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Introduction to Audit

Origin and History of Audit:

The word audit is derived from the Latin word 'audire' which means 'to hear'. The origin of audit can be traced back to very old times but the concept of modern auditing sprung up in the middle of the 19th century. In older times, methods of accounting were very simple and the number of transactions was so small that every individual was in a position to check all the transactions recorded. Whenever the owner of the business suspected fraud, he appointed an official to check the accounts. The person appointed by the employer to examine the accounts came to be known as the 'auditor'. In older times, the aim of audit was to check accounting of cash primarily. The objective was to find out whether cash had been embezzled, and if so, who did it and what was the amount involved. Thus, it was only an audit of the cash book. In present times, the main aim of audit is to find out whether the financial statements represent a ‘true and fair’ view.

Introduction to Audit

In a public limited company the division between ownership and control needs to be understood. Shareholders, own the company while the directors, manage the company. Shareholders appoint directors to look over the company on their behalf, and the legislation requires directors to prepare financial statements to be presentable to the shareholders. This division between ownership and control of the company requires a third independent party to give their opinion on the financial statements to add credibility to the whole process.

statements to add credibility to the whole process. Definition of Audit: External audit is defined as

Definition of Audit:

External audit is defined as ‘the independent examination and expression of opinion on the true and fair view of the financial statements of a company by an independent third party known as the external auditor’.

Need for Audit:

The problem that has always existed when the director’s report to the shareholders through financial statements has been the credibility of the financial statements. The financial statements being issued may:

Contain errors

Not disclose fraud

Fail to disclose relevant information

Fail to follow laws

Be misleading

The solution to these problems of credibility in reports and accounts lies in appointing, an independent person called an auditor, to investigate the reports and submit his findings.

Objective of an Audit The primary objective of an audit of financial statements is to enable the auditor to express an opinion on the financial statements of the company. In addition the audit serves the following objectives:

Fulfilment of the statutory requirements.

Increase in the credibility of the financial statements.

Increase the confidence of the stakeholders in the financial statements.

Role of External Auditor:

The primary role of an external auditor is to report on the truth and fairness of the financial statements of a company on behalf of its owners.

An external audit is a legal requirement for public limited companies, although many smaller entities are exempt from it. The financial statements have to be examined by an independent expert, the auditor, who is required to give an opinion on their truth and fairness. The shareholders have limited access to information about the operations of the company. They may lack trust in the directors and may believe that the information in the financial statements is biased. Under law, the external auditor reports to, and are, appointed by the shareholders.

Communication of opinion by the Auditors:

Once the external auditors have performed audit they present their opinion on the financial statements. The report issued after a statutory audit is addressed to the shareholders. A statutory audit report will necessarily contain the following sections:

Heading (Audit report for Company name)

Appropriate Addressee (Addressed to the shareholders/members.)

Introductory Paragraph. (We have audited the financial statements.)

Management’s responsibility of the financial statements (It is management responsibility to prepare F/S according to standards and keep proper accounting records)

Auditor’s responsibility of the financial statements (It is our duty to express opinion on the F/S.

Opinion on the financial statements.

Auditor’s signature, date of the audit report and the address of the audit report.

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Essential Audit Terms

True and Fair View:

There is no strict definition in the accounting or auditing literature for 'true and fair' view but the following perception is taken for its understanding. Financial statements are considered to be 'true and fair' when:

Have been prepared in accordance with the accounting/financial reporting standards.

Proper accounting records have been kept which were essential for the preparation of the financial statements.

Financial statements are free from material misstatements.

The financial statements present information faithfully without any element of bias.

Reasonable Assurance:

The opinion given by the external auditor on the financial reports is of ‘reasonable assurance’. No auditor can give 100% assurance. The highest level of assurance given, as in the case of statutory audit, is described as 'reasonable assurance'. 'Reasonable assurance' is less than absolute assurance. Reasonable assurance is achieved after:

The use of selective testing.

It is based on the application of 'sampling'.

Materiality:

The objective of an audit of financial statements is to enable the auditor to express an opinion on whether the financial statements are prepared in all material respects, with an identified financial reporting framework. Thus materiality is defined as:

Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.

The auditor must be concerned with identifying 'material' errors, omissions and misstatements.

To put this into practice the auditor therefore has to set his own materiality levels –this will always be a matter of judgment.

Auditor Rights and Duties:

To perform their duty with effectiveness the external auditors have been bestowed some rights. The rights and duties of the external auditors are:

Auditors Right

 

Auditors Duties

 

Access

to

books

and

records

of

the

Report and give opinion on the ‘true and fair’ view of financial statements.

company.

 

Access to information and explanation.

 

Report on the proper preparation of accounts.

Receive notice to attend general meetings.

Report

on

information

and

explanations

received.

Right to speak at general meetings.

   

Types of Audits

External Audit External audit is conducted by an independent external auditor. It is conducted as a requirement of law. Qualified chartered accountants having no connection to the company can act as external auditors of a company. Conducted on a yearly basis, the purpose of this audit is to see whether financial statements present a 'true and fair' view. The external audit is primarily conducted to add credibility to the financial statements so that the bridge created due to division of ownership and control could be managed.

Final Audit Final audit is the audit which is taken up at the close of the financial year when all the accounts have been closed and the final accounts have been prepared.

Interim Audit Interim audit is the audit which is conducted in between the two annual audits with a view to find out the interim profit of the business to enable it to declare an interim dividend.