CHAPTER ONE

THE NATURE, PURPOSE, SCOPE OF AUDIT AND ASSURANCE SERVICES

1.1. Meaning of Audit
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)/IFRS, or the
national standard of a particular country.

Financial statements include balance sheet, income statement, and 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.

1.2. Assurance Services: Overview

Assurance services are an independent examination of a company’s processes and controls.
Assurance aims to reduce information risk by improving the quality or context of the
information. Accounting professionals are qualified independent practitioners who can perform
such services. Reducing risk allows intended users to refrain from making impaired decisions.
Thus, assurance improves decision-making for users, such as investors and analysts.

Assurance focuses on analyzing the processes, controls, and operations of an organization. It

looks to determine whether the business is operating with appropriate accuracy. For example, a

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CPA will be hired to provide an assessment of a business’s procedures surrounding the
preparation of their accounting and/or financial records.

1.3. Why Audits are conducted

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 fulfills the need to ensure that those financial statements are
objective, free from bias and manipulation and relevant to the needs of users.

An audit determines whether an organization is providing a true and fair view of its financial
performance and position, which on its own is something any organization wants to achieve.
Audit is an important term used in accounting that describes the examination and verification of
a company’s financial records. It is to ensure that financial information is represented fairly and
accurately.

Also, audits are performed to ensure that financial statements are prepared in accordance with
the relevant accounting standards. The three primary financial statements are: Income
statement, balance sheet and cash flow statement. Financial statements are prepared internally
by management utilizing relevant accounting standards, such as International Financial
Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP). They are
developed to provide useful information to shareholders, creditors, government entities,
customers, suppliers, partners, etc.

Financial statements capture the operating, investing, and financing activities of a company
through various recorded transactions. Because the financial statements are developed
internally, there is a high risk of fraudulent behavior by the preparers of the statements. Without
proper regulations and standards, preparers can easily misrepresent their financial positioning to
make the company appear more profitable or successful than they actually are. Auditing is
crucial to ensure that companies represent their financial positioning fairly and accurately and
in accordance with accounting standards.

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1.4. Types of Audit and Auditors
The three primary types of audits include compliance audits, operational audits, and
financial statement audits. Although all audits involve an investigation of supporting
information, each type of audit has a different purpose. Compliance audits determine whether
the company has complied with regulations and policies established by contractual agreements,
governmental agencies, company management, or other high authority. Operational audits
assess operating policies and procedures for efficiency and effectiveness. Financial statement
audits determine whether the company has prepared and presented its financial statements
fairly, and in accordance with established financial accounting criteria.

The four types of auditors are external, internal, forensic and government. All are professionals
who use specialized knowledge to prepare specific types of audit reports.

An external auditor is a third-party consultant who independently reviews a company's

financial records, including purchasing records, payroll, accounts payable and receivable,
expense reports, inventory and tax payments. External auditors look for financial misstatements
resulting from errors, fraud or embezzlement. Because they are hired ኪራይ by a company and
not employed by it, they have no stake in the outcome of the audit and can, therefore, examine
records without bias.

Internal auditors perform the same functions as external auditors except that they are
employees of the company they are auditing. Internal auditors are important to a company's
decision-making process, as they look at aspects of the business such as risk management,
corporate governance, organizational objectives, operational efficiency and compliance.
Internal auditors identify and help rectify problems before an external audit.

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Forensic auditors perform audits with the understanding that their findings will be used in a
court of law for a trial or some form of mediation. Forensic audits are used to investigate fraud,
embezzlement or other financial crimes. A forensic auditor may be called upon to testify during
trial proceedings. Forensic audits are usually conducted by Certified Fraud Examiners (CFEs)
or accountants who specialize in the field of forensic accounting. Forensic auditors may also be
involved in audits that do not involve financial fraud, including divorces, business closures and
bankruptcy filings.

Government auditors perform audits of government agencies and of private businesses and
individuals engaged in activities that are subject to government regulations. Government
auditors perform financial audits as well as compliance audits.?????

In Ethiopia audits seem to be done primary on account of government regulation. For example,
NGOS are audited because the assets of the NGOS 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)
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.
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.
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 are audits performed by internal auditors within enterprise.

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CHAPTER TWO

THE AUDITING PROFESSION

Introduction
Standards are established to measure the quality and performance of individuals and
organizations. Standards relating to the auditing profession concern themselves both with the
CPA’s professional qualities and with the judgment exercised by CPA’s in the performance of
their professional engagement. Our purpose in this topic is to make clear the nature of generally
accepted auditing standards (GAAS). In our discussion of GAAS, we consider mainly on the
nature of the independent auditor’s report.

2.1. The Regulatory Framework of Governing Auditing

The regulatory framework of auditing consists of rules and regulations that fall under the scope
of national legislation, quoted companies and also corporate governance. Auditors, both
internal and external, must be aware of the regulatory framework for auditing applicable to the
industry of their client because a key objective of any organization will be to comply with
appropriate regulations. They should also keep abreast of any change that occurs as it could
influence the role and performance of the audit. Basically, the regulatory framework that
surrounds the auditing profession includes both national and international regulations.

a) National Level:
 National Legislation: Generally, most companies are not permitted to operate unless
they are incorporated under national legislation. The legislation sets out the rules
and regulations.
 Regulations affecting all organizations: There are specific regulations that
govern the operations of particular business activities, for example, those

industry in which the organization operates.

b) International Level
 International regulation also plays a major role in regulating the audit function. It
sets the standards and requirements for auditors and provides guidance for countries

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that do not have a well-established national regulatory framework. This contributes to the
recognition of professional accountancy qualifications among these countries.

2.2. International Standards on Auditing (ISA)

International Standards on Auditing (ISA) refers to professional standards dealing with the
responsibilities of the independent auditor while conducting the financial audit of financial info.
These standards are issued by International Federation of Accountants (IFAC) through the
International Auditing and Assurance Standards Board (IAASB). The ISAs include requirements
and objectives along with application and other explanatory material. The auditor is obligatory to
have knowledge about the whole text of an ISA, counting its application and other explanatory
material, to be aware of the objectives and to apply the requirements aptly.ንቁ

List of the Standards

The key standards issued by the ISA include:

 Respective responsibilities
 Audit planning
 Internal control
 Audit evidence
 Using work of other experts
 Audit conclusions and audit report
 Specialized areas
 Structure of ISAs
Every ISA is structured in individual sections as:

A) Introduction
Introductory material can include the purpose, scope, and subject matter of the ISA, as well as
the responsibilities of the auditor and others in context in which the ISA is established.
B) Objective
Every ISA consists of as clear statement about the objective of the auditor in the audit area

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addressed by that ISA.
C) Definitions
For higher understanding of the ISAs, pertinent terms are delineated አስረዳ in each ISA.
D) Requirements
Every objective is shored up by clearly stated requirements. Requirements are always expressed
by the phrase “the auditor shall.”
E) Application and other explanatory material
The application and other explanatory material explains more exactly what is meant by a
requirement or is intended to cover, or includes examples of procedures that can be appropriate
under certain circumstances.
Objectives of the ISA
The ISA objectives are two-fold:

 Analyzing the comparability of national accounting as well as auditing standards with

international standards, determine the degree with which applicable auditing and
accounting standards are complied, and analyze strengths and weaknesses of the
institutional framework in sustaining high-quality financial reporting.
 Assist the country in developing and implementing a country action plan for
improvement of institutional capacity with a view of strengthening the corporate financial
reporting system of the country.

2.3. Professional Ethics: Fundamental Principles, Threats and Safeguards

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.

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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: - 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.

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Ethical conflict
An ethical conflict (also known as an ethical dilemma) is when two ethical principles demand
opposite results in the same situation. In order to resolve the conflict a choice must be made that
by definition will leave at least one of the ethical principles compromised.

A key reason behind many ethical conflicts is a conflict of interest between taking decisions in
one’s own self-interest versus making decisions in the best interest of a client. For example an
auditor has a moral obligation to earn money to feed, clothe and house his family. To purely
satisfy this obligation they may take decisions that are not in the best interest of a client – for
example reducing the extent of audit work and using more junior staff to save money on costs and
generate bigger profits for the audit firm. However, the reduction in audit work and use of more
junior staff would mean that the auditor has not complied with audit standards nor delivered the
statutory audit that the client has paid for.

An ethical conflict may arise with confidential information that an accountant encounters, for
example on the discovery of a fraud. The defrauded party (which may for example be the client
company, an employee, a supplier, the shareholders or perhaps a bank) has suffered in some way
and the auditor is aware of this. The auditor’s primary responsibility is to provide an opinion on
whether the financial statements provide a true and fair view not to report fraud to the plaintiff
ከሳሽ - it is normally the choice of the company how to proceed (unless crimes such as terrorism or
money laundering are involved).

With both of the above examples numerous different courses of action could be justified using
the theories you have encountered previously. However, professional codes of ethics are
employed in the accountancy profession in order to establish consistent behaviour and a robust
ethical conflict resolution process.

Rules-based and principles-based approaches to ethical conflicts

When accountants are faced with an ethical conflict they need to know what to do. If there is a
threat to their compliance with the fundamental principles of the ethical code, how should they

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ensure their compliance and deal with the threat? There are two possible approaches that the
professional accountancy bodies could take, a rules based approach and a principles-based
approach.
i) A rules-based approach is to identify each possible ethical problem or ethical dilemma
that could arise in the work of an accountant, and specify what the accountant must do in
each situation.
ii) A principles-based approach is to specify the principles that should be applied when
trying to resolve an ethical problem, offer some general guidelines, but leave it to the
judgment of the accountant to apply the principles sensibly in each particular situation.
2.4. Legal Liability of Auditors
Concerns about the legal liability of auditors continue to grow every day. Financial auditors are
highly important people because, ultimately, they are responsible for enhancing the reliability of
financial statements for external users. Like other professionals, they can face civil and criminal
liabilities in the performance of their duties.

Without independent and competent auditors, many fraud cases worldwide would’ve gone
unnoticed, ሳይነቃበት notwithstanding all the other cases that are still undiscovered. One code of
professional conduct states that auditors must go about their business with due care. Due care is
the “prudent person” concept. Due care generally implies four things:
1. The auditor must possess the requisite አስፈላጊ skills to evaluate financial statements.
2. The auditor has a duty to employ such skill with reasonable care and diligence.
3. The auditor undertakes his task(s) with good faith and integrity but is not infallible.የማይሳሳት
4. The auditor may be liable for negligence, bad faith, or dishonesty, but not for mere errors in
judgment.

Sources of Legal Liability for an Auditor

1) Client: Breach of Contract. Auditors obtain an engagement letter and any breach of the
stated terms can be a valid reason for legal action by the company against the auditor.
2) Financial Statement Users: Negligence. The auditor has failed to use due care and has
failed to identify a material misstatement. By not identifying a material misstatement,
financial statement users are harmed, as they may rely on the published financials when
making an investment decision.

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3) Government: Fraud, also known as Gross Negligence. The auditor has knowingly
issued an incorrect audit report. The government requires public company financial
statements to accurately reflect the company’s actual results. If an incorrect audit report
is issued, then this undermines the government’s duty to help protect investors.
2.5 MATERIALITY AND RISK ASSESSMENT
2.5.1 Audit Risk
Audit risk is defined as ‘the risk that the auditor expresses an inappropriate audit opinion when the
financial statements are materially misstated. Audit risk is a function of the risks of material
misstatement and detection risk’. Hence, audit risk is made up of two components – risks of
material misstatement and detection risk.

Risk of material misstatement is defined as ‘the risk that the financial statements are materially
misstated prior to audit. This consists of two components... inherent risk ... control risk.’

Inherent risk is ‘the susceptibility ፍላጎታቸውን መጠበቅ of an assertion about a class of

transaction, account balance or disclosure to a misstatement that could be material, either
individually or when aggregated with other misstatements, before consideration of any related
controls.’

Control risk is ‘the risk that a misstatement that could occur in an assertion about a class of
transaction, account balance or disclosure and that could be material, either individually or
when aggregated with other misstatements, will not be prevented, or detected and corrected, on a
timely basis by the entity’s internal control.’

Detection risk is defined as ‘the risk that the procedures performed by the auditor to reduce audit
risk to an acceptably low level will not detect a misstatement that exists and that could be
material, either individually or when aggregated with other misstatements.’

Risk assessment procedures

SA 315 goes on to identify the following three risk assessment procedures:
a) Making inquiries ምርመራ of management and others within the entity

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Auditors must have discussions with the client’s management about its objectives and
expectations, and its plans for achieving those goals.
b) Analytical procedures ትንተናዊ
Analytical procedures performed as risk assessment procedures should help the auditor in
identifying unusual transactions or positions. They may identify aspects of the entity of which the
auditor was unaware, and may assist in assessing the risks of material misstatement in order to
provide a basis for designing and implementing responses to the assessed risks.
c) Observation and inspection ምልከታ እና ፍተሻ
Observation and inspection may also provide information about the entity and its environment.
Examples of such audit procedures can potentially cover a very broad area, including observation
or inspection of the entity’s operations, documents, and reports prepared by management, and also
of the entity’s premises ቅድመ ሁኔታ and plant facilities.

2.5.2Materiality
Materiality in auditing is defined as the magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the judgment of
a reasonable person relying on the information would have been changed or influenced by the
omission or misstatement.

The auditors’ responsibility is to determine whether financial statements are materially misstated.
If the auditor determines a material misstatement, he or she will bring it to the client’s
attention to correct. If the client refuses to correct the statements, a qualified or an adverse opinion
must be issued, depending on how material the misstatement is. Therefore, auditors must have a
thorough knowledge of the application of materiality. Materiality is relative to the size and
particular circumstances of individual companies.

In planning an audit, the auditor should assess materiality at the two levels:
2.5.3Materiality at the Financial Statement Level
Financial statements are materially misstated when they contain errors or irregularities whose
effect, individually or in the aggregate, is important enough to prevent the statements from
being presented fairly following Accounting Standards.In this context, misstatements may result
from the misapplication of applicable Accounting Standards, departures from fact, or omissions

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of the necessary information. The financial statement materiality at the financial statement level
enables auditors to determine which account balances to audit and how to evaluate the effects of
misstatements in financial information as a whole.In audit planning, the auditor should recognize
that there may be more than one level of materiality relating to the financial statement. Each
statement could have several levels.

For the income statement, materiality could be related to total revenues, operating profit, net profit
before tax, or net profit. For the statement of financial position, materiality could be based on
shareholders’ equity, assets, or liability class total.
2.5.4Materiality at the Account Balance Level
Account balance materiality is the minimum misstatement in an account balance to be considered
materially misstated. Misstatement up to that level is known as a tolerable misstatement. The
concept of materiality at the account balance level should not be confused with the term material
account balance.
The latter term refers to the size of a recorded account balance, whereas the concept of materiality
pertains to the amount of misstatement that could affect a user’s decision. The recorded balance of
an account generally represents the upper limit on the amount by which an account can be
overstated.
In making judgments about materiality at the account balance level, the auditor must consider the
relationship between it and financial report materiality. This consideration should lead the auditor
to plan the audit to detect misstatements that may be immaterial individually but that may be
material to the financial report taken as a whole when aggregated with misstatements in other
account balances.
In making judgments about materiality at the account balance level, the auditor must consider the
relationship between it and financial statement materiality. This consideration should lead the
auditor to plan the audit to detect misstatements that may be immaterial individually but that,
when aggregated with misstatements in other account balances, may be material to the
financial statements taken as a whole

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CHAPTER THREE

CLIENT ACCEPTANCE AND PLANNING THE AUDIT

3.1 Client Acceptance and Continuance

A public accounting firm must use care in deciding which clients are acceptable. The firm’s legal
and professional responsibilities are such that clients who lack integrity or argue constantly about
the proper conduct of the audit and fees can cause more problems than they are worth. Some
public accounting firms may refuse clients in what they perceive to be high-risk industries (for
example, software technology) and may even discontinue auditing existing clients in those
industries. Some smaller public accounting firms will not do audits of publicly held clients
because of the complexity of regulatory filings and the potential litigation risk. If we relate this
to overall audit risk, an auditor is unlikely to accept a new client or continue serving an existing
client if overall acceptable audit risk is below the threshold the firm is willing to accept.

3.2 Planning the Audit

Generally accepted auditing standards require adequate planning. The purpose of planning is to
provide for effective conduct of the audit (CAS 300, par. 04), and there are three main reasons
why the auditor should plan engagements properly:
 To enable the auditor to obtain sufficient appropriate audit evidence.
 To help keep audit costs reasonable.
 To avoid misunderstandings with the client.

Obtaining sufficient appropriate audit evidence is essential if the public accounting firm is to
minimize legal liability and maintain a good reputation in the professional community. Keeping
costs reasonable helps the firm remains competitive and retains its clients. Avoiding
misunderstandings with the client is important for good client relations and for facilitating
quality work at reasonable costs.

Initial audit planning, which is performed early in the engagement, involves the following steps:
1) The auditor decides whether to accept or continue doing the audit for the client. This

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decision is typically made by an experienced auditor (usually a partner) who is in a position
to make important decisions.
2) The auditor conducts an independence threat analysis.
3) The auditor identifies the client’s reasons for the audit. This information is likely to affect
the remaining parts of the audit.
4) To avoid misunderstandings, the auditor obtains an understanding with the client about the
terms of the engagement. This is laid out in the engagement letter.
5) The auditor develops an overall audit strategy, including engagement staffing.

3.3 Appointment, Remuneration, and Removal of Auditors

The Commercial Code of Federal Democratic Republic of Ethiopia set how auditors are
appointed, remunerated, and removed and also their responsibilities to third parties and the
clients. The following section deals with the appointment remuneration and revocation of
auditors especially those of auditors appointed to the public.

Article 368 Appointment of auditors

 The general meeting of every company limited by shares shall elect one or
more auditors and one or more assistant auditors.
 Shareholders representing not less than 20 % of the capital may appoint an
auditor selected by them.
 Where there is more than one auditor, they may exercise their duties jointly or
separately
 A body corporate may act as auditor

Art. 369- Nomination and term of Appointment

1) Auditors shall be elected by the meeting of subscribers and thereafter by the annual general
meeting.
2) Auditors elected by the meeting of subscribers shall hold office until the first annual
meeting. Auditors elected at an annual general meeting hold office for three years.

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3) When signing as auditor, an auditor shall add the name of the company whose accounts he

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is auditing.
Art.370. Persons Not Competent

1) The following persons may not be elected as auditors.

a. Founders, contributors in kind, beneficiaries holding special benefits, directors
of the company or of one of its subscribers or of its holding companies.
b. Spouses or relatives by consanguinity of affinity to the fourth degree inclusive,
of the person mentioned in sub-art-(1) (a).
c. Person who receives from the persons mentioned in sub- art. (1) (a) a salary or
periodical remuneration in connection with duties other than those of an auditors.
2) Auditor may not be appointed directors or managers of the company which they audit,
nor of one of its subscribers or its or of its holding company with in three years from
the date of the termination of their functions.
3) Reports submitted by an auditor and adopted by the annual general meeting shall not,
save in the case of fraud, be invalid merely by reason of the fact that the provisions of
this Article have not been observed.

Art 372.Remuneration

1) The remuneration of auditors shall be fixed by the general meeting on their appointment.
2) Where the general meeting fails to agree on the remuneration of the auditors, the
Ministry of commerce and Industry may on the application of any interested party fix
the remuneration.

Art. 371. Revocation of the appointment of Auditors

A general meeting may at any time revoke the appointment of any auditor without
prejudice to any claim he/she may have for wrongful dismiss

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