1.

INTRODUCTION

LEARNING OBJECTIVES At the end of this chapter the student should be able to: Define and explain 'Auditing' Describe the various types of audits Distinguish between the different types of auditors and the services they perform Understand the need for an audit Explain the 'Expectation gap' Distinguish between auditing and accounting Describe the audit process Appreciate the structure of the standard unqualified audit report

WHAT IS AUDITING? An audit is a Latin word, meaning "he hears". The accounts of an estate domain or manor were checked by having them read out by those who had compiled them to those in authority. The modern definition: "Auditing is the accumulation and evaluation of evidence about information to determine and report upon one's opinion about the degree of correspondence between that information and established criteria. Auditing should be done by a competent and independent person (auditor)." 1 Information and established criteria For an audit to be conducted there must be information in a verifiable form and some criteria (standards) by which the auditor can evaluate the information. The information being evaluated may be quantitative or qualitative. The most common quantitative information that is evaluated takes the form of financial statements. The criteria for such evaluation, which is objective in nature, is usually generally accepted accounting principles e.g. International Accounting Standards and/or legal requirements e.g. the Companies Act in Jamaica and the UK.

Auditing - An Integrated Approach , 7th Edition - Arens and Loebbecke

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Qualitative information may take the form of the effectiveness of computer systems. The criteria for such an evaluation may not be an established one but more than likely subjective in nature. It is for this reason why the auditors and the entities being audited agree upon the criteria well before the audit starts. (A criteria could be the level of downtime or the frequency of processing errors). Accumulation and evaluation of evidence Evidence is any information used by the auditor to determine whether the information being audited is stated in accordance with the established criteria. Evidence may take different forms: Oral Written Observation Calculation Re-performance

The level of evidence required to ensure accordance depends upon a variety of factors. However sufficient evidence must be obtained to support the auditors opinion.2 Competent and independent person (auditor). The auditor must be qualified3 to understand the criteria and also the information. He must be competent to know the form and the volume of evidence to obtain. He must also be independent in mental attitude to express unbiased judgements throughout the audit. Although absolute independence may not be possible it must be achieved to high degree. Report upon one's opinion ( Reporting) The ultimate product of the audit process is the audit report in which the auditor communicates his findings to users. Although reports differ in nature, the auditor must always inform readers of the degree of correspondence between the information and the established criteria. However, it is vitally important to know that what the auditor does is to express an opinion on the fairness of the information, he does not attest to the complete accuracy of the information THE DIFFERENT TYPES OF AUDIT Figure 1.1 on page 3 gives an overall picture of the different kinds of attestation services 4 that are provided by accounting firms. Afterwards, the discussion moves into the subcategories of the attestation service with which we are primarily concerned, Auditing.
FIGURE 1.1
2 3

See Chapter 4 Planning for more Section 154, Jamaican Companies Act 1965. ( Note - At the time of writing the Jamaican Companies Bill 2001 was yet to be passed.) 4 Atestation services refers to a service where an opinion is given.

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ATTESTATION SERVICES
EXAMINATION/ AUDIT REVIEW AGREED-UPON PROCEDURES

FINANCIAL STATEMENTS

OPERATIONAL

COMPLIANCE

STATUTORY

PRIVATE

NON - ATTESTATION SERVICES

COMPILATION UNAUDITED STATMENTS

Financial Statement Audit - the definition of this given the context previously discussed may be viewed as follows: An audit is an exercise whose objective is to enable auditors to express an opinion on whether the financial statements give a true and fair view of (or "present fairly") the entity's affairs at the period end and of its profit & loss (or income & expenditure) for the period then ended and have been properly prepared in accordance with the applicable reporting framework (for example relevant legislation and applicable accounting standards). In achieving his objective the auditor would

a) Carry out procedures designed to obtain sufficient appropriate audit evidence, in

accordance with auditing standards (contained in International Standards on Auditing - ISA5) to determine with reasonable confidence whether the financial statements are free of material misstatements b) Evaluate the overall presentation of financial statements, in order to ascertain whether they have been prepared in accordance with relevant legislation/laws and accounting standards; and
5

ISA contain basic principles and essentials procedures with which auditors are required to comply with in the conduct of every audit of financial statements, except where otherwise stated in the ISA concerned.

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c) Issue a report containing a clear expression of their opinion on the financial statements Operational Audits An operational audit is a review of any part of an organizations operating procedures and methods for the purpose of evaluating efficiency and effectiveness. At the completion of an operational audit, recommendations to management for improving operations are normally expected. An example of an operational audit is evaluating the efficiency of processing and the accuracy of processing payroll transactions in a newly installed computer system. An operational audit can vary so much depending on the nature of the organization. Of note however, is that the efficiency and effectiveness can be very difficult to evaluate objectively. This is because the information is itself very subjective in nature. Compliance Audits The purpose here is to determine whether the auditee is following specific procedures, or regulations set down by some higher authority. A compliance audit for a company could include reviewing wage rates for compliance with minimum wage laws, or examining contractual agreements with bankers and other lenders to be sure that the company is complying with legal requirements. Statutory Audit Those required by law e.g. public companies, building societies etc. Private Audit Those not required by law but performed because accountability is needed and consequently independence maintained. Agreed upon procedures An engagement consisting of procedures of an audit nature which the auditor and the client have agreed upon in order to meet the client's needs for specific information. (E.g. testing the value of inventory to be used as collateral for a loan) Reviews These are engagements which are of a lower scope than that of an audit. They consist primarily of inquiries of company personnel and analytical procedures. They also provide what is called limited assurance. Compilation A compilation of financial statements is limited to presenting in the form of financial statements information that is the representation of management. No opinion is expressed or no form of assurance is given. (The auditor basically compiles information using accounting data.) Unaudited financial statements

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For some of the few firms which are not required to have an annual audit this option exists. Each page of the resulting financial statements must have the words "unaudited".
(Author's note - from this point onwards, unless otherwise stated, whenever the term "audit" is used, I am referring to a financial statement audit).

TYPES OF AUDITORS 1. External Auditors These typically include audit firms or a firm of chartered accountants, but often include individual practitioners. The ones listed immediately below used to be referred to as the "Big Five" in the world, however based on recent incidents (see footnote 7 below), the term Final Four seems more appropriate.6 PriceWaterhouseCoopers Deloitte & Touche Ernst & Young Authur Anderson7 KPMG Peat Marwick

External auditors normally perform financial statement (external) auditing but often undertake tax and a variety of consulting services 2. Internal Auditors These are employees of the organization hired to monitor and report on the running of the company's operations. Although some of the work carried out by internal auditors are similar to that performed by external auditors, there are some important distinctions between the nature of the two functions: Item Independent Work responsibility Reporting responsibility Qualified Objective Internal auditors No Decided by management To directors/management Not necessarily To analyze effectiveness & efficiency of operations etc. External auditors Yes Fixed by statute/law To shareholders/members Must/yes To express an opinion on financial statements

Although internal auditors perform mostly operational audits, they often time help the external auditor by performing work that the external auditor can rely upon, thus reducing the external auditor's work.

See http://www.rohanchambers.com/Accounting%20Firms/accounting_firms.htm for a listing (including URLs) of the more popular firms in Jamaica and the world. 7 This auditing arm of this firm effectively no longer exists due to the collapse of one of its major clients, Enron. See http://www.arthurandersen.com for more.

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3. Government Auditors These are employed in different areas of the government whether directly or indirectly e.g. GCT auditors, revenue agents, the bank inspection unit of the BOJ These auditors mainly perform compliance auditing.
(Author's note - from this point onwards, unless otherwise stated, whenever the term "auditor" is used, I am referring to an external auditor)

WHY HAVE AN AUDIT? 1. 2. 3. 4. 5. 6. To accommodate stewardship for the shareholders purpose To enable companies to obtain capital through the securities market For companies to obtain financing through banks and other lending institutions To promote operational efficiency To reduce errors and fraud To satisfy legal requirements

EXPECTATION GAP There are some common misconceptions in relation to the role of auditors even among those who are 'financial aware'. These include 1. Many people think that the auditor reports to the directors of a company, rather than to the members 2. There is a perception that it is the auditor's duty to detect errors and fraud when in fact it is management's responsibility to detect them. DISTINCTION BETWEEN ACCOUNTING AND AUDITING Accounting is the recording, classifying and summarizing of economic events in a logical manner for the purpose of providing financial information for decision making. Auditing is concerned with determining whether the recorded accounting information properly reflects the economic events that occurred during the accounting period. However, all auditors need to understand accounting so that they can audit it. Therefore all auditors are accountants but not all accountants are auditors.

THE AUDIT PROCESS Figure 1.2 below depicts an overview of the audit process:

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FIGURE 1.2

OVERVIEW OF THE AUDIT PROCESS

TEST CONTROLS AND REASSES CONTROL RISK

PLANNING

UNDERSTAND & DOCUMENT INTERNAL CONTROL AND ASSESS CONTROL RISK

SUBSTANTIVE TESTING

COMPLETE & REVIEW THE AUDIT

AUDIT REPORT

In summary, the auditor first plans his audit which includes an assessment of the internal control structure. If this structure is assessed as being good, he may then test some of these control features to confirm this initial assessment. If however the structure is assessed as being poor, he will not perform any tests but apply a strictly substantive testing of the various balances and transactions. Next, he reviews and analyzes the overall audit, comes to a conclusion and then issues a report. THE AUDIT REPORT - the ultimate product After the auditor completes all of his work he writes a report. Presented below is an illustration of the standard unqualified audit report (also known as an unqualified or clean opinion): AUDITORS' REPORT8
March 20, 1999 To the Members of BRC Industries Limited We have audited the accompanying balance sheet of BRC Industries Limited as of December 31, 20X1, and the related statements of income, and cash flows for the year then ended. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those Standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management,

This was taken from ISA 700, Par 28, with slight modifications. The Audit Practices Committee of the Institute of Chartered Accountants of Jamaica prepared an Auditing Practice Statement to reflect an amendment to this standard report. The amendment relates to certain matters which are required by the Companies Act 1965 to be expressly stated in the Auditors Report. Note - Auditing Practice Statements are issued to provide practical assistance to auditors in implementing the Standards on Auditing or to promote good practice. These Statements are not intended to have the authority of the Standards.

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as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion In our opinion, the financial statements give a true and fair view of the financial position of the Company as of December 31, 20X1, and of the results of its operations and its cash flows for the year then ended in accordance with International Accounting Standards and comply with the provisions of the Companies Act.

Chambers & Chambers

Chartered Accountants Kingston, Jamaica

[Note - deviations from this "unqualified" opinion (normally referred to as "qualified" opinions) will be discussed in Chapter 12 - Reporting]

End of chapter questions

Multiple choice A typical objective of an operational audit is to determine whether an entitys a) Internal control structure is adequately operating as designed. b) Operational information is in accordance with generally accepted auditing standards. c) Financial statements present fairly the results of operations. d) Specific operating units are functioning efficiently and effectively 1. Which type of audit best describes that where an auditor determines whether the client has conformed to specific regulations, criteria established by directors or regulatory agencies, contractual agreements, tax laws or company policies? a) Operational audits b) Internal audits c) Financial statement audits d) Compliance audits 2. Match each description on the left with the appropriate term or phrase on the right. Terms/phrases should only be used once.

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i. Designed to provide reasonable, rather than absolute assurance ii. Involve(s) performing inquiry and analytical procedures iii. Focus(es) on degree to which the audited entity is following a set of regulations iv. Compilation and unaudited statements v. Evaluate(s) efficiency and effectiveness vi. Primary responsibility for financial statements vii. Results in financial statements a) b) c) d) e) f) g) Review Compilation Compliance audit Operational audit Non-attestation services Management Audit

3. The internal auditors responsibility is to the:

a) b) c) d) shareholders management chief accountant external auditor

4. The following is a list of independent assertions: a) The Jamaican Stock Exchange's financial statements are presented in accordance with generally accepted accounting principles b) An entity's purchasing department is not effective c) An entity is in violation of the terms of a loan agreement d) A program of the government to improve the reading skills of adults is effective e) The gift-wrapping department is not following established policies with regard to overtime because the employee hourly rate is so low. f) The inventory records do not reflect the actual quantity of goods on hand Required: For each of the assertions: 1. Indicate the type of auditor most likely to be involved 2. Indicate the type of audit that is most likely involved

5. Which of the following phases best represent the order in which an external audit
proceeds? Reporting, planning, substantive testing and internal control evaluation a) Internal control evaluation, reporting, substantive testing and planning b) Planning, internal control evaluation, substantive testing and reporting c) Planning, substantive testing, reporting and internal control evaluation 6. What is the ultimate product of an audit?

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a) b) c) d) Essays 8. William Rodney, the sole owner of a small hardware business, has been told that the business should have financial statements reported on by an independent accountant. Rodney, having some bookkeeping experience, has personally prepared the company's financial statements and does not understand why they need to be examined by an accountant. Rodney discussed the matter with Sarah Jacobs, a chartered accountant, and asked Jacobs to explain why an audit is considered important. Required: a) Describe the objectives of an audit. b) Identify five ways an independent audit may be beneficial to Rodney 9. What is meant by the expectation gap? Do you think that auditors should be held more responsible? 10. Upon successful completion of your Diploma in Business Administration from the University of Technology, you have been invited to attend an interview by one of Jamaicas leading organizations, Grace Kennedy & Co. Ltd. There are two departments in which you could take up a position, its internal audit department or its accounting department. Throughout the interview, the Finance Director posed the following three (3) questions to you. a) List five (5) distinctions between an internal auditor and an external auditor. b) With respect to the conduct of an external audit, explain the division of responsibility between that of the auditor and that of management. c) Differentiate between accounting and auditing. Audit risk Audit adjustments Audit report Audit plan

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