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FUNDAMENTALS OF AUDITING ACC311

Lecture 02

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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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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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 

AUDIT 

EXAMPLE QUANTIFIABLE 

INFORMATION

ESTABLISHED 

CRITERIA 

EVIDENCE

Financial 

Statement Audit

Annual Audit of

General Motors’

financial

statements 

Operational

Audit 

Compliance

Audit 

Evaluate whether

the computerized

payroll processing

for subsidiary is

operating

efficiently and

effectively 

Determine if

bank

requirements for

loan continuation

have been met 

General Motors

financial statements 

Number of payroll

records processed

in a month, costs of

the department, and

number of errors

made 

International

Financial

Reporting

Standards 

Company

standards for

efficiency and

effectiveness in

payroll

department 

Company records  Loan agreement

provisions 

AVAILABLE 

Documents,

records, and

outside sources

of evidence 

Error reports,

payroll records,

and payroll

processing costs 

Financial

statements and

calculations by

the auditor 

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FUNDAMENTALS OF AUDITING

AUDITING – AN INTRODUCTION 

What are the advantages and disadvantages of auditing?

Advantages of an audit

We have seen that the need for an external audit in the case of companies arises primarily from the

existence of split-up of ownership from control. There are however, certain advantages in having financial

statements audited even where no statutory requirement exists for such an audit in the case of a sole-tradership,

partnership,

or

non-profit

organizations

for

example.

These

advantages can be summarized

as follows:

a) Disputes between management may be more easily settled. For instance, a partnership which has

complicated profit sharing arrangements may require an independent examination of those

accounts to ensure, as far as possible, an accurate assessment and distribution of the profits. 

b) Major changes in ownership may be facilitated if past accounts contain an independent audit report,

for instance, where two sole traders merge their business to form a new partnership. 

c) Application to lenders/financial institutions for finance may be strengthened by the submission of

audited accounts. However do remember that a bank, for instance, is likely to be far more

concerned about the future of the business and available security, than by the past historical

accounts, audited or otherwise. 

d) The audit is likely to involve an in depth examination of the business and so may enable the auditor

to give more constrictive advice to management on improving the efficiency of the business. 

Disadvantages of an audit

Like most thing in life, audits are not entirely without their disadvantages. There are two main points to

make here: 

b) The audit fee! Clearly the services of an auditor must be paid for. It is for this reason that few

partnerships and even fewer sole traders are likely to have their accounts audited. 

c) The audit involves the client’s staff and management in giving time to providing information to

the auditor. Professional auditors should therefore plan their audit carefully to minimize the

disruption which their work will cause. 

What are the different stages of audit?

Auditing is essentially a practical task. The auditor always needs to reflect the nature of the circumstances of

the entity under audit. It is unlikely that any two audit assignments will ever identical. It is however possible

to identify a number of standard stages in a typical external audit. These are as follows: 

- Audit appointment 

- Engagement letter

- Initial planning 

 Knowledge of the business 

 Risk Assessment

 Internal control review (procedures)

 Control procedures (authorities/approvals/segregation of duties) 

- Preparation of the audit plan

- Accounting system review

- Analytical review techniques (Compliance procedures-Application of control test procedures) 

like purchasing are according to the controls established.

- Considering the ways in which audit evidence can be sought

- Substantive testing (transaction level procedures) 

- Reasonable assurance 

- Review of the financial statements (compliance with the standards/material misstatement etc.)

- Preparation and signing of report 

At the stage of considering the ways of seeking audit evidence the auditor will make a preliminary evaluation

of the entity’s control system: