CHAPTER 1

Auditing Principles and Practices

Prepared By: Rida Iftikhar

Auditing Principles and Practices

CHAPTER 1
INTRODUCTION TO AUDITING
Contents:
1.
2.
3.
4.
5.
6.
7.
8.

Origin and Meaning of Auditing

Definition of Audit
Need of Auditing
History of Auditing
Characteristics of Auditing
Objectives of auditing
Pros. And Cons.
Scope of audit

Origin and Meaning of Audit

Origin of Auditing:
In olden times auditors were known as Independent Reviewer or Stewards, the
concept of Stewardship is included in the history of audit. People living in Egypt, Greece and
Rome used to appoint Stewards for supervising and finding problems in their business.
In ancient times, concept of auditing is not as much developed and civilized as it
exists today. At that time only two types of business organizations exists including sole
proprietorship and partnership, having a very small number of transactions that every
individual can check. Whenever owners of these business organizations had any doubt about
the accounts regarding frauds in their business, they asked their accountants to appear in front
of independent reviewers (Auditors) who used to hear the accountants about the accounts of a
company.
The concept of companies was introduced after the industrial revolution in Europe,
after this revolution Joint Stock Companies came in to being due to which investment
opportunities arises for general public. It leads to the feeling that there is a need to get the
accounts audited by the auditors who will report to the shareholders of the company
regarding the financial position of the company. At that time shareholders were appointed as
auditors but due to lack of technical knowledge about the auditing and absence of required
skill, auditor is required to be Chartered Accountant now.
Meaning of Audit:
The word Audit is derived from the Latin word Audire that means To Hear Something.
The dictionary meaning of audit is the official examination of the books of accounts.
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Auditing Principles and Practices

Audit means the examination of books of accounts and financial statements by auditor with
the objective of reporting independently true and fair view of companys financial statements
to the shareholders.
From above discussion it is clear that auditing process involves three main components
including;
1. Books of accounts
2. Auditor
3. Techniques and procedures of auditing.

Definition of Audit
1. According to Montgomery, a leading American Accountant;
Audit is a systematic examination of books and records of a business or other
organizations, in order to check or verify and to report upon results thereof.
2. According to ICAP;
Auditing is the independent examination of financial information of any entity,
whether profit oriented or not and irrespective of its size and legal form, when such an
examination is conducted with a view to expresses an opinion thereon.
3. According to L. R. Dicksee;
An audit is an examination of accounting records undertaken with a view to
establish whether they completely and correctly reflect the transactions to which they
purport to relate.
4. According to Spicer and Peglar;
The audit may then said to be such an examination of the books, accounts vouchers
of a business, as shall enable an auditor to satisfy himself, whether the balance sheet
is properly drawn up, so as to give a true and fair view of the state of affairs of the
business, and that the profit and loss account give a true and fair view of the financial
period according to the best of his information and explanation given to him as shown
by the books and if not, in what respect he is not satisfy.

NEED OF AUDIT
According to Companies Ordinance 1984 every public limited company has to fulfill certain
requirements;
1. So it is mandatory for all public listed companies to have their accounts audited by the
external auditor at the end of financial year operating under the Companies Ordinance
1984. In other words it is a legal obligation to be followed by every public listed
company.
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Auditing Principles and Practices

2. Audit creates healthy investment opportunities for a company by creating goodwill of
the company in the eyes of prospective or new shareholders of the company.
3. Audit is done in order to save the interest of shareholders of the company because
they are not actively participating in the operations of the company.

CHARACTERISTICS OF AUDITING
Following are the characteristic features of auditing;
1. Accounting control:
Audit is an instrument of accounting control. The truth and fairness of accounting
information is controlled and checked by the auditing activities. So while an accountant is
performing its activities he is clear about the following check that will be applied by the
auditor on his work.
2. Safeguard:
Audit acts as a safeguard on behalf of the interest of shareholders against extravagance,
carelessness or fraudulent activities on behalf of management of the company who is acting
as an agent of shareholders to run business operations for realizing as well as utilizing the
money and assets of the shareholders.
3. Assurance:
Audit assures on the shareholders behalf that the accounts maintained truly represents
facts and expenditure has been incurred with due regularity and propriety. This also increases
the goodwill of the company.
4. Assessment:
Audit assesses the adequacy of the accounting system in order to ascertain its
effectiveness in maintaining accounting records of an organization. The auditor is aimed at
providing its opinion about the appropriateness of the accounting systems and estimations
used by the management of the company.
5. Review:
Audit carries out the review of the financial statements to know whether the accounting
records maintained by the management of the company are in agreement with those
statements as well as the truth and fairness of the statements.

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Auditing Principles and Practices

6. Reporting Tool:
Audit is a tool for reporting on the financial statements as required by the terms of the
auditors appointment and in compliance with the relevant statutory obligations. Auditor is
required to report on the financial statements reliability in order to fulfill the requirement of
his appointment.
7. Practical Subject:
Auditing is a practical subject. It is something that is done practically. The present form of
this subject matter is as a result of long history including many important developments in the
business world as well as legal requirements over the last few decades with the immense
changes in the last few years.

OBJECTIVES OF AUDITING
The objectives of auditing are divided into three main categories;
1. Primary Objectives.
2. Secondary Objectives.
3. Implied Objectives
Primary Objectives:
These are the basic activities that the auditor is supposed to perform and also the
outcomes for which the audit work is aimed at.
1. To reproduce the opinion in the form of audit report presented to the shareholders
of the company.
2. To promote the efficiency of the accounting work performed at the business
organization by understanding the internal control system of the company as well
as by giving constructive advice for the benefit of the company.
3. To promote the accuracy of the books of accounts and statements of financial
position of the company and to give true and fair view of the affairs of the
company. Compliance of books of accounts with the companies ordinance 1984
and obtaining all the necessary information required for the audit from the
management of company are also essentially required.
Secondary Objectives:
There are two basic secondary objectives;
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Auditing Principles and Practices

1. Detection and prevention of errors:
The purpose of audit is to detect and prevent errors. It is up to the auditor that what
various ways he will be using in its audit procedure to detect the errors in the records of the
company.
Errors:
Unintentional mistakes in the books of accounts are known as errors
There are basically two types of errors;

Clerical errors
Principle errors

Clerical Errors:
The errors committed by the clerical staff of the company at the initial stage of the books of
accounts.
There are three types of clerical errors;
i.

Errors of omission: complete omission of a transaction from books of accounts is

error of omission.
E.g. machinery purchased from XYZ Co. is not recorded in the purchase journal of

ii.

the company.
Errors of Commission: A transaction completely or partially recorded in the books of

iii.

original entry or wrongly posted in the ledger, in incorrect manner.

E.g. Credit posting of sales recorded as debit posting.
Counter Balanced Error: A second error is committed in order to counter balance or
compensate the effect of first error. It is also known as compensatory error or
offsetting error.
E.g. an under casting of one account by PRs. 50,000 will be compensated by the
overcasting of the other account.

Principle Errors:
These errors are committed by the management staff at higher levels and managerial levels
including the incorrect usage of accounting policies and non-compliance of accounting rules
and regulations.
There are three types of principle errors;

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Auditing Principles and Practices

i.

Incorrect Allocation: These kinds of errors arise when there is incorrect distinction

ii.

between capital and revenue expenditures.

E.g. Purchase of Raw Material is recorded as a Capital Expenditure.
Incorrect Valuation: assets are valued according to the International accounting
Standards i-e. Current assets valued at cost or Net realizable value and fixed assets
are valued at cost less depreciation. When the assets are not recorded accordingly
then these types of errors occur.
Omission of outstanding assets and liabilities: Prepayments and outstanding dues

iii.

when not recorded in the books of accounts then such errors occurred.
2. Detection and prevention of Frauds:
It is the responsibility of the auditor to use certain techniques that he finds appropriate on the
basis of his knowledge and experience to detect the frauds in the books of accounts.
Fraud:
Intentional mistakes in the books of accounts, usually by the management, any individual or
any third party associated with the business, are frauds.
Frauds are of three types;

Embezzlement of Cash: This can be occurred in number of following ways;

Omitting to enter receipts;

Making fictitious payment records;
By under casting the receipt side of the cash book;
Overcasting the payment side;
By direct theft of the cash.

E.g. cash received against payments not recorded and is embezzled. Paid vouchers again used
for payments and the relevant amount are theft.
Misappropriation of Goods: This fraud includes the use of goods purchased in the name of
company for the personal benefit. In some cases these goods may be stolen. In order to
overcome this fraud purchase and sales account should be properly maintained and regular
stock taking and periodic physical checking of stock is necessary.

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Auditing Principles and Practices

Manipulation of Accounts: This type of Fraud is most difficult to detect and prevent because
the main parties involved in this are the higher management including the directors of the
company.
E.g. Inflation or suppression of sales and purchases of the company and incorrect valuation of
assets and liabilities.
Implied Objectives:
There is a considerable moral check on the employees of the account department of
the company that they knows the auditors will come and check their work so that they
maintain their accounts up to date and with due care and diligence otherwise they have to be
answerable to the shareholders of the company about any kind of fraud or error.

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