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TOPIC 6: ELEMENTS OF AUDITING
Elements of Auditing
Meaning of Auditing
Define auditing
Auditing refers to a systematic and independent examination of books, accounts, documents and vouchers of an organization to ascertain how far the financial statements present a true and fair view of the concern. It also attempts to ensure that the books of accounts are properly maintained by the concern as required by law. Auditing has become such a ubiquitous phenomenon in the corporate and the public sector that academics started identifying an "Audit Society". The auditor perceives and recognizes the propositions before him/her for examination, obtains evidence, evaluates the same and formulates an opinion on the basis of his judgment which is communicated through his audit report.
Any subject matter may be audited. Audits provide third party assurance to various stakeholders that the subject matter is free from material misstatement. The term is most frequently applied to audits of the financial information relating to a legal person. Other areas which are commonly audited include: internal controls, quality management, project management, water management, and energy conservation.
As a result of an audit, stakeholders may effectively evaluate and improve the effectiveness of risk management, control, and the governance process over the subject matter.
The Main Objective of Auditing
Explain the main objects of auditing
Purpose & Objectives of Auditing Financial Statements
Objective
The objective of external audit is for the auditor to express an opinion on the truth and fairness of financial statements.
Accountability
The main necessity for conducting the audit of financial statements stems from the fact that the persons responsible for the preparation of financial statements are often different from the owners of large corporations.
Whereas in small owner managed companies, the owners have firs hand knowledge of the affairs of their business, management and ownership is normally separate in the case of large companies that often have thousands of shareholders. In large corporations, shareholders appoint directors to run the enterprise on their behalf. This separation of ownership and control creates the need for external audit.
Financial statements are the main source of accountability of management performance by the shareholders. However, as the management is responsible for the preparation of financial statements, shareholders have to rely on external verification by auditors in order to gain reasonable assurance that the accounts are free from material misstatements and can therefore be relied upon to be presenting true and fair view of the affairs of the company.
Reliability
Apart from the needs of owners, other users of financial statements may need to place reliance on the financial statements. External audit is a means of providing a reasonable basis for the users to place reliance on financial statements.
Examples of stakeholders (other than shareholders) that rely on audited financial statements include the following:
- Tax authorities rely on audited financial statements to determine the accuracy of tax returns filed by the companies.
- Financial institutions require audited accounts of prospective borrowers for assessing the credit risk by analyzing their liquidity and financial position.
Management uses the audit exercise to re-evaluate the company's risk management processes and internal control system by considering the feedback given by external auditors during the course of the audit in this regard.
Scope
Financial audit is intended to provide a 'reasonable' assurance over the accuracy of financial statements. It therefore does not provide absolute assurance that the financial statements are free from all misstatements. The purpose of audit is confined to provide reasonable assurance in order to avoid excessive time and cost in the performance of the audit that may outweigh any benefit that may be derived from the enhanced assurance. Absolute assurance is also impossible to guarantee in most cases due to the inherent limitations of audit.
Types of Auditing
State the types of auditing
Internal audit -is a function that, although operating independently from other departments and reports directly to the audit committee, resides within an organization (i.e. they are company employees). It is responsible for performing audits (both financial and non-financial) within a wide range of areas within a business, as directed by the annual audit plan. Internal audit look at key risks facing the business and what is being done to manage those risks effectively, to help the organization achieve its objectives. For example, they may look at risks to the company’s reputation such as the use of cheap labor in foreign countries, or strategic risks such as producing too many products in comparison to resources available etc.
External audit -is an independent body which resides outside of the organisation which it is auditing. They are focused on the financial accounts or risks associated with finance and are appointed by the company shareholders. The main responsibility of external audit is to perform the annual statutory audit of the financial accounts, providing an opinion on whether they are a true and fair reflection of the company’s financial position. As part of this, external auditors often examine and evaluate internal controls put in place to manage the risks which could affect the financial accounts, to determine if they are working as intended.
Meaning of Internal Control; Internal Check; Internal Audit
Give the meaning of: Internal control; Internal check; Internal audit
Internal control, as defined in accounting and auditing, is a process for assuring achievement of an organization's objectives in operational effectiveness and efficiency, reliable financial reporting, and compliance with laws, regulations and policies.
Internal Check
Internal check is a method of organizing the accounts system of a business concern or a factory where the duties of different clerks are arranged in such a way that the work of one person is automatically checked by another and thus the possibility of fraud, or error or irregularity is minimized unless there is collusion between the clerks. For example, the receipt of cash is entered by the cashier on the debit side of the cash book; this entry is carried to the ledger by another clerk; the statement of account relating to this transaction is sent to the customer by a third clerk and so on. Thus the same transaction has passed through three different hands and the work of one is checked automatically by the other. It is a kind of division of labour. This minimizes the possibilities of frauds and errors unless all the three join hands in defrauding their employer.
According to the special committee on Terminology, American Institute of Accountants, 1949 "Internal check-a system under which the accounting methods and details of an establishment are so laid out that the accounts procedures are not under the absolute and independent control of any person - that, on the contrary, the work of one employee is complementary of that of another, and that a continuous audit of the business is made by the employees."
The essential elements of an internal check are :
- (a) Instituting of checks on day-to-day transactions.
- (b) These checks operate continuously as a part of routine system.
- (c) Work of each person is made complementary to the work of another.
Auditors Working Paper
Mention auditors working paper
Audit working papers: are the document which record all audit evidence obtained during financial statement auditing, internal management auditing, information system auditing and investigations.
Auditing working papers are:
- Flow charts,
- manual,
- narrative note,
- checklist
Different Types of Auditors Reports and Opinion
Explain the different types of auditors reports and opinions
An audit report is an appraisal of a small business’s complete financial status. Completed by an independent accounting professional, this document covers a company’s assets and liabilities, and presents the auditor’s educated assessment of the firm’s financial position and future. Audit reports are required by law if a company is publicly traded or in an industry regulated by the Securities and Exchange Commission (SEC). Companies seeking funding, as well as those looking to improve internal controls, also find this information valuable.
Unqualified Opinion
Often called a clean opinion, an unqualified opinion is an audit report that is issued when an auditor determines that each of the financial records provided by the small business is free of any misrepresentations. In addition, an unqualified opinion indicates that the financial records have been maintained in accordance with the standards known as Generally Accepted Accounting Principles (GAAP). This is the best type of report a business can receive. Typically, an unqualified report consists of a title that includes the word “independent.” This is done to illustrate that it was prepared by an unbiased third party. The title is followed by the main body. Made up of three paragraphs, the main body highlights the responsibilities of the auditor, the purpose of the audit and the auditor’s findings. The auditor signs and dates the document, including his address.
Qualified Opinion
In situations when a company’s financial records have not been maintained in accordance with GAAP but no misrepresentations are identified, an auditor will issue a qualified opinion. The writing of a qualified opinion is extremely similar to that of an unqualified opinion. A qualified opinion, however, will include an additional paragraph that highlights the reason why the audit report is not unqualified.
Adverse Opinion
The worst type of financial report that can be issued to a business is an adverse opinion. This indicates that the firm’s financial records do not conform to GAAP. In addition, the financial records provided by the business have been grossly misrepresented. Although this may occur by error, it is often an indication of fraud. When this type of report is issued, a company must correct its financial statement and have it re-audited, as investors, lenders and other requesting parties will generally not accept it.
Disclaimer of Opinion
On some occasions, an auditor is unable to complete an accurate audit report. This may occur for a variety of reasons, such as an absence of appropriate financial records. When this happens, the auditor issues a disclaimer of opinion, stating that an opinion of the firm’s financial status could not be determined.
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