat Bekele
City University College Department of Accounting & Finance

An organization may also employ auditors to determine whether other

organizations or individuals are complying to its requirements when it
has such authority. A good example of this is the Tax Authority which
employs its own auditors to ensure that taxpayers are complying with
the tax law.
Audits of Financial Statements
An audit of financial statement is conducted to determine whether the
overall financial statements are stated in accordance with specified
criteria. Normally, the criteria are generally accepted accounting
principles. The financial statements most commonly included are:
 The statement of financial position
 Income statement
 Statement of changes in financial position including accompanying
footnotes
The assumption underlying an audit of financial statements is that they
will be used for different purposes by different users and the conclusion
drawn by one auditor after performance of audit is relied upon by all
users for efficiency reasons. There are of course some users who do not
rely on the general purpose statements and conduct further
investigations depending upon their specific needs.
Types of Auditors
The most common types of auditors are:
 Auditors of the Office of the Federal Auditor General (OFAG)
 Tax auditors
 Internal auditors
 External auditors
Auditors of the Office of the Federal Auditor General (OFAG)
The office of the Federal Auditor General of the Federal Democratic
Republic of Ethiopia is established by Proclamation No. 68/1997. The
Federal Auditor General is appointed by the Council of Peoples
Representatives upon recommendation by the Prime Minister. The
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Asrat Bekele
City University College Department of Accounting & Finance

Federal Auditor General is accountable to the Council of Peoples’

Representatives and between sessions to the President of the Federal
Republic.
Some of its major powers and duties are the following:
 Audit or cause to be audited the accounts of the Federal
Government offices and organizations
 Audit or cause to be audited accounts involving budgetary
subsidies and any special grants extended by the Federal
Government to Regional Governments
 Audit the accounts of private contractors relating to the Federal
Government contractual work which involves a sum exceeding Br.
500,000
 Carry out or cause to be carried out, as may be necessary,
program and efficiency or performance audit in order to ensure
that the performance of Federal Government offices and
organizations is in accordance with the law, economically sound
and has attained the desired objectives
 Report audit findings to the head of the audited Federal
Government office or organization, the result of the audits
performed shall also be immediately submitted to the Council of
Peoples’ Representatives, where it indicates the commission of a
crime
 Issue directives, in cooperation with other offices concerned,
regarding accounts and property auditing procedures and
standards
 Issue certificates of competence to internal auditors to be employed
by any Federal Government offices and organizations
 Where it has reasons to believe that any account has been kept in
a criminal and dishonest manner, impound such books,
documents, ledgers, vouchers and other materials related to such
account
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Asrat Bekele
City University College Department of Accounting & Finance

 Make efforts, in cooperation with other concerned government

offices, with a view to promote the Accounting and Auditing
Profession; take appropriate measures to ensure that the
development of the Accounting and Auditing Profession of the
Federal Government is in the right direction
 Issue, renew, suspend and cancel certificates of competence of
private auditors and accountants.
The OFAG, thus, hires its own auditors to discharge the above stated
duties and responsibilities. The auditors of OFAG are expected to have
extensive knowledge of relevant Federal Government rules and
regulations, accounting policies and procedures as well as Generally
Accepted Accounting Principles (GAAP), and audit procedures of OFAG.
The accounts of the Office of the Federal Auditor General shall be
audited by a body to be designated by the Council of Peoples’
Representatives or by the President of the Federal Republic, where the
council is not in session.
Each Regional Government also has an office entrusted with the powers
and duties of auditing various organs of the Regional Government,
among other things.
Tax Auditors
The Federal Inland Revenue Authority and similar offices of the Regional
Governments are entrusted with responsibility of enforcing the tax laws.
To this end, the tax authorities engage their own auditors to audit tax
returns of taxpayers to determine whether such tax returns comply with
the tax law. The tax returns audited have varying degrees of complexity.
Those auditors who are engaged in audit of financial statements to this
effect by the tax authority are expected to have considerable knowledge
in the areas of Generally Accepted Accounting Principles (GAAP), taxation
or provisions of the tax law, and auditing.

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Asrat Bekele
City University College Department of Accounting & Finance

Internal Auditors
Internal auditors are employed by individual companies to audit for
management and provide valuable information for making decisions
concerning effective operation of the business. The size and responsibility
of the internal audit group varies considerably depending upon the size
and requirement of the organization, and the internal audit reports to:
 The president or the CEO directly
 Another high executive officer
 Or the audit committee of the board of directors
Some internal audit staffs consist of one or two employees and engage in
routine compliance auditing only; others may consist of numerous
employees who have diverse responsibilities, including many outside the
accounting area. Many internal auditors have become involved in
operational auditing or have developed expertise in evaluating computer
systems.
To operate effectively, the internal auditor must be independent of the
line functions in an organization, but he/she cannot be independent of
entity as long as the employer-employee relationship exists.
Independent External Auditors
The primary responsibility of the external auditors is the performance of
audit function on published financial statements. Most of the
discussions to be made hereafter shall refer to performance of this
function.
In Ethiopia the OFAG is the licensing authority as stated above and
membership of an internationally recognized professional body like ACCA
or CPA and post qualification audit experience of up to three years is
required to be licensed to practice as an independent auditor.
Purpose of Audit
The purpose of an external audit engagement is to enable the auditor
express an opinion on whether the financial statements audited:

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Asrat Bekele
City University College Department of Accounting & Finance

 Give a true and fair view or present fairly in all material respects
the entity’s affairs
 Are prepared, in all material respects, in accordance with an
applicable financial reporting frame work
This opinion is embodied in the audit report and addressed to those
interested parties who commissioned the audit or to whom the auditor is
responsible under relevant statue.
In expressing the audit opinion the auditor has to carry out such
procedures and take such steps as designed to obtain reasonable
assurance that the financial are properly stated in all material respects.
There are certain inherent limitations present in any kind of examination
which require the use of judgment. Hence there is an unavoidable risk
that even some material misstatements may remain undiscovered, and
absolute certainty in auditing is rarely attainable.
However, it is the sacred duty of the auditor to plan and perform the
audit with an attitude of professional skepticism that the financial
statements being audited may be materially misstated and extend his
procedures even at the slightest indication of fraud or error which may
result in material misstatements so that he can confirm or dispel his
suspicions.
Thus the opinion expressed by the auditor helps to establish the extent
of credibility of the financial statements but should not be construed as
an assurance as to the future viability of the organization or as to the
efficiency or effectiveness with which the management has conducted the
affairs of that unit.
Agency Theory
Agency relationships occur when one party, the principal, employs
another party, the agent, to perform a task on their behalf. Modern
organization theory views an organization as comprising various interest
groups often called stakeholders.

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Asrat Bekele
City University College Department of Accounting & Finance

The stakeholders a company are all those who are influenced by, or can
influence, the company’s decisions and actions and ranges from the
shareholders to management and the community in the local
neighborhood.
Those stakeholders charged with governance i.e. those whose role is to
supervise management need to ensure that the management operate the
business in the interests of the shareholders and other stakeholders and
not, purely in their own, personal interests.
In most countries it is possible for businesses to operate through
companies - a process known as incorporation which has two
implications:
 The creation of a distinction between the owners of the business
and the business itself, which may in turn lead to the business
being run by managers who are distinct from its owners
 The granting of limited liability status so that, if the business fails,
the owners only stand to lose a specific amount of money – hence
the term limited.
A legal framework was therefore needed for how companies should be
operated
 To protect business owners from unscrupulous managers
 To protect the business world and the public at large from owners
taking unfair advantage of limited liability status
This in turn had two results
 The legal requirement for accounts to be prepared by management
on a regular basis to account to the shareholders for their
stewardship of the business
 The recognition of the need for those accounts to be checked in
some way by someone independent of the managers – the auditor.
Stewardship is the responsibility to take good care of resources. A
steward is a person entrusted with management of another person’s
property.
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Asrat Bekele
City University College Department of Accounting & Finance

There is a fiduciary or good faith relationship between shareholders and

managers of a company. There is a separation of ownership and control
in the sense that the shareholders own the company while the directors
take the decision at the company. The directors must take their decisions
in the interests of the shareholders rather than in their own selfish
personal interests.
In terms of agency theory, directors can be seen as the agents of the
shareholders, employees as the agents of directors and external auditors
as agents of shareholders.
Each principal needs to recognize that, although he is employing the
agent, the agent will have interests of his own to protect and thus may
not fully carry out the requirements of the principal – a conflict of
interest may arise. An example of this could be:
The directors have a duty of stewardship of the company’s assets.
However, they are also interested in their level of remuneration and, if
this increases, the assets of the company go down. The decision to award
directors pay increase may be in the hands of the directors themselves.
Scope of an Audit
The scope of an audit is dependent upon:
 The terms of agreement between the auditor and the client
 Statutory requirements
 Requirements of relevant professional bodies
A properly conducted audit is organized to cover adequately all aspects of
the organization as far as they are relevant to the financial statements
under audit. To this end the auditor:
 Studies and evaluates the accounting systems and the related
internal controls and tests the internal controls to decide on the
nature, extent and timing of other audit procedures
 Carries out such other tests, enquiries and other verification
procedures of transactions and balances as considered
appropriate
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Asrat Bekele
City University College Department of Accounting & Finance

The auditor then bases his opinion by:

 Comparing the financial statements with the underlying
accounting records and other source data to see whether they
properly summarize transactions and events
 Considering the judgments the management has made in
preparing the financial statements
 Assessing the selection and consistent application of accounting
policies and the manner in which information has been classified,
and the adequacy of disclosure
It should be noted that the auditor is not responsible for the preparation
of the financial statements on which opinion is formed and expressed.
This is the responsibility of the management of the particular
organization and also covers:
 Maintenance of adequate accounting records and internal controls
 The selection and application of appropriate accounting policies
and
 Safeguarding of the assets of the organization
The managers are not entitled to rely upon the auditor to protect them
from any short comings in carrying out their responsibilities whereas the
auditor is entitled to rely upon safeguards and internal controls
instituted by the management.
Of course in forming and expressing professional opinion on the financial
statements the auditor has his own independent responsibility. This
responsibility is heavy and cannot be discharged without a full
realization of the professional skill and judgment which need to be
exercised in carrying out his duties.

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