AUDITING PART I- AcFn 3161

Chapter 1
An Overview of Auditing

Learning Objectives
 Explain the general nature of auditing, and its historical development
 Distinguish between financial statement audits, compliance audits and operational
audits
 Distinguish between external and internal audits
 Distinguish between different types of auditors
 Describe how auditing differs from accounting
 Explain why financial statement audits are necessary

Introduction
The word auditing is derived from the Latin 'audire', meaning 'to listen'. Governmental
accounting records were approved only after a public hearing in which the accounts were read
aloud. A wise man – the auditor – listened carefully to a spoken description of a situation,
applied his wisdom, his professional judgment, and came to an opinion. In the course of time,
auditing has developed into a systematic undertaking that is carried out in both the private and
the public sectors and both internally and externally.

The development of auditing is to a large extent determined by the history of commerce,

accounting and bookkeeping. In ancient times, the benefit of record keeping as a support
mechanism for the determination of profit/wealth or as a decision support system for achieving
profit maximization was unknown. But at the end of the medieval period, when trade started to
flourish in Italy, the need for systematic record keeping was felt and this led to the invention of
double entry in 1494, in Italy. Another major factor was the industrial revolution that took place
in Great Britain, in 1980, which led to the emergence of large corporations. These developments
resulted in the demand for the services of book-keeping and auditing (internal and external)
financial representations.

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Factors such as Increase in complexity of business organizations, Separation of ownership and
management, Legislative control ( Issuance of laws requiring maintenance of books by
companies, qualifications of auditors, manner of their appointment, their duties, rights and
liabilities etc with a view to safeguard the interests of shareholders and also third parties, ) ,
Judicial pronouncements (Courts decisions on issues related to the legal liabilities of auditors).
and Computerized accounting (which forced the auditors to adopt new techniques and approach
to examinations of books of account and financial statements) have contributed a lot for the
development of Auditing.

1.1 Definition and Nature of Auditing

 Definition of Auditing
Various authors have defined auditing, some of the definitions are the following:
 Auditing is a systematic process of objectively obtaining and evaluating evidence
regarding assertions about economic actions and events to ascertain the degree of
correspondence between those assertions and established criteria and communicating the
results to interested users (A comprehensive definition cited in Ricchiute 1982).
 Auditing is the examination of accounting records with a view to ascertaining their
accuracy and compliance with relevant statutory provisions, accounting standards,
professional pronouncements, and the organisational policies. The Chartered Institute of
Public Finance and Accountancy (CIPFA), as cited by Johnson (1996:47), .
 Auditing is a process of reducing to a socially acceptable level the information risk to
users of financial statements (Robertson 1990).
 Auditing is a systematic examination of financial statements, records and related
operations, to determine adherence to GAAPs, management policies or stated
requirements (Robert E. Schlosser cited in Jain 1993).
 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 competent and independent person (Arens et al
2006).

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From the above definitions it is possible to understand that auditing has the following
attributes:
1. It is a systematic process involving examination of the accounting records and other
documents of an organization. This implies that auditing uses logical, structured and organized
steps and procedures.
2. It involves a task of objectively obtaining and evaluating evidence : This means that auditors
form opinion based on evidences examined and evaluated without bias and prejudice
3. Auditing is conducted by competent and independent person – it means, an auditor is
required to have the essential skill and experience and has to be independent to avoid bias.
 External auditors that provide opinion on company’s financial statements are called
independent auditors.
 Internal auditors are also required to be independent and their independence is
maintained:
o by keeping them independent of the operating units they audit
o by making the Chief Audit Executive (CAE) to report administratively to the
general manager and functionally to the audit committee of the BODs of the
company
4. It involves evaluations of evidences regarding assertions about economic actions and events:
The auditor acts as an independent third party engaged by the principal to assess the information
provided by the agent and report on the fairness of the financial statements
5. Its determines and report on the degree of correspondence between the information and
established criteria.
The essence of auditing lies in checking realities against standards. To conduct an audit, there
must be verifiable information and established criteria. Eg GAAPs for financial statement audit;
inland revenue codes for tax audit; etc
6. It involves Communicating the Results to interested users:
 Preparing the audit report is the final stage in the auditing process. The auditor’s
findings are communicated to users- eg. stockholders, management, creditors,
governmental agencies, and the public.
 To summarize, the definitions comprise the following four basic elements of auditing:

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  Independence from the matter being audited- it is conducted by competent and
independent person
 Technical works in the form of evidence gathering and the examination of
documents;
 Reporting- the expression of an opinion based on that evidence; thus reduces risk
of using incorrect and biased information.
 There is a clearly delimited audit subject matter- there must be verifiable
information and established criteria.
 The nature of auditing can also be summarized as follows:
 Competent and independent person/s → accumulate and evaluate evidence , ie,
verify if the information corresponds to the established criteria → then based on
the evaluation, audit reports are prepared.

1.2 Accounting vs. Auditing

 Many users consider auditing and accounting as similar mainly due to the following:
 Most auditing is usually concerned with accounting information
 Many auditors have considerable expertise in accounting matters
 The title “Certified Public Accountants”, is given to individuals performing audit
title
 The major raw material for auditing work comes from the accounting data and the
accounting systems which capture and process this data, Thus, understanding
these data and systems require the auditor to be a qualified accountant.
 However, the processes involved in auditing and accounting are different.
 Accounting is essentially a constructive process which involves identifying, measuring,
recording, organizing, summarizing and communicating information about economic
events.
 Auditing, on the other hand, is a critical (evaluative) process involving gathering and
evaluating audit evidences and communicating findings (about fairness of financial
statements) based on these evidences
The following points are helpful in understanding the difference between accounting and
auditing.

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Basis of difference Accounting Auditing
1. Scope It is about recording, summarizing and It is about the examination and
preparing financial reports for decision checking of accounting records and
making and interpreting them financial statement
2. Nature It is primarily constructive and concerned It is analytical in nature and
with current recording of business facts essentially retrospective
3. Objectives One of its objectives is determining the It aims at certifying the correctness
financial result of the business and of the financial statements prepared
communicating it to users by accountants
4. Qualifications Understanding GAAPs could be sufficient for the An auditor must be a Chartered
work of an accountant; thus an accountant need
Accountant; auditors must
not be a Chartered Accountant; accountants are
thoroughly understand the work of
not required to have knowledge of auditing.
accountants, they should understand
GAAPs.
5. Commencement Accounting usually starts when book- Auditing starts when the work of
keeping (the recording part of accounting) accountancy ends.
is completed
6. Knowledge An accountant need not be expert in An auditor cannot perform auditing
auditing without knowing the principles of
accountancy, knowledge of
accounting is essential
7. Duration Accounting work is undertaken Auditing is generally done at the
throughout the year end of the financial year
8. Status An accountant is a permanent employee An auditor is not a permanent
of the business employee of the business concern
and may be changed from year to
year.
9. Report An accountant is not required to submit a An auditor is required to submit the
report to the top management when the report to the top management after
accounting work is over the completion of the audit work

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1.3 Type of Audit and Auditors

1.3.1 Types of Audits

 Audit may be classified in various ways. They may be classified according to:
1. The primary beneficiary of the audit – Internal and external Audit
2. The primary objectives of the audit –Financial statement audits, Compliance audits,
Operational audits and Forensic audits
Internal Vs External Audit
 Based on primary beneficiary of the audit, ie. those for whom the audit is conducted,
audits may be classified as internal and external audit.
 Internal and external audits are different types of independent appraisal activities; each
provides unique professional responsibilities, opportunities and challenges to its
practitioners.
 Both have their root in ancient times, they had essentially the same beginning, and there
was no distinction between the two prior to nineteenth century.
Internal Audit:
 it is an audit conducted by employee of an organization into any aspect of its operation
 It is conducted for parties (usually management) internal to the entity.
 It may be performed by personnel from an outside source (such as an accounting firm
when the service is outsourced.).
 Internal auditors work focuses on investigation and appraisal of the effectiveness of the
company operations for management.
 The Institute of Internal Auditors (IIA) defined internal auditing as follows:
 “Internal auditing is an independent, objective assurance and consulting activity designed
to add value and improve an organization's operations. It helps an organization
accomplish its objectives by bringing a systematic, disciplined approach to evaluate and
improve the effectiveness of risk management, control, and governance processes”.
 It is conducted in accordance with management's requirement
 The requirements may be wide-ranging or narrowly-focused, and continous (ongoing) or
one-off in nature.

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  For example, it may be as broad as investigating the appropriateness of, and level of
compliance with, the organization’s systems of internal control, or as narrow as
examining the entity’s policies and procedures for ensuring compliance with health and
safety regulations.
 Internal auditors must be independent of the department heads and other executives
whose work they review.
 Internal auditors, however, can never be independent in the same sense as the
independent auditors because they are employees of the company they are examining.
 Two ways of maintaining independence for IA:
1. Reporting to the audit committee (Reporting to a level in the organization that does not
affect its independence)
2.making internal auditors independent from the activities they audit
External Audit
 It is an audit performed for parties external to the auditee.
 Experts, independent of the auditee and its personnel, conduct these audits in accordance
with requirements which are defined by or on behalf of the parties for whose benefit the
audit is conducted.
 The best known and most frequently performed external audits are statutory audits (audits
carried out because the law requires them of compliances)’ and public sector entities
financial statements (ie financial statement audits).
 Compliance audits conducted by Customs office and the Inland Revenue are also
examples of external audits.
 External audits are also described as a societal control which serves the needs of internal
and, more importantly, external financial information users.
 External auditors conduct opinion audit

Difference between IA and EA

Internal Audit (IA) External Audit (EA)
Is performed by an organization’s employee or by an Is performed by an independent contractor
independent entity (outsource or co-source)

Main purpose - to aid management in achieving the Main purpose - the expression of opinion on

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most efficient administration of the business client’s financial statements
Not limited to accounting controls, IAs also monitor Limited to the examination of financial
administrative control; they appraise effectiveness of
statements
internal control in various departments, branches or
other organizational unit of the company
Serves needs of the organization, though the function Sevres third parties who need reliable financial
must be managed by the organization statements
Its responsibility is to the organization and all of its Has a statutory responsibility to parties outside
stakeholders the client company
Focuses on future event by evaluating the adequacy Focuses on the accuracy and understandability
and effectiveness of systems of risk management and of events expressed in financial statements
internal control, to assure the accomplishment of (whether F/Ss show a true and fair view),
entity goals and objectives
Seeks to advise management on whether its major Seeks to test the underlying transactions that
operations have sound systems of risk management form the basis of the financial statements
and internal controls
Is directly concerned with the prevention of fraud in Is incidentally concerned with the prevention
any form or extent in any activity reviewed and detection of fraud in general, but directly
concerned when financial statements may be
materially affected
Is independent of the activities audited, but is ready to Is independent of management and the board
respond to the needs and desires of all elements of of directors both in fact and in mental attitude
management
Reviews activities continually Reviews records supporting financial
statements periodically, usually once in a year
Internal auditors are “business generalists” who Are CPAs
specialize in efficiency and effectiveness for the good
of the organization (interdisciplinary)
No obligation to repeat their audits in an annual basis Each significant items in the financial
statements is examined annually
The techniques used in financial audits by both may be similar so internal and external auditors should
coordinate their efforts. Effective internal audit serves as a deterrent to fraud and inefficiency and makes the work
of the external auditors easier, this in turn will reduce the cost of audit for the organization..

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 Point of differences can also be summarized as follows:
Internal Audit External Audit
Objective Sound risk management Accounts=true and fair view
Scope of work Overall systems: VFM, Fraud, MIS and Accounts, profit and loss
Compliance accounts, balance sheet, annual
reports and financial systems
Independence From operations by professionalism and From company via statutory
status rights and APB codes
Structure Varies: CAE, managers, seniors and Partners, managers, seniors and
assistances trainees
Staff Competent persons trained in internal Qualified and part qualified
auditing accountants
Methodology Risk-based systems-based audits, Vouching and verification and
assurance and consulting works some use of risk based systems
approach
Reports Comprehensive structured reports to Brief standardized published
management and the audit committee and reports to shareholders and users
brief executive summaries of accounts

Standards IIA and/or others Various APB requirements

Legislation Generally not mandatory apart from parts Companies legislation and various
of public sector but encouraged in most public sector statutes
sectors
Size Only larger organizations All registered companies and
public sector (small companies
may have exemptions)

Financial, Compliance and Performance Audit

 CPAs perform three major types of audits:
1. Financial statement audit
2. Compliance audit
3. Operational audit
Financial statement audit
 It examines whether financial statements give true and fair view of or fairly
represent the financial position, result and cash flows
 The results of financial statement audits are distributed to a wide spectrum of
users such as shareholders, creditors, regulatory agencies, and the general public
through the auditors report on financial statements.

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  In addition, the external auditor also prepares a report to the audit committee of
the board of directors, about the company’s accounting policies, internal controls
and other audit findings.
 Financial statement audits for major corporations are indispensible to the functioning of
securities markets, as many users rely on financial statement audits to obtain assurance
about the reliability of information used to support investment decisions.
 As the complexity of businesses increase, it is not sufficient for auditors to focus on
accounting transactions to determine whether financial statements are fairly stated or not.
 Thus, an integrated approach to auditing is essential since it considers both the risk of
errors and operating controls intended to prevent errors.
Compliance audit
 A compliance audit is a review of an organization’s procedures to determine whether
certain financial or operating activities of an entity confirm to specified conditions,
procedures, rules, or regulations set by some higher authority.
 A compliance audit measures the compliance of an entity with established criteria.
 The established criteria in this type of audit may come from a variety of sources. Eg
creditors, govt
 Compliance audits are usually associated with government auditors
 -eg tax authority, the government internal auditing arm, or audit of bank by
banking regulators eg to determine if banks comply with capital reserve
requirements.
 Results of compliance audit are also reported to the management within the
organizational unit being audited.
Operational audit
 This type of audit is sometimes referred to as a performance audit or a management audit.
 It is usually initiated by the entity’s management and is conducted by competent,
experienced professionals (internal or external to the organization) who report their
findings to management.
 An operational audit may apply to the organization as a whole or to a segment of the
organization, such as subsidiary, division or department.

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  The objective of the audit may be broad, for example, to improve the overall efficiency of
the entity or narrow and designed for example, to solve a specific problem such as
excessive staff turnover.
 Since criteria for effectiveness and efficiency are not as clearly established as GAAPs
and laws, an operational audit tends to require more subjective judgment than audits of
financial statements or compliance audit.
 Purpose of Operational Audit:
 Appraisal of controls, compliance, protection of assets, verification, appraisal of
performance and recommendations for operating improvements
1. Appraisal of controls- determining whether controls are sound and adequate
2.Compliance- determining whether specific control policies, programs, or procedures are
operating satisfactorily. Controls have no use if not complied with.
3.Protection of assets - testing the effectiveness of control systems designed to protect assets
4.Verification- Internal reports are verified to promote accuracy and reliability of information
5. Appraisal of performance- evaluations of performances
6.Recommendations for operating improvements- reports on operational audits typically include
not only an assessment of efficiency and effectiveness, but also recommendations for
improvement.

Forensic audit
 The purpose of forensic audit is the detection or deterrence of a wide variety of
fraudulent activities. The use of auditors to conduct forensic audits has grown
significantly, especially where the fraud involves financial issues. Some examples where
a forensic audit might be conducted include:
 Business or employee fraud,
 Criminal investigation, Shareholder or partnership disputes,
 Business economic losses and Matrimonial disputes (divorce proceedings).
 For example, in a business fraud engagement, an audit might involve tracing funds or
asset identification and recovery. An employee fraud investigation might involve the
existence, nature, extent, and identification of the perpetrator of asset misappropriation.
A forensic audit can also be conducted to trace and locate assets in a divorce proceedings.

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  Some reading materials classify audits as Statutory Audits - audits carried out because the
law requires them (eg audit of F/S); Private Audits – audits conducted into a firm’s
affairs by independent auditors because owners desire it, not because the law requires it.
Eg. Audits of the accounts of sole traders and partnerships; Internal Audits- an audit
conducted by employee of an organization into any aspect of its operation and
Management Audit- an inquiry into the effectiveness of the management. However, the
common classifications are the one discussed earlier.

1.3.2 Types of Auditors

 Basically, auditors are divided into independent/external auditors and internal auditors.
Governmental auditors take both the functions of internal and external auditors.
 Depending on the skills they possess and the activities they conduct, auditors can also be
commonly classified as:

1. Certified Public Accounting Firms (Independent Auditors)

2. Government Accountability Office Auditors, (Government Auditors)
3. Internal Revenue Agents,
4. Internal Auditors.
5. Forensic Auditors

1. Certified Public Accounting Firms (Independent Auditors)

 These are CPAs who are either individual practitioners or members of public accounting
firms who render services to clients.
 The title CPA/CPA firms indicate that those who express an audit opinions on financial
statements should be licensed as CPAs.
 Licensing involves passing the uniform CPA/ACCA examinations and obtaining
practical experience in auditing (from one to three years of professional experience).
 It is by virtue of their education, training and experience that independent auditors are
qualified to perform an audit.

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  The CPA certificate is not only a license to practice but also a symbol of technical
competence. This official recognition by the state is comparable to that accorded to the
legal, medical, and other professions.
 They provide services to clients on fee basis
2. Government Accountability Office Auditors, (Government Auditors)
 Government auditors are employed by various local, state, and federal governmental
agencies.
 They conduct comprehensive audits which combine elements of financial report,
compliance and performance auditing.
 In US, the US Government Accountability Office (GAO) is a nonpartisan agency in the
legislative branch of the federal govt.
 GAO contains the Congress’s audit staff and is headed by the Comptroller General.
 The audit staff reports to the Congress which implies that the Congress has its own audit
staff from which it receives reports.
 GAOs assignment include:
 audits of government agencies
 Operational audits
 examinations of corporations holding government contracts
 In Ethiopia, Auditor General Office performs audit of Governmental Offices & Public
Sector entities such as hospitals and educational institutions.
 These auditors perform Value-for Money Audits as part of Comprehensive Auditing.
 Comprehensive Auditing has three facets:
 The traditional financial attest audit,
 A compliance audit-in the private sector, the auditor tests compliance with
corporate policies, including those on control procedures,; in the public sector, the
auditor tests compliance with government statutes;
 The Value for Money or operational Audit, which evaluates economy, efficiency
and effectiveness. Effectiveness refers to the accomplishment of objectives while
efficieny refers to the resources used to achieve those objectives. Economy
means that resources are acquired in appropriate quantities when needed at the
right price. The auditor will asses whether financial, human, and physical

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 resources are managed with due regard to Economy, efficiency and Effectiveness
(3Es).
Internal Revenue Agents
 Tax laws are defined by the highest organ of the government of a country, interpreted by
courts and enforced by the internal revenue offices.
 Internal revenue agents are auditors who are responsible to determine whether tax payers
returns/tax liabilities are properly calculated, recorded and paid to the government.
 They basically perform compliance audit.
 Tax laws are highly complicated, there are different types of taxes (individual, estate,
corporate, gift etc), and they can be interpreted in many ways under different
jurisdictions.
 Thus auditors assigned in this area should have sufficient knowledge about tax laws and
the skill to conduct an effective audit.
Internal Auditors
 Internal auditors are employees of the organization they audit;
 They are employed by individual companies to investigate and appraise the effectiveness
of company operations for management.
 Internal auditors audit for management, much as GAO does for Congress.
 Much of their attention is given to the appraisal of internal controls (the study and
evaluation of both accounting and administrative controls).
 The scope of the internal audit function extends to all phases of organizational activities.
 A large part of their work consists compliance audit and operational audits. In many
countries internal auditors are highly involved in financial audits.
 Internal auditors report directly to the highest authority in an organization or to the audit
committee of the BODs.
 This strategic placement high in organization structure helps to assure that internal audits
will have ready access to all units of the business, and that their recommendations will be
given prompt attention by department heads.
Forensic Auditors
 Forensic auditors are employed by corporations, government agencies, public accounting
firms, and consulting and investigative services firms.

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  They are trained in detecting, investigating, and deterring fraud and white-collar crime.
Some examples of situations where forensic auditors have been involved include:
 Analyzing financial transactions involving unauthorized transfers of cash between
companies
 Reconstructing incomplete accounting records to settle an insurance claim over
inventory valuations;
 Identifying money-laundering activities by reconstructing cash transactions
 Investigating and documenting embezzlement, and negotiating insurance
settlements.

Comparisons of External, Internal and Governmental Auditors:

External/Independent Auditors Internal Auditors Governmental Auditors
CPA’s who are hired as independent Company employees Local, state or federal
contractors by many different who audit their own employees who may audit their
companies company exclusively own organization or other
governmental organizations.
Perform mostly financial statement Perform mainly Perform mostly compliance
audits operational audits audits
Examine financial statement assertions Examine all or part of Examine person’s or entity’s
organization’s activities actions
Criterion is GAAPs Criteria are the Criteria are policies, codes,
efficiency and/or laws, regulations, etc.
effectiveness of the
company’s operations
Report on fairness if financial Report on Report on compliance with
statement in conformity with GAAPs recommended criteria
improvements
Report goes to many different types of Report usually goes to Report usually goes to a
users the company itself specific agency

1.4 Economics of Auditing

Why Auditing is needed?

 It is evident that relevance and reliability are the two primary qualities that make
accounting information useful for decision.
 Users of financial statement look to independent auditor’s report for assurance about the
reliability of information and are conformance to GAAPs (a measure of relevance of
financial information).

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The Concept of Business Risk and Information Risk
 Economic activities take place in an atmosphere of business risk, which includes
inflation, competitors, increased tax, government may discontinue subsidies, employees
my strike and so on.
 Auditors do not directly influences a company’s business risk, but have significant effect
on information risk.
 Information Risk is a risk that results from inaccurate financial statements - the risk that
the financial statements may be incorrect, incomplete, biased or misleading (not reliable,
not relevant). Auditing is needed since it reduces information risk.
 Eg banks and other financial institutions reduce information risk by relaying on
audited financial statements of borrowers.
 The answers to the following three basic questions help to understand causes of
information risk and the importance of auditing to reduce this risk:
 Why the information reported by management might not be reliable?
 Why is it so important to the users of the information that the information is
reliable?
 Why not users audit the information they received by themselves, why do they
need independent auditors to audit?
The American Accounting Association’s (AAA) Committee on Basic Auditing Concepts (1973)
summarized the criteria that create the demand for auditing or the major causes of information
risks that justify auditing as follows:
(Causes of Information Risk and the Need for Auditing) :
Auditing is needed due to the following:
1. Conflict of interest,
2. Consequences of error,
3. Remoteness
4.Volume & complexity of transaction.
1. Conflict of interest
If information is provided by someone whose goal is different/inconsistent from the decision
maker, the information may be biased in favor of the provider.

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Eg. between borrowers and lenders; board of directors and the owners of a corporation; b/n tax
payers and the government
 Thus, there is a potential conflict of interest between the preparers and users of
the financial statements.
 Eg, when borrowers prepare financial statements to lenders, there is a chance that they
may bias the information to increase the chance of obtaining the loan. They may report
wrong amount or fail to disclose important information, eg, about liabilities and other
commitments.
 In corporate form organizations , since ownership is separated from control,
stewardship and stewardship accounting justify the concept of auditing.
 The directors report on the performance of the business and independent auditors
ensure the fairness of the reports ( financial statements) prepared by the directors.
 Auditing plays a vital role in helping to ensure that directors provide, and users
are confident in receiving information which is a fair representation of company’s
financial affairs.
 Income tax from individuals and organizations is a major source of revenue for
the government. Tax payers may understate income because of self interest. The
government used audited financial statements and reports of organization in order
to reduce the risk of incorrect and biased information.
 Thus audit plays a vital role in helping to ensure that preparers of financial
statement provide, and users are confident in receiving information which is a fair
representation of entity’s financial affairs.
2. Consequence of Error
 If financial statement users base their decisions on unreliable and misleading
financial statements, they may suffer serious financial loss.
3. Remoteness
 Legal, physical, and economic factors, constrain users not to verify for themselves the
reliability of the information contained in the financial statements.
eg.- owners have no legal right to access company’s books and records

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 - In many cases top management of a corporation is remote from the operation (the
plant) thus rely on information prepared by others, which implies the existence of a risk that
information may be inaccurate;
-users may not afford the time, expense and expertise of checking financial statements
for themselves
4. Volume and Complexity of transactions
 As companies grow in size, the volume of their transactions have also increased, this in
turn will increase the chance that transactions may be recorded improperly.
 When many minor misstatements remain undiscovered, the combined to total will be
significant and affect the dependability of financial statements and other reports.
 Further, especially in recent years, economic transactions and the accounting systems
which capture and process the, have become very complex.
 Both the subject matter of accounting and the process of preparing financial statements
have become increasingly complex. Thus all these complexities show the increasing
need for auditing
 The four conditions collectively contribute to information risk.
 Investors, creditors, labor organizations, government and private analysists, and others
depend on reliable information to be risk free.
 Auditors assume a social role of attesting to published financial information, thereby
offering users some assurance that the information risk is low.
 In sum, auditing is a risk reduction activity and enhance the credibility of financial
statement by reducing information risk
Economic Benefits of an Audit
 Access to capital market
 Without audits, companies would be denied access to these capital markets (eg.
the requirement that without audit, companies cannot register securities and trade
on securities market) and may private companies would be denied access to loans.
 Low Cost of capital: Because of the reduced information risk associated with
audited financial statements, creditors may offer loans with lower interest rates to
borrowers.

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  Deterrent to inefficiency and fraud:
 Research has showed that when employees know that an independent audit is to
be made, they care to take fewer errors in performing accounting functions and
are less likely to misappropriate company assets.
 Thus, the data in company records will be more reliable, and losses from
embezzlements and the like will be reduced.
 In addition, the fact that financial statement assertions are to be verified reduces
the likelihood that management will engage in fraudulent financial reporting.

 Control and Operational improvements:

 Based on observations made during a financial statement audit, the independent auditor
often makes suggestions to improve internal control, to evaluate management’s
assessments of business risks, to recommend improved performance measures, and to
make recommendations to achieve greater operational efficiencies within the client’s
organization.
 These benefits are especially valuable to small and medium-sized companies.
 In sum, auditing is beneficial since it reduces information risk that is caused by factors
such as biases and motives of the provider (conflict of interest), errors, remoteness of
information, voluminous and complexity of data.
Limitation of an Audit
 Reasonable Cost: a limitation on the cost of an audit results in selective testing, or
sampling, of the accounting records and supporting data.
 Reasonable Length of Time: usually there is a time constraint, and this may affect the
amount of evidence that can be obtained concerning subsequent events, and the time may
not be sufficient to resolve uncertainties existing at the statement date.
Limitations associated with the accounting system:
 Alternative Accounting Principles: alternative accounting principles are permitted
under GAAP/, and it is the user that must be knowledgeable about a company’s
accounting choices and their effect of financial statements.

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  Accounting estimates: estimates are inherent part of the accounting process, thus
uncertainties exist. An audit cannot add exactness and certainty to financial
statements when these factors do not exist.

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