CHAPTER 2: INTRODUCTION TO AUDITING

I.THE NATURE, PURPOSE AND SCOPE OF AN AUDIT

A. The Historical Development of Auditing
The word audit comes from the Latin word audire, meaning to hear. According to
Flint (1988), audit is a social phenomenon which serves no purpose or value except of its practical
usefulness and its existence is wholly utilitarian. Flint (1988) further explains, the audit function
has evolved in response to a perceived need of individuals or groups in society who seek
information or reassurance about the conduct or performance of others in which they have an
acknowledged and legitimate interest. Flint (1998) argues that audit exists because interested
individuals or groups are unable for one or more reasons to obtain for themselves the information
or reassurance they require. Hence, an audit function can be observed as a means of social control
because it serves as a mechanism to monitor conduct and performance, and to secure or enforce
accountability. Mackenzie (as cited in Normanton, 1996, p. vii) in the foreword to The
Accountability and Audit of Governments made the following remark: Without audit, no control;
and if there is no control, where is the seat of power? All in all, an audit function plays a critical
role in maintaining the welfare and stability of the society.
Many auditors (e.g. Mascarenhas & Turley, 1990; Abdel-Qader, 2002; Porter, et al., 2005)
concur with Flint (1988) that the aim of an audit has always been a dynamic rather than a static
one. Brown (1962) asserts that the objective and techniques of auditing have changed during the
four hundred years of recognizable existence of auditing to suit the changing needs and
expectations of society. It can be observed that the changes in needs and expectations of society
are highly influenced by the factors contextual to the economic, political and sociological
environment at a particular point of time. Therefore, the review of the historical development of
auditing enables one to understand, analyze and interpret the evolution of auditing due to the
change in expectations of the society.
The evolution of auditing practices
To facilitate the examination of the historical development of auditing, this review will be
divided into the following five chronological periods: (i) Prior to 1840; (ii) 1840s-1920s; (iii) 1920s1960s; (iv) 1960s-1990s; and (v) 1990spresent.
i.
Prior to 1840
Generally, the early historical development of auditing is not well documented (Lee, 1994).
Auditing in the form of ancient checking activities was found in the ancient civilizations of China
(Lee, 1986), Egypt and Greece (Boyd, 1905). The ancient checking activities found in Greece
(around 350 B.C.) appear to be closest to the present-day auditing. The existence of such activities
can be proven by Aristotles quotation (as cited in McMickle, 1978, pp. 11-12) as follows:
Ten [logistae].and ten [euthuni].are chosen by lot. Every single public officer must
account to them. They have sole control over those subject to [examination]. they place
their findings before the courts. Anyone against whom they prove embezzlement is
convicted and fined by the court ten times the sum discovered stolen. Anyone whom the
court on [their].evidence convicts of corruption, is also fined ten times the amount of
bribe. If he is found guilty of administrative error, they assess the sum involved, and he is
fined that amount provided in this case that he pays it within nine months; otherwise the
fine is doubled.
Similar kinds of checking activities were also found in the ancient Exchequer of England. When
the Exchequer was established in England during the reign of Henry 1(1100-1135), special audit
officers were appointed to make sure that the state revenue and expenditure transactions were
properly accounted for (Gul, et al., 1994, p. 1). The person who was responsible for the
examinations of accounts was known as the auditor. The aim of such examination was to prevent
fraudulent actions (Abdel-Qader, 2002).
Likewise, the existence of checking activities was found in the Italian City States. The merchants of
Florence, Geneo and Venice used auditors to help them to verify the riches brought by captains of
sailing-ships returning from the Old World and bound for the European Continent. Again, auditing in
this period was concerned about detection of fraud. The audit found in the City of Pisa in 1394 was

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somehow similar to those found in the Italian City State. It was meant to test the accounts of
government officials to determine whether or not defalcation had taken place (Brown, 1962).
According to Porter, et al (2005), auditing had little commercial application prior to the
industrial revolution. This is because industries during this period were mainly concerned with
cottages and small mills which were individually owned and managed. Hence, there was no need
for the business managers to report to owners on their management of resources. As a result,
there is little use of auditing.
In a nutshell, in the period pre-1840, the auditing at the time was restricted to performing
detailed verification of every transaction. The concept of testing or sampling was not part of the
auditing procedure. The existence of internal control is also unknown. Fitzpatrick (1939)
commented that the audit objective in the early period was primarily designed to verify the honesty
of persons charged with fiscal responsibilities.
ii.
1840s-1920s
The practice of auditing did not become firmly established until the advent of the industrial
revolution during the period 1840s-1920s in the UK (Gill & Cosserat, 1996, p. 9; Ricchiute, 1989, p.
9). According to Brown (1962), the large-scale operations that resulted from the industrial
revolutions drove the corporate form of enterprise to the foreground. Large factories and machinebased production were established (Abdel-Qader, 2002). As a result, a vast amount of capital is
needed to facilitate this huge amount of capital expenditure.
The emergence of a middle class during the industrial revolution period provided the funds for
the establishment of large industrial and commercial undertakings. However, the share market
during this period was unregulated and highly speculative. As a consequence, the rate of financial
failure was high and liability was not limited. Innocent investors were liable for the debts of the
business. In view of this environment, it was apparent that the growing number of small investors
was in dire need of protection (Porter, et al, 2005). Hence, the time was ripe for the profession of
auditing to emerge (Brown, 1962).
In response to the socio-developments in the UK during this period, the Joint Stock Companies
Act was passed in 1844. The Joint Stock Companies Act stipulated that Directors shall cause the
Books of the Company to be balanced, and a full and fair Balance Sheet to be made up. In
addition, the Act provided the appointment of auditors to check the accounts of the company.
However, the annual presentation of the balance sheet to the shareholders and the requirement of
a statutory audit were only made compulsory in 1900 under the Companies Act 1862 (UK) (Leung,
et al., 2007).
According to Porter, et al (2005) the accountant particularly in the early years of this period,
was normally the company manager and his duties were to ensure proper use of the funds
entrusted to him. The auditors during this period were merely shareholders chosen by their fellow
members. Brown (1962) claimed that the auditors during this period were required to perform
complete checking of transactions and the preparation of correct accounts and financial statements.
Little attention was paid to internal control of the company.
Porter, et al (2005) commented that the duties of auditors during this period were influenced
by the decisions of the courts. For example, the verdicts from the case of London and General Bank
(1985) and Kingston Cotton Mill (1896) reinforced that the audit objective was detection of fraud
and errors. These cases in turn established the general standard of work expected of auditors.
Likewise, as noted in the auditing book of Lawrence R Dicksee (1892 cited in Leung, et al, 2004, p.
7): A Practical Manual for Auditors, the objectives of auditing were: (i) the detection of fraud; (ii)
the detection of technical errors, and (iii) the detection of errors of principles. It can be concluded
that the role of auditors during the period of 1840s-1920s was mainly on fraud detection and the
proper portrayal of the companys solvency (or insolvency) in the balance sheet.
iii.
1920s-1960s
The growth of the US economy in the 1920s-1960s had caused a shift of auditing development
from the UK to the USA. In the years of recovery following the 1929 Wall Street Crash and ensuing
depression, investment in business entities grew rapidly. Meanwhile, the advancement of the

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securities markets and credit-granting institutions had also facilitated the development of the
capital market in this period. As companies grew in size, the separation of the ownership and
management functions became more evident. Hence to ensure that funds continued to flow from
investors to companies, and the financial markets function smoothly, there is a need to convince
the participants in the financial markets that the companys financial statement provided a true and
fair portrayal of the relevant companys financial position and performance (Porter, 2005).
In view of the economic condition, the audit function was mainly to provide credibility to the
financial statements prepared by company managers for their shareholders. Consensus were
generally achieved that the primary objective of an audit function is adding credibility to the
financial statement rather than on the detection of fraud and errors. Such a change in audit
objective is evidenced in successive edition of Montgomerys Auditing text issued during this period
which stated An incidental, but nevertheless important, objective of an audit is detection of fraud.
(1934, p. 26). Primary responsibilityfor the control and discovery of irregularities necessarily lies
with management. (1940, p. 13). Hence, it can be witnessed that the shift of the focus of an audit
function from preventing and detecting fraud and error towards assessing the truth and fairness of
the companies financial statements began at this period.
The concept of materiality (Queenan, 1946) and sampling techniques (Brown, 1962) were used
in auditing during this period. The development of material concept and sampling technique was
due to the voluminous transactions involved in the conduct of business by large corporations
operating in widespread locations. It is no longer practical for auditors to verify all the transactions.
Consequently, sampling and the development of judgment of materiality were essential. The use of
sampling technique during this period can be proven from the following statement of Short (1940,
p. 226) it is not necessary to make a detailed examination of every entry, footing, and posting
during the period in order to get the substance of the value which resulted from an audit.
Corresponding to the use of sampling techniques, auditors need to rely on internal control of
the company to facilitate the use of such research approach. The reliance on internal control during
this period can be witnessed from the following statement found in page 240 of Accountants Digest
in March 1936:
The first step to take when planning an audit by test methods consists of a thorough
investigation of the system on which the books are keptIt is not the auditors sole duty to
see that the internal check is carried out but to ascertain how much it can be relied upon to
supplement his investigation.
The fundamental principles of auditing during this period were influenced by some major
auditing cases such as the case of McKesson and Robbins (1938). The verdict of this case had
resulted in the emphasis of physical observation of assets such as cash and stock, and the use of
external evidence. In addition, the Royal Mail case highlighted the need of audit for the profit and
loss statements. However, the audit of profit and loss account was only made mandatory with the
enactment of Securities and Exchange Commission Act 1934 in the USA and Companies Act 1948
in the UK.
In short, the social-economic condition in the period had highly influenced the development of
auditing. As highlighted by Porter, et al (2005) the major characteristics of the audit approach
during this period, among others, included: (i) reliance on internal control of the company and
sampling techniques were used; (ii) audit evidence was gathered through both internal and
external source; (iii) emphasis on the truth and fairness of financial statements; (iv) gradually
shifted to the audit of Profit and Loss Statement but Balance Sheet remained important; and (v)
physical observation of external and other evidence outside the book of account.
iv.
1960s to 1990s
The world economy continued to grow in the 1960s-1990s. This period marked an important
development in technological advancement and the size and complexity of the companies. Auditors
in the 1970s played an important role in enhancing the credibility of financial information and
furthering the operations of an effective capital market (Porter, et al., 2005). Similar description on
the auditors role was found in The New York Times on 6 April 1975 (Leung, et al., 2004, p. 10)

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that the duties of auditors, among others, were to affirm the truthfulness of financial statements
and to ensure that financial statements were fairly presented. Hence, the role of auditors with
regard to the audit of financial statement generally remained the same as per the previous period.
Despite the overall audit objectives remaining similar, Davies (1996) opines that auditing had
undergone some critical developments in this period. In the earlier part of this period, a change in
audit approach can be observed from verifying transaction in the books to relying on system.
Such a change was due to the increase in the number of transactions which resulted from the
continued growth in size and complexity companies where it is unlike for auditors to play the role of
verifying transactions. As a result, auditors in this period had placed much higher reliance on
companies internal control in their audit procedures. Furthermore, auditors were required to
ascertain and document the accounting system with particular consideration to information flows
and identification of internal controls. When internal control of the company was effective, auditors
reduced the level of detailed substance testing.
In the early 1980 there was a readjustment in auditors approaches where the assessment of
internal control systems was found to be an expensive process and so auditors began to cut back
their systems work and make greater use of analytical procedures (Salehi, 2007). An extension of
this was the development during the mid-1980s of risk-based auditing (Turley & Cooper, 1991).
Risk-based auditing is an audit approach where an auditor will focus on those areas which are more
likely to contain errors. To adopt the use of risk-based auditing, auditors are required to gain a
thorough understanding of their audit clients in term of the organization, key personnel, policies,
and their industries (Porter, et al., 2005) Hence, the use of risk-based auditing had placed strong
emphasis on examining audit evidence derived from a wide variety of sources, i.e. both internal
and external information for the audit client.
According to Porter, et al (2005), most of the companies in this period had introduced computer
systems to process their financial and other data, and to perform, monitor and control many of
their operational and administrative processes. Similarly, auditors placed heavy reliance on the
advanced computing auditing tool to facilitate their audit procedures. In addition to the auditing of
financial statement, auditors at the same time were providing advisory services to the audit clients.
Leung, et al (2004, p. 24) made the following comments in connection with the role of auditors in
providing such services:
There was a surge of one-stop shows such as multidisciplinary practices and the
development of holistic audit strategies which provided an extensive range of non-audit
services performed for audit client. Accounting and auditing during this period has become
an industry with strong competition among firms, a blurring of relationship with clients, an
apparent failure to exercise due diligence by some.
Porter, et al (2005) opined that the provision of advisory services emerged as a secondary
audit objective in the period of 1960s-1990s. Since then, the role of auditors has always been
highly associated with such advisory services.
v.
1990s-present
The auditing profession witnessed substantial and rapid change since 1990s as a result of the
accelerating growth at the world economies. It can be observed that auditing in the present day
has expanded beyond the basic financial statement attest function. According to Porter et al
(2005), present-day auditing has developed into new processes that build on a business risk
perspective of their clients. The business risk approach rests on the notion that a broad range of
the clients business risks are relevant to the audit. Advocates of the business risk approach opined
that many business risks, if not controlled, will eventually affect the financial statement.
Furthermore by understanding the full range of risks in businesses, the auditor will be in a better
position to identify matters of significance and relevance to the audit profession on a timely basis.
Since the early 1990s, the audit profession began to take increased responsibility to detect and
report fraud and to assess, and report more explicitly, doubts about an auditees ability to continue
in conformance with societys and regulators increasing concern about corporate governance

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matters. Adoption of the business risk approach in turn enhances auditors ability to fulfill these
responsibilities (Porter, et al., 2005).
Presently, the ultimate objective of auditing is to lend credibility to financial and non-financial
information provided by management in annual reports; however, audit firms have been largely
providing consultancy services to businesses. By 2000, consulting revenues exceeded auditing
revenues at all the major audit firms in the USA. Regulators of the auditing profession and the
investing public began to doubt whether audit firms could remain independent on audit issues when
the firms were so dependent on consulting revenues. The quality of audits is being placed under
scrutiny after a series of financial scandals of public companies such as Sunbeam, Waste
Management, Xeror, Adelphia, Enron and WorldCom. The collapses of these giant corporations had
brought about a crisis of confidence in the work of auditors (Boynton & Johnson, 2006).
As a consequence of the high level of litigation and criticism against the auditors, nearly all
large accounting firms split their consulting arms into separate companies and made
announcements on their more stringent rules and measures to ensure better independence and
audit quality. In addition, a spate of radical reforms was undertaken in various countries, by the
accounting bodies, governments, stock exchange commissions and academics to strengthen the
audit practice (Leung, et al., 2004). Some of the key reform activities include:
(1)
The Sarbanes-Oxley Act (The US)
In response to the fall of Enron the Sarbanes-Oxley Act was implemented. It outlines
the rules on auditor independence, for example, the control of audit quality, and the rotation
of audit partners as well as the prohibition of conflict-of-interest situation. Furthermore, the
act also requires auditors to report to the audit committee on those significant matters. The
Public Company Accounting Oversight Board which oversees audit firms and their
procedures and the enforcement of accounting standards is also established as a result of
this act.
The Sarbanes-Oxley extended the duties of auditor to audit the adequacy of internal
controls over financial reporting. This is in view of the fact that a number of commissions
recognized the importance of internal control in preventing financial statement
misstatement.
(2)
Ramsay report (Australia)
As a result of the collapse of HIH Insurance Ltd, the Australian Government
Commission engaged professor, Ian Ramsay to investigate the issue of auditor
independence. It was recommended that auditor independence can be improved through
the following ways:
Include a statement in the Corporations Act that auditors are to be
independent;
Require auditors to declare to the Board of Directors that their independence
is maintained;
Prohibit special relationships between the auditor and client;

Establish an auditor independence supervisory board;

Establish an audit committee to oversee the issue of non-audit services, audit

fees, scope disagreements and auditor-client relationships.
Although the overall audit objectives in the present period remained the same, i.e.
lending credibility to the financial statement, critical changes have been made to the audit
practice as a result of the extensive reform in various countries. Leung, et al (2004, p. 24)
is of the opinion that such reform has implicated the auditing profession in the following
ways: (i) The role of auditors is expected to converge: refocusing on the public interest,
redefining audit relationship, ensuring integrity of financial reports, separation of non-audit
function and other advisory services; (ii) The audit methods revert to basics i.e. risk
attention, fraud awareness, objectivity and independence, and (iii) increase attention on the
needs of financial statement users.

CHAPTER 2: INTRODUCTION TO AUDITING

In summary, the review of the historical development of auditing has evolved the
audit function through a number of stages. Auditing first emerged in the form of ancient
checking activities in the ancient civilizations of China, Egypt and Greece. However, the
practice of modern auditing did not become firmly established until the advent of the
industrial revolution in the mid nineteenth century in the UK. The audit practice in the mid
1800s to early 1900s can be regarded as traditional conformance role of auditing as
auditing was mainly concerned with ensuring the correctness of accounts and detecting
frauds and errors. Over the past 30 years or so, the auditor played an enhancing role by
enhancing the integrity and credibility of financial information. Today, auditors are expected
not only to enhance the credibility of the financial statement, but also to provide valueadded services, such as reporting on irregularities, identifying business risks and advising
management on the internal control environment (Cosserat, 2004). However, extensive
reforms were implemented in various countries as a result of the collapse of big
corporations; it is expected that the role of auditors will converge. Leung, et al (2004, p. 23)
claimed that the role of auditors has moved from mere conformance through an enhancing
role to a convergence role. It is evident that the paradigm of independent auditing has
shifted over the years. It is believed that it may continue to shift in the future.
The Ethical Case of Auditing
a) Philosophy of auditing
The audit process is a well- established and recognized control mechanism of the capital
market economy. It is a process on which the users of financial reporting call and rely. However,
little is known about the circumstances of its creation and the conditions necessary for its existence
and continuing development. In 1961, Mautz and Sharf published The Philosophy of Auditing a
project whose origins can be traced back to 1930s. When Mautz and Sharaf wrote this monograph,
auditing theory, unlike accounting theory, had received little attention. They outlined an extensive
discussion on auditing philosophy, methodology of auditing and postulates of auditing. They also
discussed the central areas in auditing such as evidence, due audit care, fair presentation,
independence and ethical conduct.
Auditing could no longer be permitted to develop on an ad hoc basis if it were to fulfil
its mission and satisfy public expectations. Accordingly it was argued that a philosophy of
auditing was needed both to provide a direction for auditing practice in an advanced
economic society, and to underwrite the claim to add credibility to the financial statements
of enterprises.
(Michael Power, 1990: 71)
Due to its innovative approach, the study of Mautz and Sharaf (1961) was a seminal work
regarding the theoretical foundations of auditing, and is considered as a milestone in auditing. In
their view, the development of a philosophy of auditing requires a study of its nature and problems
in the light of principles. This calls for an examination of its methods, presuppositions and
concepts. In this respect, they proposed a philosophy of auditing that elaborated first principles and
thereby attempted to provide a systematic organization of a hitherto loose structure of practices
and ideas. They investigated the possibility of an integrated body of auditing theory.
Mautz and Sharaf argued that auditing has its methodological roots in a scientific logic whereby
the evidence process depends upon a rational structure of observation, examination and
evaluation.
R.K Mautz and H.A. Sharaf
In 1961 published a monograph called The Philosophy of Auditing in the USA. This was
the beginnings of attempts to codify a coherent theory of auditing and included discussion
on the philosophy of auditing, methodology and auditing postulates or assumptions. They
attempted to create order out of a somewhat chaotic mix of practices and ideas.
They held that auditing is based on scientific logic where the auditing process is a rational
process of examination, observation and evaluation of evidence. A full discussion of these
ideas is not appropriate for this book but the essence of Mautz and Sharafs approach is that
auditing practice should be built on a sound philosophy of auditing because basing actions
on an underpinning philosophy means:

CHAPTER 2: INTRODUCTION TO AUDITING

going back to first principles of what an audit is, what purpose it serves and what
usefulness it has for society;
that knowledge has to be ordered in a systematic way; and it
defines auditings place in and usefulness to society
Broadly, Mautz and Sharaf adopted a scientific approach to auditing claiming that
auditing practice, with its heavy emphasis on probability and a scientific approach to
evidence, has much in common with scientific method. They developed eight tentative
postulates or factors necessary for audits to achieve the desired result.
These postulates or assumptions are:
1. Financial statements and financial data are verifiable.
2. There is no necessary conflict of interest between the auditor and the management
of the enterprise under audit.
3. The financial statements and other information submitted for verification are free
from collusive and other unusual irregularities.
4. The existence of a satisfactory system of internal control eliminates the probability of
irregularities.
5. Consistent application of generally accepted principles of accounting result in fair
presentation of the financial position and the results of operations.
6. In the absence of clear evidence of the contrary, what has held true in the pas for
the enterprise under examination will hold true in the future.
7. When examining financial data for the purpose of expressing an opinion thereon, the
auditor acts exclusively in the capacity of an auditor.
8. The professional status of the independent auditor imposes commensurate
professional obligations.
Whilst practitioners may disagree with these assumptions remember they are the basis
of a theory, they are not definitive statements defining an audit. In practice they are there
as a foundation or basis for inference and discussion, they are not statements of universal
truth.
Whilst these postulates or factors are useful in many ways, there are several key factors
which Mautz and Sharaf did not consider which are of fundamental importance today. These
are:

The questions of risk and control which were not considered to be as important in the
1960s as we consider them to be today.
Mautz and Sharaf do not pay much attention to the concept of accountability
between parties e.g. the accountability of the entity to the public or to investors. This
was considered more by Flint.
The basis of Mautz and Sharafs approach is founded in scientific method which refers
to evidence gathering processes, the testing of hypotheses and probability theory.
There are problems with this, particularly in the exercise of an auditors judgement in
the absence of conclusive evidence, and the fact that scientists are often able to
repeat experiments when trying to validate an hypothesis, whereas auditors only get
one opportunity to gather the evidence they need.
The relationships between auditing concepts in order to develop a general framework
of auditing

Whilst Mautz and Sharaf undoubtedly contributed greatly to the philosophy of auditing
they were very much grounded in the idea of scientific method and paid less attention to the
idea of auditing as a social phenomenon, i.e. that it had a value to society generally and not
just to those involved in the commercial entity. It was Professor Flint who added this
dimension.
Flint Philosophy and Principles of Auditing
In 1988 Professor David Flint published Philosophy and Principles of Auditing: An
Introduction which built on and updated the work of Mautz and Sharaf. He also developed a

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series of postulates as a basis for the development of a theory of auditing. Flints postulates
or assumptions are:
1. The fundamental condition for the existence of an audit is accountability, either
private (e.g. between management and shareholders), or public accountability.
2. The subject matter of accountability is too remote, too complex and/or of too great
a significance for the discharge of the duty (to be accountable) to be demonstrated
without the process of audit.
3. Essential distinguishing characteristics of audit are the independence of its status
and its freedom from investigatory and reporting constraints.
4. All aspects of an audit, its conduct, the work carried out and its conclusions must be
capable of being evidenced.
5. There have to be standards of accountability for those who carry out audits which
form the standard by which actual performance can be measured. This means:
that there are standards of accountability for conduct, performance, achievement
and quality of information,
actual conduct, performance, achievement, quality and so on can be measured and
compared with these standards by reference to known criteria, and
that the process of measurement and comparison requires skill and the exercise of
judgement.
6. The meaning, significance and intention of financial and other statements and data
which are audited are sufficiently clear that the credibility which is given to it as a
result of audit can be clearly expressed and communicated.
7. An audit produces an economic or social benefit.
Flints postulates are based on the fundamental idea that auditing has a social benefit
and is not simply a technical exercise for the purposes of regulation for example. It is not
the place of this book to expand on these ideas but perhaps students could consider the
value of reliable financial information to stakeholders in companies, for example:
to both potential investors;
to regulators of companies;
to employees;
to suppliers and customers;
to the taxation authorities.
b) Definition and Objective of An Audit
What is an audit?
An audit is an independent examination and expression of an opinion on the financial
statements of an enterprise.
The purpose of an audit is to enhance the degree of confidence of intended users in the
financial statements. This is achieved by the expression of an opinion by the auditor on whether
the financial statements are prepared, in all material respects, in accordance with an applicable
financial reporting framework.
In the case of most general purpose frameworks, that opinion is on whether the financial
statements are presented fairly, in all material respects, or give a true and fair view in accordance
with the framework.
COMPREHENSIVE DEFINITION :
Auditing is an examination of the accounting books and the relative documentary evidence so that
an auditor may be able to find out the accuracy of figures and may be able to make report on the
balance sheet and other financial statements which have been prepared from there.
According to R. K. Moutz, "Auditing is concerned with the verification of accounting data
with determining the accuracy and reliability of accounting statement and record."

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The primary objective of auditing is to report on true and fairness of the financial
statements. The audited financial statements add creditability.
The secondary objective of auditing is to detect suspected errors and fraud and
assist the management in tackling them.

Objectives of Audit
Basic objective of auditing is to prove true and fairness of results presented by profit and
loss account and financial position presented by balance sheet. Its objectives are classified into two
groups which are given below:

Primary Objectives of Audit

The main objectives of audit are known as primary objectives of audit. They
are as follows:
i. Examining the system of internal check.
ii. Checking arithmetical accuracy of books of accounts, verifying posting, costing,
balancing etc.
iii. Verifying the authenticity and validity of transactions.
iv. Checking the proper distinction of capital and revenue nature of transactions.
v. Confirming the existence and value of assets and liabilities.
vi. Verifying whether all the statutory requirements are fulfilled or not.
vii. Proving true and fairness of operating results presented by income statement and
financial position presented by balance sheet.
Subsidiary Objectives of Audit
These are such objectives which are set up to help in attaining primary
objectives. They are as follows:
i. Detection and prevention of errors
Errors are those mistakes which are committed due to carelessness or
negligence or lack of knowledge or without having vested interest. Errors may be
committed without or with any vested interest. So, they are to be checked carefully.
Errors are of various types. Some of them are:
* Errors of principle
* Errors of omission
* Errors of commission
* Compensating errors
ii. Detection and prevention of frauds
Frauds are those mistakes which are committed knowingly with some vested
interest on the direction of top level management. Management commits frauds to
deceive tax, to show the effectiveness of management, to get more commission, to
sell share in the market or to maintain market price of share etc. Detection of fraud
is the main job of an auditor. Such frauds are as follows:
* Misappropriation of cash
* Misappropriation of goods
*Manipulation of accounts or falsification of accounts without any
misappropriation
iii. Under or over valuation of stock
Normally such frauds are committed by the top level executives of the
business. So, the explanation given to the auditor also remains false. So, an auditor
should detect such frauds using skill, knowledge and facts.
iv. Other objectives
* To provide information to income tax authority.

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* To satisfy the provision of company Act.
* To have moral effect
c) Why Independent Auditing is Necessary?
Importance of Auditor Independence
The primary purpose of an audit is to provide company shareholders with an expert,
independent opinion as to whether the annual accounts of the company reflect a true and fair view
of the financial position of the company and whether they can be relied on. Independence is the
main means by which an auditor demonstrates that he can perform his task in an objective
manner.
The Need for Auditor Independence
The auditor should be independent from the client company, so that the audit opinion will
not be influenced by any relationship between them. The auditors are expected to give an unbiased
and honest professional opinion on the financial statements to the shareholders.
Doubts are sometimes expressed regarding the independence of external auditors. It can be
argued that unless suitable corporate governance measures are in place, a firm of auditors may
reach audit opinions and judgments that are heavily influenced by the wish to maintain good
relations with the a client company. If this happens, the auditors can no longer be said to be
independent and the shareholders cannot rely on their opinion.
Accounting firms sometimes engage set audit fees at less than the market rate and make up
for the deficit by providing non-audit services, such as management consultancy and tax advice. As
a result, some audit firms have commercial interests to protect too. This raises concerns that the
auditor's interests to protect shareholders of a company and his commercial interests may conflict
with each other.
A high profile example would be the relationship between Enron and their auditors, Arthur
Andersen. In 2000, Andersen received $27m for non-audit services, compared with $25m for audit
services, meaning Enron accounted for over 25% of the fees generated by the firms Houston
office. In the aftermath of Enrons demise, the accounting firm was accused of not acting
independently and suggestions were made that they had gone along with the accounting practices
in Enron in order to retain their work.
Threats to Auditor Independence
The audit profession has recognized the following threats to auditor independence, many of which
are linked to the provision of non-audit services:

Self-interest threat: Where an auditor is financially dependent on the audit client or

where an auditor or someone closely associated with him has a financial or other interest in
the audit client. The auditor also depends on the management of the company to secure its reappointment as auditor.

Familiarity threat: The relationship between the auditor and client is long-standing or
otherwise is so familiar that the auditor becomes involved in advising the client or acting in a
management role.

Self-review threat: A judgment is required of the auditor which demands that previous
work of the firm (whether audit or non-audit) be challenged or re-evaluated.

The intimidation threat: The auditor is intimidated by actual or potential pressures from
the client or other party.

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CHAPTER 2: INTRODUCTION TO AUDITING

The advocacy threat: The auditor becomes involved in actively promoting or defending
the clients interests.

Reliance on the Audit

The need for independence arises because in many cases users of financial statements and
other third parties do not have sufficient information or knowledge to understand what is contained
in a companys annual accounts. Thus, they rely on the auditors independent assessment. Public
confidence in financial markets and the conduct of public interest entities relies partly on the
credibility of the opinions and reports given by auditors in relation with financial audits.
C. The Notion of Accountability, Stewardship & Agency
Accountability
Accountability means holding those in charge accountable for their actions.
In the context of a company, it means holding the directors who manage the company responsible
for explaining their actions to the shareholders who own the company.
Auditors act in the interest of the primary stakeholders whilst having regard to the wider
public interest. The identity of the primary stakeholders in determined by reference to the statute
of agreement requiring an audit. For companies, the primary stakeholder is the general body of
shareholders.
Stewardship
Stewardship is when a person is responsible for taking care of something on behalf of another.
This is known as a Fiduciary Relationship and exists between directors and shareholders as
directors are responsible for the management of the shareholders property.
Directors or other managers of an enterprise have the responsibility of stewardship for the
property of that enterprise.
Responsibilities, which may be duties embodied in statute, may include:
Keeping books of accounts and proper accounting records;
Producing a balance sheet and income statement that show a true and fair view;
Producing a directors report which is consistent with the financial statements and contains
certain specified information
Agency
Agency is where an agent acts on behalf of a principle to perform tasks for them.
In the context of a company, the directors are the agents of the shareholders (principles) who
entrust them to manage the running of the business.
This separation of ownership and management is often referred to as the Agency Problem.
A director can be described as an agent having a fiduciary relationship with a principal (i.e.
the company that employs him).
(A fiduciary relationship is one of trust.)
In meeting their responsibilities of stewardship, managers have fiduciary duties to safeguard
assets and implement and operate an adequate accounting and internal control system.
D. The Social Concept of an Audit and its Changing Role
The social concept of audit is a special kind of examination by a person other than the
parties involved which compares performance with expectation and reports the result. It is part of
the public and private control mechanism of monitoring and securing accountability.
Changing Role of Auditing
A review of the historical development of auditing has shown that the objective of auditing
and the role of auditors are constantly changing as they are highly influenced by contextual factors
such as the critical historical events (e.g. the collapsed of big corporations), the verdict of the
courts, and technological developments (e.g. advancement of computing systems and CAATs). It
can be observed that any major changes in these contextual factors are likely to cause a change in
the audit function and the role of auditors. As a result, auditing is seen to be evolving at all times.

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CHAPTER 2: INTRODUCTION TO AUDITING

Mautz (1975, p. 2) claimed that the audit function in a market economy ultimately evolved
by social consent because:
Society either accepts or rejects the role of a professional group assumes for itself,
in time the group either finds a role acceptable to society or the group disappears.
As conditions and apparent needs change, society may reject roles formerly
considered accepted so professional groups must continually be alert to the
desirability of role modification and revision.
However, it is important to note that the change in societys expectation and the response of
the auditing profession towards these changes are not always at the same pace. Hence there is a
natural time gap between the changing expectation of the users and the response by the
profession and due to this time gap there arises what has been stated as the expectation gap or
audit expectation gap (Saha & Baruah, 2008). Even though the existence of such a natural time
gap is inevitable, Flint (1998) advises that auditors should be sensitive to the changing expectation
of the relevant groups while at the same time containing these expectations within the constraints
of what is possible. He also claims that there are inevitably economic and practical limitations on
what an audit can do, and this is something which those who wish the benefit must understand.
ROLE OF THE AUDITOR CURRENT STATE
The audit is valuable and should not be underestimated (all participants).
Although dated, a clean opinion on the financial statements and internal controls over financial
reporting provides investors with some comfort as to the other financial information provided by
management (investors and analysts).
Auditors currently evaluate certain auditable forward-looking information underlying financial
statement estimates (e.g., level 3 fair value measurements, useful lives, salvage value,
assumptions underlying post-employment benefit obligations) (auditors and former regulators).
Auditing standards require the auditor to read the annual report and identify material
inconsistencies between unaudited (e.g., MD&A) and audited (financial statement) information.
Additionally, many auditors review earnings releases for consistency with the information generated
as a part of the in-progress audit. These procedures provide value, however, many users are
unaware that these procedures are performed (audit committee and preparers).
It is not practicable for auditors to be involved in all of managements meetings and conference
calls with investors, analysts and others participants. Additionally, auditor involvement could reduce
the substance and timeliness of information provided by management (investors and preparers).
Auditors provide significant value to the audit committee and management through their audit
tests and observations relative to accounting principles, estimates, assumptions, control
environment, tone at the top, fraud risk, etc. (preparers and audit committee members).
E. Philippines Standards on Auditing (PSAs)
Philippine Standards on Auditing (PSAs)
120

Framework of Philippine Standards on Auditing

200

Objective and General Principles Governing an Audit of Financial Statements

[amended by PSA 700 (Revised)]

210

Terms of Audit Engagements [amended by PSA 700 (Revised)]

220
(Revised)

Quality Control for Audits of Historical Financial Information

230
(Revised)

Audit Documentation

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CHAPTER 2: INTRODUCTION TO AUDITING

240
(Revised
2005)

The Auditors Responsibility to Consider Fraud in an Audit of Financial Statements

250

Consideration of Laws and Regulations in an Audit of Financial Statements

260

Communications of Audit Matters with Those Charged with Governance

300
(Revised)

Planning an Audit of Financial Statements

315

Understanding the Entity and Its Environment and Assessing the Risks of Material
Misstatement

320

Audit Materiality [amended by PSA 240 (Revised 2005)]

330

The Auditors Procedures in Response to Assessed Risks

402

Audit Considerations Relating to Entities Using Service Organizations

500
(Revised)

Audit Evidence

501

Audit Evidence - Additional Considerations on Specific Items

505

External Confirmations

510

Initial Engagements--Opening Balances

520

Analytical Procedures

530

Audit Sampling and Other Selective Testing Procedures

540

Audit of Accounting Estimates

545

Auditing Fair Value Measurements and Disclosures

550

Related Parties

560

Subsequent Events [amended by PSA 700 (Revised)]

570

Going Concern

580

Management Representations [amended by PSA 240 (Revised 2005)]

600

Using the Work of Another Auditor

610

Considering the Work of Internal Auditing

620

Using the Work of an Expert

700
(Revised)

The Independent Auditors Report on a Complete Set of General Purpose Financial

Statements

701

Modifications to the Independent Auditors Report

710

Comparatives

720

Other Information in Documents Containing Audited Financial Statements

800

The Independent Auditors Report on Special Purpose Audit Engagements [amended

by PSA 700 (Revised)]

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CHAPTER 2: INTRODUCTION TO AUDITING

II. TYPES OF AUDIT
Based on primary audit objectives, there are three major types of audit- Financial, Compliance and
Operational.
Financial Statement Audit
A financial statement audit is the examination of an entity's financial statements and
accompanying disclosures by an independent auditor. The result of this examination is a
report by the auditor, attesting to the fairness of presentation of the financial
statements and related disclosures. This is an audit conducted to determine whether the
financial statements of an entity are fairly represented in accordance with an identified
financial reporting framework.
Compliance Audit
Compliance audit involves a review of an organizations procedures to determine whether
the organization has adhered to specific procedures, rules or regulations. The performances
of compliance audit is dependent upon the existence of verifiable data and recognized
criteria established by an authoritative body. A common example of this type of audit is the
examination conducted by BIR examiners to determine whether entities comply with tax
rules and regulations.
Operational Audit
An operational audit is a study of a specific unit of an organization for the purpose of
measuring its performance. The main objective of this type of audit is to assess entitys
performance, identify areas for improvement and make recommendations to improve
performance. This type of audit is also known as Performance Audit or Management
Audit.
It should be noted that, although there are different types of audit, all audits possess the same
General Characteristics. They all involve:
1. Systematic examination and evaluation of evidence which are undertaken to ascertain
whether assertions comply with established criteria; and
2. Communication of the results of the examination, usually in a written report, to the party by
whom, or on whose behalf, the auditor is appointed.
Unlike compliance and financial statement audits, where the criteria are usually defined, criteria
used in operational audit to evaluate the effectiveness and efficiency of operations are not clearly
established.
COMPARISON AMONG THE DIFFERENT TYPES OF AUDIT
Financial Audit

Compliance Audit

Operational Audit

Assertions made
by the Auditee

That the financial

statements are fairly
presented.

That the
organization has
complied with laws,
regulations or
contracts.

That the organizations

activities are conducted
effectively and efficiently.

Established
criteria

Financial reporting
standards or other
financial reporting
framework.

Laws, regulations
and contracts.

Objectives set by the

board of directors.

Content of the
auditors report

An opinion about
whether the financial
statements are fairly
presented in
conformity with an
identified financial

Reports in the
degree of
compliance with
applicable laws,
regulations and
contracts

Recommendations or
suggestions on how to
improve operations

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CHAPTER 2: INTRODUCTION TO AUDITING

reporting framework
Auditors who
generally perform

External Auditors

Government
Auditors

Internal Auditors

15