CHAPTER TWO

GENERALLY ACCEPTED AUDITING STANDARDS AND TYPES OF AUDIT REPORTS

2.1. What is Auditing Standard?

Auditing standards are general guidelines to aid
auditors in fulfilling their professional responsibilities.
Auditors are required to follow certain standards in
conducting audit work.
Although countries may develop and follow their
own standards, the American Institute of Certified
Public Accountants (AICPA) develops auditing
standards for the proper conduct of financial
statement audits.
Hence, it has developed ten standards divided into
three categories as general standards (3 in number),
standards of fieldwork (3), and standards of reporting
(4).
2.2. Generally Accepted Auditing Standards(GAAS)

The 10 GAAS, which were developed by the AICPA

fall into three categories:
 Generalstandards, Standards of field work, and Reporting
standards
2.2.1. General Standards
The general standards stress the important personal
qualities that the auditor should possess.
1. The auditor must have adequate technical training
and proficiency to perform the audit.
2. The auditor must maintain independence in mental
attitude in all matters relating to the audit.
3. The auditor must exercise due professional care in
the performance of the audit and the preparation of
the report.
2.2.2. Standards of Field Work
 The standards of field work concern evidence
accumulation and other activities during the actual
conduct of the audit.
1. The auditor must adequately plan the work and
must properly supervise any assistants.
2. The auditor must obtain a sufficient understanding
of the entity and its environment, including its
internal control, to assess the risk of material
misstatement of the financial statements whether
due to error or fraud, and to design the nature,
timing, and extent of further audit procedures.
3. The auditor must obtain sufficient appropriate
audit evidence by performing audit procedures to
afford a reasonable basis for an opinion regarding
the financial statements under audit.
2.2.3. Standards of Reporting
 The four reporting standards require the auditor to
prepare a report on the financial statements taken as a
whole, including informative disclosures.
1. The auditor must state in the auditor’s report whether
the financial statements are presented in accordance
with GAAP.
2. The auditor must identify in the auditor’s report those
circumstances in which such principles have not been
consistently observed in the current period in relation to
the preceding period.
3. When the auditor determines that informative
disclosures are not reasonably adequate, the auditor
must so state in the auditor’s report.
4. The auditor must either express an opinion regarding
the financial statements, taken as a whole, or state that
an opinion cannot be expressed, in the auditor’s report.
 2.3 Professional Ethics
Ethics is discipline dealing with
good and evil, and with moral duty.
(AICPA) has adopted six broad
ethical principles.
Those are fundamental principles
and guidelines on which ethical
standards of auditors are based.
 1) Integrity: A professional accountant
should be straightforward and honest in
performing professional services.
 2) Objectivity: The principle of objectivity
imposes the obligation on all professional
accountants to be fair, intellectually
honest and free of conflicts of interest.
 3) Professional Competence: A
professional accountant in agreeing to
provide professional services implies that
he is competent to perform the services.
 4) Confidentiality: Professional
accountants have an obligation to respect
the confidentiality of information about a
client's (or employer's) affairs acquired in
the course of professional services.
 5) Professional Behavior: An accountant
should act in a manner consistent with the
good reputation of the profession.
 6) Technical Standards: Professional
services should be carried out in accordance
with the relevant technical and professional
standards.
The code of ethics for auditors
has the following important parts:
(1) Independence, integrity and
objectivity
(2) Minimum competence and
technical standards
(3) Responsibility to client and
colleague
 (3) Independence, Integrity
and Objectivity
 According to this code of ethics, an auditor
should be independent, have integrity, and
be objective.
 Independence refers to the auditors’
freedom from control or influence of others.
 Objectivity indicates the auditors’ ability to
judge based on observable phenomena and
be uninfluenced by emotions or personal
prejudices.
 An auditor's independence may be
impaired in one or a combination of the
following situations.
i. Financial involvement with
clients and appointments in
companies
ii. Services to audit clients,
personal and family relationships
iii. Fees, Goods and Services:
Ownership of the capital of an
auditing firm
 (2) Minimum Competence
and Technical Standards
 The second code of ethics states that an
auditor should not accept an engagement
unless she/he has the necessary skills to do it
well.
 This requirement includes knowledge of GAAP
as well.
 Besides, once the auditor accepts the duty,
she/he has to work carefully.
 That means she/he has to plan adequately and
should supervise any junior staff members.
 Furthermore, an auditor's work should be
complete.
(3) Responsibilities to Clients

 Confidentiality: An auditor should maintain

any information forwarded to him by a client
as a result of his privileged position
confidentially.
 Audit Report: Auditors should prepare audit
reports timely (based on their agreement
with their client)
 Fees: Auditing services should be priced via
fees and commissions. And computation of
fees should be on the basis of appropriate
rates per hour or per day for the time of
each person involved in the services.
 2.4 Legal Responsibility and
Liability of Auditors
 Before you directly move to study the
section, it is better to understand the
nature of audit contracts.
 Normally a company that needs auditing
services first contacts an auditor and
deals with the terms.
 The terms of an audit work includes fees,
the type of work to be done, date of
issuing the report, etc.
 Once an agreement is reached, it signs
audit contract with the auditor.
 Definition of key words

Breach of Contract: failure to

perform the obligations or duties of
a contract.
Civil liability: liability that occurs
when the rights of a specific
individual or group of individuals is
violated. Tort falls under civil
liability.
Criminal liability: liability that
occurs when an act, considered to
 Constructive Fraud: reckless disregard of
facts. Fraud is assumed even without proof
of intent to deceive. It is sometimes used
interchangeably with gross negligence.
 Gross Negligence: an extreme deviation
from professional standards of due care (or
absence of minimum care). Practically for
auditors it means failure to detect a
misstatement that should have been
detected by the application of GAAS
Due diligence: adherence to GAAP and
GAAS in performing an audit. It is an
auditor’s defense in court.
Express: something which is written
(expressed) in a contract.
Implied: something that is not actually
written but is normally expected from a
contract.
Fraud: an intentional act of deceit,
designed to get an unjust advantage
that results in an injury on others.
Liable: legally bound, under obligation,
having a duty, having no choice.
Material: a fact that influences the
decisions of a person.
Privities of a contract: contractual
relationship between two parties that
creates a duty. In audit contract the
auditor and the client posses express
privities of contract, sometimes privities
of contract is implied to third parties.
Tort: a private wrong other than
contractual, i.e. personal injury or
property damage, resulting from
negligence. A person who suffers
damage of such type may get
redress in a law of court.
An auditor is responsible to
perform her/his duty in
accordance with the contract –
expressed or implied.
She/he has to provide an
objective opinion on the faire
presentation of financial
statements.
However, she/he is said to be
failed to perform: -
(1) If she/he couldn’t complete
the job as per the contract
(2) If she/he issued erroneous
audit report. For example if an
auditor states the financial
statements offer fair presentation
of the financial position and
results of operation, while they
don’t.
 Failure to perform (or unacceptable
performance) can be breach of contract or
tort. Let me explain one by one.
 Breach of contract – refers to luck of
performance that doesn’t have additional
harm other than duty undone. In breach of
contract, the auditor is required to return part
or the entire fee received from his client.
 Tort – means luck of performance which
causes additional harm other than the duty
undone. Therefore under tort, the auditor must
compensate the person who suffers harm.
In general, an auditor has higher
duty of due professional care to
those who have privities of
contract.
To parties without privities of
contract, an auditors duty is
limited to not to defraud.
When do we say an auditor is legally
liable?
For an auditor to be liable, the plaintiff
should proof the following:
 The auditor had a duty to do something
 She/he didn’t do her/his duty (or had
deceived intentionally – for fraud)
 Someone relied on her/his work
 The person who relied on her/his work
suffered a loss as a result
 An auditor’s failure to perform duty gives
rise to two basic types of liabilities. Those
are civil liability and criminal liability.
 i. Civil liability: in civil action, if the
defendant (the accused) is judged to
have caused an injury, she/he, normally,
has to pay damages to the plaintiff (the
one who complains on him).
 ii. Criminal liability: under criminal
actions, if the defendant is found to be
guilty, she/he has to ʺpay a debt to
societyʺ. It can be by paying fine or
serving time in jail.
2.4. Audit Report
Auditors provide their own
objective opinion on the fair
presentation of financial
statements.
Audit opinion is provided in an
audit report – a report that
communicates the results of the
audit work to interested parties.
2.4.1 Forms of Audit Reports

An audit reports can be prepared

in two forms. These are long form
and short form audit reports.
i. Long-Form Audit Report
 In many countries it is customary for the
auditor to prepare a ‘long-form’ report to
the entity’s board of directors in addition
to the publicly published ‘short-form’
report.
 This form of report shows information
including
 Overview of the audit engagement,
 Analysis of financial statements,
 Risk management and internal control,
 Reportable conditions,
 Fees and optional topics.
Overview of the audit
engagement
The first content of this form of report
is an over view of the engagement.
In the overview, the report discusses

The nature,
Scope,
Organization,
Level of materiality,
New audit work, and
Work with other auditors and experts.
Analysis of Financial
Statements
The second issue included is
analysis of financial statements.
Accounting issues requiring
subjective judgment, changes in
accounting policies, acquisitions
and disinvestments, financial
position, and quality of profits etc
are included.
Risk Management and Internal
Control
An auditor should, as soon as
practicable, either communicate
with the audit committee, the
board of directors and senior
management, or obtain evidence
that they are appropriately
informed, regarding non-
compliance (with applicable laws
and regulations) that comes to
the auditor’s attention.
Fees
 Of course, every client is interested in
how much fees they are paying and
what services they receive.
 Typically discussed in the long-form
report are an overview of the budget
and actual audit costs, costs for related
engagements, and service delivery
issues.
 Service delivery issues would include
staffing, important changes, quality
survey and follow-up.
Reportable Conditions
Major internal control problems
(reportable conditions) should be
reported to management, and where
necessary, the board of directors.
In deciding whether a matter is a
reportable condition, the auditor
considers factors such as the size of
the company and its ownership
characteristics, the organizational
structure, and the complexity and
diversity of company activities.
ii. Short form Audit Report
This form of report is commonly
issued to non – administrative
stockholders, creditors, analysts
etc.
 2.4.2 Types of Audit Reports
Reports are essential to audit and
assurance engagements because
they communicate the auditor’s
findings.
The audit report is the final step in
the entire audit process.
Users of financial statements rely
on the auditor’s report to provide
assurance on the company’s
financial statements.
The five (5) common types of auditor’s
reports are:
(1) Standard Unqualified Opinion Report
(2) Unqualified opinion with
explanatory paragraph or modified
wording.
(3) Qualified opinion Report
(4) Adverse Opinion Report
(5) Disclaimer opinion Report
1. Standard Unqualified Audit Report

This type of report is issued by an

auditor when the financial statements
presented are free from material
misstatements and are presented fairly
in accordance with GAAP.
It is the best type of report an auditee
may receive from an external auditor.
The standard unqualified audit report is
sometimes called a clean opinion .
Cont…
 Standard unqualified opinion is provided
when all of the following conditions are
fulfilled.
 All necessary statements are included,
 The three general standards of GAAS and
three field work standards have been
followed.
 The statements are found to be prepared
according to GAAP, and include all the
necessary disclosures (including foot notes)
 There are no reasons to qualify the report.
 2.Unqualified Audit Report with Explanatory Paragraph or Modified Wording

In certain situation, an unqualified audit

report is issued, but the wording deviates
from the standard unqualified report.
The unqualified audit report with
explanatory paragraph or modified
wording meets the criteria of a complete
audit with satisfactory results and
financial statements that are fairly
presented, but the auditor believes it is
important or is required to provide
additional information.
Cont…
The followings are the most important
causes of the addition of an explanatory
paragraph in the standard unqualified
report.
i. Lack of consistent application of
GAAP
ii. Substantial doubt about going
concern
iii. Auditors agrees with a
departure from a Promulgated
Principle
iv. Reports involving Other Auditors
 i. Lack of consistent application of
GAAP:
 Accounting principles should be followed
consistently.
 However, a client might be found
inconsistently following GAAP.
 The client may include this change in a
foot note.
 In such cases if the auditor agrees with
the change, she/he should explain it in
her/his report.
 But if she/he doesn’t agree to the change,
she/he has to qualify her/his opinion.
 ii. Substantial doubt about going
concern:
 The going concern principle states that a business
entity is expected to continue operating at a profit
for an indefinite period of time.
 However, the auditor may doubt a clients going
concern.
 In this case, she/he should state it in her/his report.
 In what conditions does an auditor doubt going
concern (substantially)?
 Here are some examples to doubt going concern of
a client's business:
 If the auditor feels the company doesn’t have
enough cash to meet its obligations
 If the client's single warehouse is burned by fire etc
 Here should note that the auditor should state
doubt about going concern even though the
financial statement are fairly presented.
 iii. The auditor agrees with
promulgated departure from GAAP:
Sometimes the company’s
departure from GAAP is
acceptable, if adhering to the
principles would have produced a
misleading result.
In this case, the auditor can issue
standard unqualified audit report
with additional explanation for
the change.
 iv. Reports involving other
auditors:
 Sometimes an audit work may be performed by
two auditors.
 For example if a client had a branch in distant
areas, where the cost of travel is very high, an
auditor in the nearby area may perform the audit
work of the branch.
 In such cases, the two audit firms first determine
which of them is a primary auditor.
 Once determined, the primary auditor will decide
if the other auditor's work is material.
 If it is found to be immaterial, the primary
auditor makes no mentions of the other auditor's
work in the report.
 Qualified, Adverse and Disclaimer Audit Reports

 There are circumstances where the conditions of

unqualified audit report are not satisfied.
 When these conditions are not satisfied, the
auditor issues an opinion other than unqualified
audit report.
 The three conditions requiring departure from
unqualified audit report are:
1. The scope of the audit has been restricted
2. Financial statements have not been prepared in accordance with
GAAP
3. The auditor is not independent
 Threemain types of audit reports are issued
under this condition: Qualified, Adverse opinion,
and Disclaimer opinion.
 3. Qualified Opinion Report
A Qualified Opinion report is issued
when the auditor encountered one of
the two types of situations (Deviation
from GAAP and Limitation of scope)
however, the rest of the financial
statements are fairly presented.
Scope Restriction/ Limitation of
scope
 Is the first reason that leads to
qualification of opinion.
 An audit is said to have scope restriction
if the auditor couldn’t accumulate
sufficient evidence to form an opinion.
 Scope restriction can be caused by two
things.
 The first one if the client’s management
refuses to give the required information,
known as client imposed restriction.
 And the second one is scope restriction
caused by circumstances.
 Which of the two restrictions do you think
is more serious?
 A client imposed restriction is more
serious than those caused by
circumstances.
 Because the auditor, generally, concludes
that the client is trying to conceal fraud.
 An example of client imposed restriction
can be:
 Not allowing to examine marketable
securities
 Not allowing to confirm certain receivables
 Such restriction on scope of the audit calls
for a qualified opinion.
 Scope restriction imposed by circumstances
also calls for qualification of opinions.
 Of course it is less serious than client imposed
restriction.
 Such restrictions are not necessarily caused
by the client.
 An example of this type of restriction can be:
 If an NGO (client) has a branch such as a clinic
in a remote area where regular commercial
transportation doesn’t exist, the auditor may
fail to examine the operations of the clinic.
 In such circumstances the auditor should use
alternative methods of examining accounts,
operations, etc in question.
 But if she/he is still unsatisfied, her/his opinion
is qualified.
 Departure from GAAP:

 It is the second reason that requires issuing a

report containing a qualified opinion.
 That means if the financial statements are not
prepared in accordance with GAAP. And the
departure is material. For example,
 Using the cash basis of accounting,
 Not recognizing depreciation
 Failing to disclose accounting methods used in a
footnote etc.
 Note: not all departures from GAAP require
qualification of opinions. Qualification is
necessary only for material departures. However
if the departure from GAAP is really bad, an
adverse opinion is issued.
 4. Adverse Opinion Report

 An Adverse Opinion is issued when the auditor

determines that the financial statements of an
auditee are materially misstated and, when
considered as a whole, do not conform with GAAP.
 It is considered the opposite of an unqualified or
clean opinion.
 Investors, lending institutions, and governments
very rarely accept an auditee’s financial
statements if the auditor issued an adverse
opinion.
 (An adverse opinion almost certainly would cause
a bank to deny any loan requested by the client. )
cont…
 On what circumstances is an adverse opinion
provided?
 An adverse opinion is issued when the effect of a
departure from GAAP is so material and pervasive
to the financial statements that the auditor
concludes that a qualification of the report is not
adequate to disclose the misleading or incomplete
nature of the financial statements.
 So, how do we choose between a qualified and
adverse opinion?
 Of course, deciding to issue an opinion other than
the standard unqualified opinion as well as choosing
between the two is difficult.
 It requires determining the materiality of the matter.
 However, the following should be considered in
determining materiality:
Cont…
 i. The magnitude (dollar or Birr amount) of
the item: a standard rule of thumb is anything
over 10% of net income (for income statement
items) and over 10% of total assets for balance
sheet items is considered to be material.
 ii. The nature of the item: the following items
generally, have a lower materiality threshold (i.e.
a lower misstatement is considered material):
 illegal or fraudulent transactions compared to
honest mistakes.
 a transaction that makes a difference between a
small net income and small net loss.
Cont…
 iii. The significance of the item to the client:
some items are more important than other items
depending on situations. For example if a client wants
to use receivables as collateral, the materiality level
for receivable can be 10% of total receivables. In this
case receivables are more important to the client so
that lower materiality threshold is set.
 iv. The effect on financial statements as a
whole: an item that has a significant effect on the
financial statements as a whole will have lower
materiality threshold. In this case, the auditor should
read the statements as if she/he were a user. Items
that have significant influence of her/his decisions are
considered to have higher effect on the statements
as a whole.
 Note: Generally, determining materiality for scope
restriction qualification is more difficult than
qualification for departure from GAAP.
Cont…
Generally, an adverse opinion is only
given if the financial statement
pervasively differs from GAAP.
The wording of the adverse report is
similar to the qualified report.
The scope paragraph is modified
accordingly and an explanatory
paragraph is added to explain the
reason for the adverse opinion after the
scope paragraph but before the opinion
paragraph.
 5. Disclaimer of Opinion Report

A Disclaimer of Opinion is issued when

the auditor could not form, and
consequently refuses to present, an
opinion on the financial statements.
 This type of report is issued when the
auditor tried to audit an entity but could
not complete the work due to various
reasons and does not issue an opinion.
 Auditing Standards provide certain
situations where a disclaimer of opinion
may be appropriate:
Cont..
• lack of independence, or material
conflict(s) of interest, exist between the
auditor and the auditee;
• There are significant scope limitations,
whether intentional or not, which hinder
the auditor’s work in obtaining evidence
and performing procedures;
• There is a substantial doubt about the
auditee’s ability to continue as a going
concern or, in other words, continue
operating ;