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Fundamentals of Auditing

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Fundamentals of Auditing ­ACC 311
VU
Lesson 02
Fundamentals of Auditing
Auditing ­ An Introduction
What is an auditor's report?
The primary aim of an audit is to enable the auditor to say "these accounts show a true and fair view" or, of
course, to say that "they do not show a true and fair view".
At the end of his audit, when he has examined the entity, its record, and its financial statements, the auditor
produces a report addressed to the owners/stake holders in which he expresses his opinion of the truth and
fairness, and sometimes other aspects, of the financial statements.
Standard format of Auditor's Report as per the Companies Ordinance 1984:
FORM 35A
AUDITORS' REPORT
We have audited the annexed balance sheet of COMPANY NAME as at THE DATE and the related profit
and loss account, cash flow statement and statement of changed in equity together with the notes forming
part thereof, for the year then ended and we state that we have obtained all the information and
explanations which to the best of our knowledge and belief were necessary for the purposes of our audit.
It is the responsibility of the company's management to establish and maintain a system of internal control
and prepare and present the above said statements in conformity with the approved accounting standards
and the requirements of the Companies Ordinance, 1984. Our responsibility is to express an opinion on
these statements based on our audit.
We conducted our audit in accordance with the auditing standards as applicable in Pakistan. These
standards require that we plan and perform the audit to obtain reasonable assurance about whether the
above said statements are free of any material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the above said statements. An audit also includes
assessing the accounting policies and significant estimates made by management, as well as evaluating the
overall presentation of the above said statements. We believe that our audit provides a reasonable basis for
our opinion and, after due verification, we report that:
a) In our opinion, proper books of accounts have been kept by the company as required by the
Companies Ordinance, 1984
b)  In our opinion:
i. The balance sheet and profit and loss account together with the notes thereon have been
drawn-up in conformity with the Companies Ordinance, 1984, and are in agreement with the
books of account and are further in accordance with accounting policies consistently applied
ii. The expenditure incurred during the year was for the purpose of the company's business; and
iii. The business conducted investments made and the expenditure incurred during the year were
in accordance with the objects of the company.
c) In our opinion and to the best of our information and according to the explanations given to us, the
balance sheet, profit and loss account, cash flow statement and statement of changes in equity together
with the notes forming part thereof conform with approved accounting standards as applicable in
Pakistan and, give the information required by the Companies Ordinance, 1984, in the manner so
required and respectively give a true and fair view of the state of the company's affairs as at DATE and
of the profit/loss its cash flows and changes in equity for the year then ended; and
d) In our opinion Zakat deductible at source under the Zakat and Usher Ordinance, 1980 was deducted by
the company and deposited in the Central Zakat Fund established under Section 7 of that Ordinance.
Date
Signature
Place
(Name(s) of Auditors)
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Fundamentals of Auditing ­ACC 311
VU
Standard format of Auditor's Report as per the International Auditing Standards:
INDEPENDENT AUDITOR'S REPORT
[Appropriate Addressee]
Introductory Paragraph
We have audited the accompanying financial statements of ABC Company, which comprise the balance
sheet as at December 31, 20X1, and the income statement, statement of changes in equity and cash flow
statement for the year then ended, and a summary of significant accounting policies and other explanatory
notes.
Management's Responsibility for the Financial Statements
Management is responsible for the preparation and fair presentation of these financial statements in
accordance with International Financial Reporting Standards. This responsibility includes: designing,
implementing and maintaining internal control relevant to the preparation and fair presentation of financial
statements that are free from material misstatement, whether due to fraud or error; selecting and applying
appropriate accounting policies; and making accounting estimates that are reasonable in the circumstances.
Auditor's Responsibility
Our responsibility is to express an opinion on these financial statements based on our audit. We conducted
our audit in accordance with International Standards on Auditing. Those standards require that we comply
with ethical requirements and plan and perform the audit to obtain reasonable assurance whether the
financial statements are free from material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the
financial statements. The procedures selected depend on the auditor's judgment, including the assessment
of the risks of material misstatement of the financial statements, whether due to fraud or error. In making
those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair
presentation of the financial statements in order to design audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal
control. An audit also includes evaluating the appropriateness of accounting policies used and the
reasonableness of accounting estimates made by management, as well as evaluating the overall presentation
of the financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our
audit opinion.
Opinion
In our opinion, the financial statements give a true and fair view of (or" present fairly, in all material
respects,") the financial position of ABC Company as of December 31, 20X1, and of its financial
performance and its cash flows for the year then ended in accordance with International Financial
Reporting Standards.
Report on Other Legal and Regulatory Requirements
[Form and content of this section of the auditor's report will vary depending on the nature of the auditor's
other reporting responsibilities.]
[Auditor's signature]
[Date of the auditor's report]
[Auditor's address]
What stands for auditor's opinion?
The auditor, in his report, does not say that the financial statements do show a true and fair view. He can
only say that in his opinion the financial statements show a true and fair view. The reader or user of
financial statements will know from his knowledge of the auditor whether or not to rely on the auditor's
opinion. If the auditor is known to be independent, honest, and competent, then his opinion will be relied
upon.
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Fundamentals of Auditing ­ACC 311
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What are the different types of audit?
Three types of audits are discussed in general, i.e.,
1. Financial statement audits
2. Operational audits
3. Compliance audits
Financial Statement Audits
An audit of financial statements is conducted to determine whether the overall financial statements (the
quantifiable information being verified) are stated in accordance with specified criteria. Normally, the
criteria are the requirements of the applicable International Financial Reporting Standards (IFRSs) and the
Companies Ordinance 1984. The financial statements most commonly comprises of the Balance Sheet,
Income Statement, Statement of Changes in Equity, Cash Flow Statement, and Notes to the accounts.
The assumption underlying an audit of financial statements is that these will be used by different groups for
different purposes. Therefore, it is more efficient to have one auditor who will perform an audit and draw
conclusions that can be relied upon by all users than to have each user perform his or her own audit. If a
user believes that the general audit does not provide sufficient information for his or her purposes, the user
has the option of obtaining more data. For example, a general audit of a business may provide sufficient
financial information for a banker considering a loan to the company, but a corporation considering a
merger with that business may also wish to know the replacement cost of fixed assets and other information
relevant to the decision. The corporation may use its own auditors to get the additional information.
Operational Audits
An operational audit is a review of any part of an entity's operating procedures and methods for the
purpose of evaluating efficiency and effectiveness. At the completion of an operational audit,
recommendations to management for improving operation are normally expected.
An example of an operational audit is evaluating the efficiency and accuracy of processing payroll
transactions in a newly installed computer system. Another example, where most accountants would feel
less qualified is evaluating the efficiency, accuracy, and customer satisfaction in processing the distribution
of letters and parcels by a courier company such as TCS.
Because of the many different areas in which operational effectiveness can be evaluated, it is impossible to
characterize the conduct of a typical operational audit. In one organization, the auditor might evaluate the
relevancy and sufficiency of the information used by management in making decisions to acquire new fixed
assets, while in a different organization the auditor might evaluate the efficiency of the paper flow in
processing sales.
In operational auditing, the reviews are not limited to accounting. They can include the evaluation of
organization structure, computer operations, production methods, marketing, and any other area in which
the auditor is qualified.
The conduct of an operational audit and the reported results are less easily defined than for either of the
other two types of audits. Efficiency and effectiveness of operations are far more difficult to evaluate
objectively than compliance or the presentation of financial statements in accordance with accounting
conventions and principles; and establishing criteria for evaluating the quantifiable information in an
operational audit is an extremely subjective matter.
In this sense, operational auditing is more like "management consulting" than what is generally regarded as
"auditing". Operational auditing has increased in importance in the past decade.
Compliance Audits
The purpose of a compliance audit is to determine whether the entity is following specific procedures, rules,
or regulations set down by some higher authority.
A compliance audit for a private business could include determining whether accounting personnel are
following the procedures prescribed by the company controller, reviewing wage rates for compliance with
minimum wage laws, or examining contractual agreements with bankers and other lenders to be sure the
company is complying with legal requirements.
In the audit of governmental units such as districts school, there is extensive compliance auditing due to
extensive regulation by higher government authorities. In virtually every private and non profit organization,
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Fundamentals of Auditing ­ACC 311
VU
there are prescribed policies, contractual agreements, and legal requirements that may call for compliance
auditing.
Results of compliance audits are typically reported to someone within the entity being audited rather than to
a broad spectrum of users.
Management, as opposed to outside users, is the primary group concerned with the extent of compliance
with certain prescribed procedures and regulations. Hence, a significant portion of work of this type is done
by auditors employed by the entity itself.
There are exceptions; when an organization wants to determine whether individuals or entities that are
obligated to follow its requirements are actually complying, the auditor is employed by the entity issuing the
requirements.
An example is the auditing of taxpayers for compliance with the federal tax laws, where the auditor is
employed by the government to audit the taxpayers' tax returns.
Following table summarizes the three types of audits and includes an example of each type and an
illustration of three of the key parts of the definition of auditing applied to each type of audit.
Examples of the Three Types of Audits
TYPES OF
EXAMPLE
QUANTIFIABLE
ESTABLISHED
AVAILABLE
AUDIT
INFORMATION
CRITERIA
EVIDENCE
Financial
Annual Audit of
General Motors
International
Documents,
Statement Audit
General Motors'
financial statements
Financial
records, and
financial
Reporting
outside sources
statements
Standards
of evidence
Operational
Evaluate whether
Number of payroll
Company
Error reports,
Audit
the computerized
records processed
standards for
payroll records,
payroll processing
in a month, costs of
efficiency and
and payroll
for subsidiary is
the department, and
effectiveness in
processing costs
number of errors
payroll
operating
made
department
efficiently and
effectively
Compliance
Determine if
Company records
Loan agreement
Financial
Audit
bank
provisions
statements and
requirements for
calculations by
loan continuation
the auditor
have been met
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Table of Contents:
  1. AN INTRODUCTION
  2. AUDITORSí REPORT
  3. Advantages and Disadvantages of Auditing
  4. OBJECTIVE AND GENERAL PRINCIPLES GOVERNING AN AUDIT OF FINANCIAL STATEMENTS
  5. What is Reasonable Assurance
  6. LEGAL CONSIDERATION REGARDING AUDITING
  7. Appointment, Duties, Rights and Liabilities of Auditor
  8. LIABILITIES OF AN AUDITOR
  9. BOOKS OF ACCOUNT & FINANCIAL STATEMENTS
  10. Contents of Balance Sheet
  11. ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
  12. Business Operations
  13. Risk Assessment Procedures & Sources of Information
  14. Measurement and Review of the Entityís Financial Performance
  15. Definition & Components of Internal Control
  16. Auditing ASSIGNMENT
  17. Benefits of Internal Control to the entity
  18. Flow Charts and Internal Control Questionnaires
  19. Construction of an ICQ
  20. Audit evidence through Audit Procedures
  21. SUBSTANTIVE PROCEDURES
  22. Concept of Audit Evidence
  23. SUFFICIENT APPROPRIATE AUDIT EVIDENCE AND TESTING THE SALES SYSTEM
  24. Control Procedures over Sales and Debtors
  25. Control Procedures over Purchases and Payables
  26. TESTING THE PURCHASES SYSTEM
  27. TESTING THE PAYROLL SYSTEM
  28. TESTING THE CASH SYSTEM
  29. Controls over Banking of Receipts
  30. Control Procedures over Inventory
  31. TESTING THE NON-CURRENT ASSETS
  32. VERIFICATION APPROACH OF AUDIT
  33. VERIFICATION OF ASSETS
  34. LETTER OF REPRESENTATION VERIFICATION OF LIABILITIES
  35. VERIFICATION OF EQUITY
  36. VERIFICATION OF BANK BALANCES
  37. VERIFICATION OF STOCK-IN-TRADE AND STORE & SPARES
  38. AUDIT SAMPLING
  39. STATISTICAL SAMPLING
  40. CONSIDERING THE WORK OF INTERNAL AUDITING
  41. AUDIT PLANNING
  42. PLANNING AN AUDIT OF FINANCIAL STATEMENTS
  43. Audits of Small Entities
  44. AUDITORíS REPORT ON A COMPLETE SET OF GENERAL PURPOSE FINANCIALSTATEMENTS
  45. MODIFIED AUDITORíS REPORT