CHAPTER 1

Basic Concepts of Audit & Assurance

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Chapter Contents
 Introduction
 What is Audit?
 Statutory and Non-Statutory Audit
 Assurance
 Assurance and Reports
 Limitations of Audit and Materiality
 Definition of Financial Audit
 Relationships among Auditors, Client, & External Users
 Objectives & Scope of Financial Audit
 Types of Audit Engagement & Level of Assurance
 Types of Audit
 Users of Audit Reports
 Audit Process
 Audit Engagement Letter
 The Audit Opinion
 The Audit Report
 Important terms used in Auditing
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Introduction
 The word "audit" is derived from the Latin word "audire",

meaning “to hear”. In carrying out his examination and

verification of records, the auditor had to listen to his auditees
(those who maintained the accounts).
 A free-market economy can exist only if there is sharing of

accurate, reliable information among parties that have vested

interest in the financial performance and future prospects of an
organization.
 The term audit generally refers to an official inspection of an

organization's record (e.g. accounts etc.) typically by an

independent body.
 Auditing is not just limited to accounting, financial, or business

records, but extends to many other areas in life. 3

What is Audit?
 Audit in general refers to financial audit of a business
organization, however, if it is performed for other purposes
usually includes a prefix such as quality audit or environmental
audit and so etc.
 An audit in business is a systematic and independent examination

of books, accounts, statutory records, documents and vouchers of

an organization to ascertain how far the financial statements as
well as non-financial disclosures present a true and fair view of
the concern.
 Whilst an audit might produce by-products such as advice to the

directors on how to run the business, its objective is solely to

report to shareholders.
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Statutory and Non-Statutory Audit
 Statutory Audit is required under national statute for variety of

businesses, including limited liability companies. Charities,

investment firms, and trade unions are examples of additional
organizations that need a statutory audit. The key benefit of
statutory audit to shareholders is the impartial view provided by
the auditors. Advantages might include recommendations being
made in relation to accounting and control systems and the
possibility that auditors might detect fraud and error.
 Non-Statutory Audits are performed by independent auditors at

the request of the company’s owners, proprietors, members,

trustees, professional and governing bodies, or other interested
parties, instead of being required by law.
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Difference between Book-keeping,
Accountancy & Auditing
 Book-keeping is an art of recording the business transactions in the

books of original entry and the ledger. (performed by clerk or so)

 Accountancy means the compilation of accounts in such a way that

one is in a position to know the state of affairs of the business.

(performed by accountant)
 Auditing is the verification of book of entries and accounts to find

out their accuracy. (performed by auditor)

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Assurance
An assurance engagement is one in which a practitioner
(auditor) expresses a conclusion designed to enhance the
degree of confidence of the intended users other than the
responsible party about the outcome of the evaluation or
measurement of a subject matter against criteria.
 The outcome of the evaluation or measurement of a subject

matter is the information that results from applying the

criteria.
 Due to its independence and impartiality, an audit provides

assurance to the shareholders and other stakeholders of a

company on the financial statements.
 Assurance services include a range of assignments, from7
Assurance (Cont’d)
The degree of assurance given by the impartial professional will
depend on the nature of the exercise being carried out.

Directors prepare financial statements for the benefit of members.

They assert that the financial statements give a true and fair view.
The auditors provide assurance on that assertion.
To provide such assurance, the auditors must:
 Assess risk
 Plan audit procedures
 Conduct audit procedures
 Assess results
 Express an opinion

The degree of satisfaction achieved and, therefore, the level of

assurance which may be provided, is determined by the nature of
procedures performed and their results.
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Need for Assurance
The need for assurance services arises from several factors,
such as:
 Potential bias in providing information

 Remoteness between users and the organization or trading

partner
 Complexity of the transaction, information or processing

systems
 Riskiness of investment (managing risk)

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Assurance and Reports
The auditors' report on company financial statements is
expressed in terms of truth and fairness. This is generally
taken to mean that financial statements:
 Are factual

 Are free from bias

 Reflect the commercial substance of the business's

transactions

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Assurance and Reports (Cont’d)
The auditor's report refers to the fact that the audit is
planned and performed to obtain ‘reasonable assurance’
whether the financial statements are free from material
misstatement.
An audit gives the reader reasonable assurance on the truth
and fairness of the financial statements, which is a high, but
not absolute assurance. The auditor’s report does not
guarantee that the financial statements are correct, but that
they are true and fair within a reasonable margin of error.
 One of the reasons that an auditor does not give absolute

assurance is because of the inherent limitations of audit. 11

Limitations of Audit and Materiality
The assurance given by auditors is governed by the fact that
auditors use judgement in deciding what audit procedures to
use and what conclusions to draw, and also by the limitations
of every audit.

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Limitations of Audit and Materiality
(Cont’d)
 Materiality is an expression of the relative significance or

importance of a particular matter in the context of the

financial statements as a whole.
 A matter is material if its omission or misstatement would

reasonably influence the economic decisions of users taken

on the basis of the financial statements.
 Materiality depends on the size of the item or error judged in

the particular circumstances of its omission or misstatement.

For example, a fraud, illegal act or other irregularity is
considered more material than an error of the same dollar
amount.
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
Relationships among Auditors, Client,
& External Users

Auditor
Auditor issues
Client or audit report relied upon
committee (auditee) by users to reduce
Hires auditor information risk

Provides
Client capital & External Users
(Auditee) Finance (Stakeholders)
Client provides
financial statements to
users
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Financial Audit
A Financial Audit is an objective examination and evaluation
of the financial statements of an organization to make sure
that the records are a fair and accurate representation of the
transactions they claim to represent.
A Financial Audit is a process of collection and evaluation of
facts for the purpose of reporting to the interested parties on
economic information in terms of financial statements that
include;
a) Balance Sheet (Statement of Financial Position)

b) Income Statement (Statement of Profit and Loss)

c) Statement of Cash Flows

d) Statement of Changes in Equity 15

Objectives of Financial Audit
The objective of an audit of financial statements is to enable the
auditor to express an opinion whether the financial statements
are prepared, in all material respects, in accordance with an
applicable financial reporting framework. (International
Standards on Auditing (ISA)
 Audits are performed;

a) to ascertain the validity and reliability of information,

b) to provide an assessment of a system’s internal control,

c) to promote corporate governance in the organization

d) to control the organizations’ information risk,

e) to enable the auditor to express an opinion on the organization

under evaluation based on the work done on a test basis. 16
Scope of Audit
 Audit scope and objectives have a different meaning

depending on the person performing the audit as well as the

reason behind the audit.
 The term ‘Scope of Audit’ refers to the audit procedures

deemed necessary in the circumstances to achieve the

objectives of the audit.
The scope of audit is determined by the auditor having regard
to following:
(a) Terms of the Audit Engagement

(b) Requirement of Relevant Statute (National & International

Standards)
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Types of Audit Engagement & Level of
Assurance

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Types of Audit
 Some of the major types of audit are:

a) Internal Financial Audit (Internal Control System - conducted

on behalf of management of an enterprise)

b) External Financial Audit (Independent Audit - to discover

whether the financial statements of an enterprise are reliable)

c) Cost Audit (examination and verification of the cost accounts

& records to check efficiency of cost structure)

d) Tax Compliance Audit (examination of tax returns and

computations to check compliance with tax regulations)

e) Quality Audit (to verify the effectiveness of a quality

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management system)
Types of Audit (Cont’d)
Other types of audit include:
 Performance Audit (evaluating the efficiency, effectiveness, and
productivity of business operations)
 Operational Audit (evaluating the efficiency, effectiveness, and
productivity of business operations)
 Environmental Audit (to assess the organization’s compliance with

environmental laws)
 Social Audit (examining an organization’s social responsibility
initiatives)
 Shari’ah Audit (to verify the Shari’ah compliance of business
organizations)

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Users of Audit Reports
The various parties interested in the accounts of a company are
sometimes referred to as stakeholders.

Although they will each judge the accounts by different criteria, they
will all gain assurance from learning that the accounts they are
reading have been subject to an independent report.

Key stakeholders include:

1. Shareholders
2. Directors
3. Government and Tax Authorities
4. Banks and Lending Companies (Creditors)
5. Other Agencies (Rating agencies etc.)
6. Competitors
7. The Public

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Audit Process

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Audit Process

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Audit Engagement Letter
An engagement letter defines the legal relationship (or
engagement) between a professional firm (e.g., law,
investment banking, consulting, advisory or accountancy firm
and audit firm) and its client(s).jo log hier kre ga
Most engagement letters follow a standard format.
This letter generally states:
a) The terms and conditions of the engagement addressing

the scope of the engagement

b) The terms of compensation for the firm.

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Basic Elements of an Audit Engagement Letter

 It confirms the auditor’s acceptance of the appointment.

 The objectives and scope of the audit.

 The extend of auditor’s responsibilities to the client.

 The form of any reports or other communication of results

of the engagement to be provided by the auditor.

 Unrestricted access to records, documentation and other

information requested in connection with audit.

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Agreements of the Terms of Engagements
The engagement letter should request the client to confirm
the terms of the engagement by acknowledging the receipt of
the engagement letter.

Letter should also confirm three important matters:

1. Arrangements regarding the planning and performance of

the audit.

2. Arrangement regarding consultation with the client’s

Board of directors or Audit & Governance Committee etc.

3. Description of any other letters or reports the auditor

expects to issue to the client.

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The Audit Opinion
The principal aim of the external audit is to provide an independent
opinion on the truth and fairness of the financial statements.

The audit opinion may imply that certain conditions are met because
any discrepancies would have been highlighted in the report.

In the UK, such implied /(unwritten garantees)assurances typically

include the following:
 Proper accounting records have been maintained.
 Sufficient audit returns have been obtained from branches not
visited.
 The financial statements align with the accounting records and
returns.
 The auditor has received all necessary information and
explanations for the audit.
 Directors' emoluments and other benefits are accurately disclosed
in the financial statements.
 Details of loans and other transactions benefiting directors and
others are correctly recorded in the financial statements. 27
Types of Audit Opinions
1. Unqualified (Clean) Opinion: Where the auditor is satisfied that
the financial statements fairly present the financial position and
results of the entity and comply with the accounting standards.
2. Qualified Opinion: Where the auditor believes that the financial
statements are generally true and fair "except for" a specific
exceptions or issues that need to be disclosed. These may include
deviations from accounting principles or limitations in the scope
of the audit.
3. Adverse Opinion: If the nature and materiality of the
misstatement(s) is such that the auditor believes the financial
statements cannot provide a true and fair view (due to significant
misstatements or non-compliance with accounting standards),
even with a qualification, the auditor issues an adverse opinion.
4. Disclaimers of Opinion (Inability to Provide Opinion)*: This
type of auditor’s statement essentially makes it clear that the
auditor is not in a position to express a specific opinion (due to
significant limitations in the audit process or lack of sufficient
evidence) on the overall status of the financial records of the
client. A disclaimer of opinion may be issued when there is any28
Circumstances that may result in
other than Unqualified/Clean
Opinion
The auditor may disagree with the management
about the matters such as,
a) acceptance of accounting policies selected,

b) method of application of accounting policies,

and
c) the adequacy of disclosures in the financial
statements.

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Auditor’s Report
Auditor's report is a formal opinion, or
disclaimer thereof, issued by either an internal
auditor or an independent external auditor as a
result of an internal or external audit or
evaluation performed on a legal entity or
subdivision thereof (called an "auditee").
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Basic Elements of an Auditor’s Report
An auditor’s report include the following basic elements:

1. Title; the auditor’s report should have an appropriate title.

2. Addressee: the auditor’s report should be appropriately

addressed as required by circumstances of the engagement and
local laws and regulations.

3. Opening or introductory paragraph;

a) The auditor’s report should identify the financial statements

and the financial institution that has been audited,
including the dates and the period covered by the financial
statements.

b) The auditor’s report should include the statement that the

financial statements and the financial institution undertaken
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Basic Elements of an Auditor’s Report (Cont’d)
4. Scope paragraph; “scope” refers to the auditor’s ability to perform
audit procedures deemed necessary in the circumstances.

5. Opinion paragraph; the auditor’s report should clearly state the

auditor’s opinion as to whether the financial statements give a true
and fair view in accordance with GAAP & IAS or any other
international agency.

6. Dates of the report; the auditor should date the report as of the
completion date of the audit.

7. Auditors Address; the report should name a specific location, which

is ordinarily the city where the auditor maintains the office.

8. Auditors Signatures; the report should be signed either in the name

of the audit firm, the personal name of the auditor or both, as
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Important Terms in Auditing
Inherent Risk - the risk that material misstatements exist before
considering the client’s internal controls.
Reasonable Assurance - means that an audit is designed to
provide sound assurance that the financial statements taken as a
whole are free from any material misstatement.
Information risk - is the probability that the information circulated
by a company will be false or misleading.
Audit Opinion - is a formal statement issued by an independent
auditor expressing their assessment of the accuracy and fairness of
a company's financial statements in accordance with applicable
accounting standards and regulatory requirements.
Recurring Audit - is used for repeating the Audit for rechecking
and making amendments in audit report (if required).
Professional Skepticism - in auditing terms means to have an
open and reasonably questioning mind in the face of discrepancies.

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THANK YOU

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