History of Auditing - Seminar

8/3/2019 History of Auditing - Seminar

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A SEMINAR ON

THE HISTORICAL BACKGROUND OF AUDITING

BY

GROUP ONE 2009/2010 MSc CLASS

PRESENTED TO THE

DEPARTMENT OF ACCOUNTANCY

FACULTY OF MANAGEMENT SCIENCES

NNAMDI AZIKIWE UNIVERSITY, AWKA

IN PARTIAL COMPLETION OF THE COURSE:

ACC 615 AUDITING AND INVESTIGATIONS

JUNE 15, 2010


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ABSTRACT

This paper aims to analyze the historical background, objectives and scope of examination of auditing and audit

planning and supervision. It is found that auditing has evolved through a number of stages. In the mid 1800s to early1900s, the audit practice was considered as traditional conformance role of auditing. However, for the past 30

years, the auditor has been playing an enhancing role. Today, auditors are expected not only to enhance the

credibility of the financial statement, but also to provide value-added services. Nevertheless, following extensive

reform in various countries as a result of the collapse of big corporations, it is expected that the role of auditors will

converge. It is evident that the paradigm about auditing has shifted over the years and it is likely to continue shifting

in the future.


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OBJECTIVE OF THE PAPER

This paper aims to analyze the development of auditing over the years, with particular reference to the nature and

objectives of auditing, the responsibilities of auditors and the audit techniques used. The reasons for such an analysis

is to enable readers to gain an understanding of the audit development over the years. Secondly, it provides theevidences on auditing as a discipline that modifies its role over the years to meet the changing needs and expectations

of society.

TABLE OF CONTENT

CONTENTS PAGES

Abstract i

Objective of the paper iiTable of content iii

Introduction 1

Definition of audit 2

Scope of examination 2

Evolution of auditing practices 3

The period Prior to 1840

The period 1840s to 1920s

The period 1920s to 1960s

The period 1960s to 1990sThe period 1990s to present day.

The rise of internal audit

Internal audit Vs. External audit

Types of audit

Audit planning and supervision

Planning

Supervision

references


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INTRODUCTION

The word audit came from the Latin word audire, meaning to hear. According to Flint (1988), audit is a social

phenomenon which serves no purpose or value except if its practical usefulness and its existence is wholly utilitarian.

Flint (1988) further explains that the audit function has evolved in response to a perceived need of individuals orgroups in society who seek information or reassurance about the conduct or performance of others in which they

have an acknowledged and legitimate interest. Flint (1998) further argues that audit exists because interested

individuals or groups are unable for one or more reasons to obtain for themselves the information or reassurance they

require. Hence, an audit function can be observed as a means of social control because it serves as a mechanism to

monitor conduct and performance, and to secure or enforce accountability. Mackenzie in the foreword to The

Accountability and Audit of Governments made the following remark:

Without audit, no control; and if there is no control, where is the seat of power?

All in all, an audit function plays a critical role in maintaining the welfare and stability of the society.

Many auditors in the likes of Mascarenhas & Turley, 1990; Abdel-Qader, 2002; Porter, et al., 2005 concurred with

Flint (1988) that the aim of an audit has always been a dynamic rather than a static one. Brown (1962) asserts that the

objective and techniques of auditing have changed during the four hundred years of recognizable existence of

auditing to suit the changing needs and expectations of society. It can be observed that the changes in needs and

expectations of society are highly influenced by the factors contextual to the economic, political and sociological

environment at a particular point of time. Therefore, the review of the historical development of auditing enables one

to understand, analyze and interpret the evolution of auditing due to the change in expectations of the society.

Auditing as it exists today was established only in the later part of the nineteenth century, born out of the complexity

of modern day business world. During the 18th

century, industrial revolution brought in large scale production, steam

power, improved facilities and better means of communication. This resulted in the origin of Joint stock form of

organizations. Shareholders contribute capital of these companies but do not have control over the day to day

working of the organization. The shareholders who have invested their money would naturally be interested in

knowing the financial position of the company, to enable them to know this; the shareholders formed a body known

as the board of directors who then present as account to them at the end of each financial year. Soon, a problem of

believing that their funds have been honestly and prudently managed arose, this originated the need of an


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independent person who would check the accounts and report back to the shareholders on the accuracy of the

accounts and the safety of their investment.

At this stage, it is important to have the concept ofaudit defined.

DEFINITION OF AUDIT

The Auditing Standard defined an audit as the independent examination of and an expression of opinion on the

financial statement of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with

any relevant statutory obligation.

According to R. K. Mautz, auditing is concerned with the verification of accounting data, with determining the

accuracy and reliability of accounting statements and reports.

Lawrence R. Dicksee, puts it this way an audit is an examination of accounting records undertaken with a view to

establishing whether they correctly and completely reflect the transactions to which they relate. In some instances, it

may be necessary to ascertain whether the transactions themselves are supported by authority.

It is clear from the above definitions that auditing is the systematic and scientific examination of the books of

accounts and records of a business so as to enable the auditor to satisfy himself that the Balance Sheet and the Profit

and Loss Account are properly drawn up so as to exhibit a true and fair view of the financial state of affairs of the

business and profit or loss for the financial period. The Auditor have to go through various books and accounts and

related evidence to satisfy himself about the accuracy and authenticity to report the financial health of the business.

THE EVOLUTION OF AUDITING PRACTICESTo facilitate the examination of the historical development of auditing, this review will be divided into the following

five chronological periods:

(i) The period Prior to 1840;(ii) The period 1840s to 1920s;(iii) The period 1920s to 1960s;(iv) The period 1960s to 1990s; and


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(v) The period 1990s to present day.THE PERIOD PRIOR TO 1840Generally, the early historical development of auditing is not well documented (Lee, 1994). Auditing in the form of

ancient checking activities was found in the ancient civilizations of China (Lee, 1986), Egypt and Greece (Boyd,1905). The ancient checking activities found in Greece (around 350 B.C.) appear to be closest to the present-day

auditing. During this period, every single public officer must account for everything given to them. Anyone against

whom they prove embezzlement is convicted and fined by the court ten times the sum discovered stolen. Anyone,

whom the court on [their].evidence convicts of corruption, is also fined ten times the amount of bribe. If he is

found guilty of administrative error, they assess the sum involved, and he is fined that amount provided in this case

that he pays it within nine months; otherwise the fine is doubled. Similar kinds of checking activities were also found

in the ancient Exchequer of England. When the Exchequer was established in England during the reign of Henry

1(1100-1135), special audit officers were appointed to make sure that the state revenue and expenditure transactions

were properly accounted for (Gul, et al., 1994). The person who was responsible for the examinations of accountswas known as the auditor. The aim of such examination was to prevent fraudulent actions. Likewise, the existence

of checking activities was found in the Italian City States. The merchants of Florence, Geneo and Venice used

auditors to help them to verify the riches brought by captains of sailing-ships returning from the Old World and

bound for the European Continent. Again, auditing in this period was concerned about detection of fraud. The audit

found in the City of Pisa in 1394 was somehow similar to those found in the Italian City State. It was meant to test

the accounts of government officials to determine whether or not defalcation had taken place (Brown, 1962).

According to Porter, et al (2005), auditing had little commercial application prior to the industrial revolution. This is

because industries during this period were mainly concerned with cottages and small mills which were individually

owned and managed. Hence, there was no need for the business managers to report to owners on their management

of resources. As a result, there is little use of auditing. During this period, a system of accounting known as charge

and discharge principle were kept by the early Greek and Roman accounts. This principle enforced accounting for

stewardship. It maintained a check on the honesty and accuracy of the stewards charged with some trust. The Greek

considered accountability of official very important that every steward, agent or public official had to render account

periodically by producing the two lists. The charge list consists of the opening balance of goods/monies due to the

principal, plus the goods/monies received on his behalf during the period while the discharge list consists of expenses

made on behalf of the principal, the balance represents the amount due to him at the end of the period. (Ngozi, B.

N.& Okoye, E. I. 1998)


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In a nutshell, in the period pre-1840, the auditing at the time was restricted to performing detailed verification of

every transaction. The concept of testing or sampling was not part of the auditing procedure. The existence of

internal control is also unknown. Fitzpatrick (1939) commented that the audit objective in the early period was

primarily designed to verify the honesty of persons charged with fiscal responsibilities.

THE PERIOD 1840s TO 1920sThe practice of auditing did not become firmly established until the advent of the industrial revolution during the

period 1840s-1920s in the UK (Gill & Cosserat, 1996, Ricchiute, 1989). According to Brown (1962), the large-scale

operations that resulted from the industrial revolutions drove the corporate form of enterprise to the foreground.

Large factories and machine-based production were established. As a result, a vast amount of capital is needed to

facilitate this huge amount of capital expenditure. The emergence of a middle class during the industrial revolution

period provided the funds for the establishment of large industrial and commercial undertakings. However, the share

market during this period was unregulated and highly speculative. As a consequence, the rate of financial failure washigh and liability was not limited. Innocent investors were liable for the debts of the business. In view of this

environment, it was apparent that the growing number of small investors was in dire need of protection (Porter, et al,

2005). Hence, the time was ripe for the profession of auditing to emerge (Brown, 1962).

In response to the socio-developments in the UK during this period, the Joint Stock Companies Act was passed in

1844. The Joint Stock Companies Act stipulated that Directors shall cause the Books of the Company to bebalanced, and a full and fair Balance Sheet to be made up. In addition, the Act provided the appointment ofauditors

to check the accounts of the company. However, the annual presentation of the balance sheet to the shareholders and

the requirement of a statutory audit were only made compulsory in 1900 under the Companies Act 1862 (UK).

According to Porter, et al (2005) the accountant particularly in the early years of this period, was normally the

company manager and his duties were to ensure proper use of the funds entrusted to him. The auditors during this

period were merely shareholders chosen by their fellow members. Brown (1962) claimed that the auditors during this

period were required to perform complete checking of transactions and the preparation of correct accounts and

financial statements. Little attention was paid to internal control of the company. Porter, et al (2005) commented that

the duties of auditors during this period were influenced by the decisions of the courts. For example, the verdicts

from the case of London and General Bank (1985) and Kingston Cotton Mill (1896) reinforced that the audit

objective was detection of fraud and errors. These cases in turn established the general standard of work expected of


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auditors. Likewise, as noted in the auditing book of Lawrence R Dicksee (1892 cited in Leung, et al, 2004, p. 7): A

Practical Manual for Auditors, the objectives of auditing were:

(i) the detection of fraud;(ii) the detection of technical errors, and(iii) the detection of errors of principles. It can be

Concluded that the role of auditors during the period of 1840s-1920s was mainly on fraud detection and the proper

portrayal of the companys solvency (or insolvency) in the balance sheet.

THE PERIOD 1920s TO 1960sThe growth of the US economy in the 1920s-1960s had caused a shift of auditing development from the UK to the

USA. In the years of recovery following the 1929 Wall Street Crash and ensuing depression, investment in business

entities grew rapidly. Meanwhile, the advancement of the securities markets and credit-granting institutions had also

facilitated the development of the capital market in this period. As companies grew in size, the separation of theownership and management functions became more evident. Hence to ensure that funds continued to flow from

investors to companies, and the financial markets function smoothly, there is a need to convince the participants in

the financial markets that the companys financial statement provided a true and fair portrayal of the relevant

companys financial position and performance (Porter, 2005). In view of the economic condition, the audit function

was mainly to provide credibility to the financial statements prepared by company managers for their shareholders.

Consensus were generally achieved that the primary objective of an audit function is adding credibility to the

financial statement rather than on the detection of fraud and errors. Such a change in audit objective is evidenced in

successive edition of Montgomerys Auditing text issued during this period which stated An incidental, but

nevertheless important, objective of an audit is detection of fraud. Primary responsibilityfor the control anddiscovery of irregularities necessarily lies with management. Hence, it can be witnessed that the shift of the focus of

an audit function from preventing and detecting fraud and error towards assessing the truth and fairness of the

companies financial statements began at this period. The concept of materiality (Queenan, 1946) and sampling

techniques (Brown, 1962) were used in auditing during this period. The development of material concept and

sampling technique was due to the voluminous transactions involved in the conduct of business by large corporations

operating in widespread locations. It is no longer practical for auditors to verify all the transactions. Consequently,

sampling and the development of judgment of materiality were essential. The use of sampling technique during this


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period can be proven from the following statement it is not necessary to make a detailed examination of every

entry, footing, and posting during the period in order to get the substance of the value which resulted from an audit.

Corresponding to the use of sampling techniques, auditors need to rely on internal control of the company to

facilitate the use of such research approach. The reliance on internal control during this period can be witnessed fromthe following statement found in page 240 of Accountants Digest in March 1936: The first step to take when

planning an audit by test methods consists of a thorough investigation of the system on which the books are keptIt

is not the auditors sole duty to see that the internal check is carried out but to ascertain how much it can be relied

upon to supplement his investigation.

The fundamental principles of auditing during this period were influenced by some major auditing cases such as the

case of McKesson and Robbins (1938). The verdict of this case had resulted in the emphasis of physical observation

of assets such as cash and stock, and the use of external evidence. In addition, the Royal Mail case highlighted the

need of audit for the profit and loss statements. However, the audit of profit and loss account was only mademandatory with the enactment of Securities and Exchange Commission Act 1934 in the USA and Companies Act

1948 in the UK. In short, the social-economic condition in the period had highly influenced the development of

auditing. As highlighted by Porter, et al (2005) the major characteristics of the audit approach during this period,

among others, included:

(i) reliance on internal control of the company and sampling techniques were used;(ii) audit evidence was gathered through both internal and external source;(iii) emphasis on the truth and fairness of financial statements;(iv) gradually shifted to the audit of Profit and Loss Statement but Balance Sheet remained important; and(v) physical observation of external and other evidence outside the book of account.

THE PERIOD 1960s to 1990sThe world economy continued to grow in the 1960s-1990s. This period marked an important development in

technological advancement and the size and complexity of the companies. Auditors in the 1970s played an important

role in enhancing the credibility of financial information and furthering the operations of an effective capital market.

Similar description on the auditors role was found in The New York Times on 6 April 1975 (Leung, et al., 2004, p.

10) that the duties of auditors, among others, were to affirm the truthfulness of financial statements and to ensure that

financial statements were fairly presented. Hence, the role of auditors with regard to the audit of financial statement


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generally remained the same as per the previous period. Despite the overall audit objectives remaining similar,

Davies (1996) opines that auditing had undergone some critical developments in this period. In the earlier part of this

period, a change in audit approach can be observed from verifying transaction in the books to relying on system.

Such a change was due to the increase in the number of transactions which resulted from the continued growth in

size and complexity of companies where it is unlike for auditors to play the role of verifying transactions. As a result,auditors in this period had placed much higher reliance on companies internal control in their audit procedures.Furthermore, auditors were required to ascertain and document the accounting system with particular consideration

to information flows and identification of internal controls. When internal control of the company was effective,

auditors reduced the level of detailed substance testing.

In the early 1980 there was a readjustment in auditors approaches where the assessment of internal control systems

was found to be an expensive process and so auditors began to cut back their systems work and make greater use of

analytical procedures (Salehi, 2007). An extension of this was the development during the mid-1980s of risk-based

auditing (Turley & Cooper, 1991). Risk-based auditing is an audit approach where an auditor will focus on thoseareas which are more likely to contain errors. To adopt the use of risk-based auditing, auditors are required to gain a

thorough understanding of their audit clients in terms of the organization, key personnel, policies, and their industries

(Porter, et al., 2005) Hence, the use of risk-based auditing had placed strong emphasis on examining audit evidence

derived from a wide variety of sources, i.e. both internal and external information for the audit client.

According to Porter, et al (2005), most of the companies in this period had introduced computer systems to process

their financial and other data, and to perform, monitor and control many of their operational and administrative

processes. Similarly, auditors placed heavy reliance on the advanced computing auditing tool to facilitate their audit

procedures. In addition to the auditing of financial statement, auditors at the same time were providing advisory

services to the audit clients. Leung, et al (2004) made the following comments in connection with the role of auditors

in providing such services: There was a surge of one-stop shows such as multidisciplinary practices and the

development of holistic audit strategies which provided an extensive range of non-audit services performed for audit

client. Accounting and auditing during this period has become an industry with strong competition among firms, a

blurring of relationship with clients, an apparent failure to exercise due diligence by some. Porter, et al (2005) opined

that the provision of advisory services emerged as a secondary audit objective in the period of 1960s-1990s. Since

then, the role of auditors has always been highly associated with such advisory services.


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THE PERIOD 1990s TO THE PRESENT DAYThe auditing profession witnessed substantial and rapid change since 1990s as a result of the accelerating growth at

the world economies. It can be observed that auditing in the present day has expanded beyond the basic financial

statement attest function. According to Porter et al (2005), present-day auditing has developed into new processes

that build on a business risk perspective of their clients. The business risk approach rests on the notion that a broadrange of the clients business risks are relevant to the audit. Advocates of the business risk approach opined thatmany business risks, if not controlled, will eventually affect the financial statement. Furthermore by understanding

the full range of risks in businesses, the auditor will be in a better position to identify matters of significance and

relevance to the audit profession on a timely basis. Since the early 1990s, the audit profession began to take increased

responsibility to detect and report fraud and to assess, and report more explicitly, doubts about an auditees ability to

continue in conformance with societys and regulators increasing concern about corporate governance matters.Adoption of the business risk approach in turn enhances auditors ability to fulfill these responsibilities (Porter, et al.,

2005). Presently, the ultimate objective of auditing is to lend credibility to financial and non-financial information

provided by management in annual reports; however, audit firms have been largely providing consultancy services tobusinesses. By 2000, consulting revenues exceeded auditing revenues at all the major audit firms in the USA.

Regulators of the auditing profession and the investing public began to doubt whether audit firms could remain

independent on audit issues when the firms were so dependent on consulting revenues. The quality of audits is being

placed under scrutiny after a series of financial scandals of public companies such as Sunbeam, Waste Management,

Xeror, Adelphia, Enron and WorldCom. The collapses of these giant corporations had brought about a crisis of

confidence in the work of auditors (Boynton & Johnson, 2006). As a consequence of the high level of litigation and

criticism against the auditors, nearly all large accounting firms split their consulting arms into separate companies

and made announcements on their more stringent rules and measures to ensure better independence and audit quality.

In addition, a spate of radical reforms was undertaken in various countries, by the accounting bodies, governments,

stock exchange commissions and academics to strengthen the audit practice (Leung, et al., 2004). Some of the key

reform activities include:

(1) The Sarbanes-Oxley Act (The US) In response to the fall of Enron the Sarbanes-Oxley Act was implemented. It

outlines the rules on auditor independence, for example, the control of audit quality, and the rotation of audit partners

as well as the prohibition of conflict-of-interest situation. Furthermore, the act also requires auditors to report to the

audit committee on those significant matters. The Public Company Accounting Oversight Board which oversees

audit firms and their procedures and the enforcement of accounting standards is also established as a result of this

act. The Sarbanes-Oxley extended the duties of auditor to audit the adequacy of internal controls over financial


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reporting. This is in view of the fact that a number of commissions recognized the importance of internal control in

preventing financial statement misstatement.

(2) Ramsay report (Australia) As a result of the collapse of HIH Insurance Ltd, the Australian Government

Commission engaged professor Ian Ramsay to investigate the issue of auditor independence. It was recommended

that auditor independence can be improved through the following ways: Include a statement in the Corporations Actthat auditors are to be independent; Require auditors to declare to the Board of Directors that their independence is

maintained; Prohibit special relationships between the auditor and client; Establish an auditor independence

supervisory board; Establish an audit committee to oversee the issue of non-audit services, audit fees, scope

disagreements and auditor-client relationships.

Although the overall audit objectives in the present period remained the same, i.e. lending credibility to the financial

statement, critical changes have been made to the audit practice as a result of the extensive reform in various

countries. Leung, et al (2004, p. 24) is of the opinion that such reform has implicated the auditing profession in the

following ways: (i) The role of auditors is expected to converge: refocusing on the public interest, redefining auditrelationship, ensuring integrity of financial reports, separation of non-audit function and other advisory

services;

(ii) (ii) The audit methods revert to basics i.e. risk attention, fraud awareness, objectivity and independence,and

(iii) (iii) increase attention on the needs of financial statement users.

THE RISE OF INTERNAL AUDIT

The double-entry bookkeeping system invented in the 13th century provided the means for those engaged in

commerce to control transactions with suppliers and customers, and check the work of employees. Historical records

suggest that internal auditors were being utilized prior to the 15th century. These auditors, employed by kings or

merchants, were charged with detecting or preventing theft, fraud, and other improprieties. Control techniques such

as separation of duties, independent verification, and questioning (i.e. "auditing") to detect and prevent irregularities

are thought to have originated during that time. Thus, control assessment and fraud detection have become known as

the "roots" of internal auditing.
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As industry and commerce evolved, so did control methods and auditing techniques. These methods migrated to the

United States from England during the industrial revolution. Managerial control through auditing continued to gain

favor up to and through the 20th century. Many events contributed.

The economy of the United States was growing rapidly after World War I and required better techniques forplanning, directing, and evaluating business activities. Unfortunately, the growth was accompanied by a rise in price-

fixing, interlocking directorates, stock manipulations, and false statements of business performance. Regulatory

actions followed and auditing was used as a means to confirm that laws were being followed. The Federal Trade

Commission (FTC) was created in 1914. The Great Depression and the 1930s brought more regulatory action for

publicly traded securities. The Securities Act of 1933, the Securities and Exchange Act of 1934, the Public Utilities

Holding Company Act of 1935, and the Investment Company Act of 1940 were enacted by the United States

Congress.

As the need for auditing grew, corporations realized that they could no longer rely solely on external auditors from

public accounting firms. Corporations began hiring auditors as their own employees to verify financial transactions

and test compliance with accounting controls. Many of these internal auditors were hired from external auditing

firms. They brought to the companies that hired them auditing methods used by public accountants with a financial

statement focus. These internal auditors concentrated on financial auditing. Management viewed these internal

auditors as a means to reduce external audit fees while maintaining the same level of financial audit coverage. Within

some organizations this image of internal auditing still persists.

Internal auditing started to emerge as a function distinctly different from external auditing about the middle of the

20th century. Then, a significant event brought internal auditing to the forefrontthe Foreign Corrupt Practices Act

of 1977. The Act was the government's response to outcries as news of corporate wrong-doings increased. The Actwas passed to prevent secret funds and bribery. It specifically prohibited offering of bribes to foreign officials. It

required organizations to maintain adequate systems of internal control and maintain complete and accurate financial

records. While the Act did not specifically call for an internal auditing function, internal auditors were poised and

ready to help management fulfill the requirements of this Act. Testing and evaluation of internal controls within

companies increased significantly. The role of internal auditors was viewed with new importance.
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In the mid-to-late 1980s there were a number of large business failures and financial statement frauds. On several

occasions external auditing firms failed to detect those frauds. The issues of fraudulent financial reporting were

examined by a group of private sector organizations which included the American Institute of Certified Public

Accounts (AICPA), the American Accounting Association (AAA), the Financial Executives Institute (FEI), the

Institute of Internal Auditors (IIA), and the National Association of Accountants (NAA). This group oforganizations, known as the Treadway Commission, issued its final recommendations in 1987. Several

recommendations of the Treadway Commission were of great significance to internal auditors. Among other

recommendations, the Commission's report directs companies to maintain adequate internal control systems, to

establish effective and objective internal audit functions staffed with adequate qualified personnel, and to coordinate

internal auditing with the external audit of the financial reports. The Commission's report also directed internal

auditors to consider whether their findings of a non-financial nature could impact the financial statements. The

Treadway Commission also directed its sponsoring organizations to develop guidance on internal control. That

sponsoring group did so, issuing its report Internal Control Integrated Framework in 1992, which again

emphasized the importance of internal controls in organizations.

The evolution of internal auditing tracks changing business practices and concepts of internal control. At the most

basic level, internal controls are individual preventive, detective, corrective, or directive actions that keep the

operations functioning as intended. Basic controls, when aggregated, create whole networks and systems of control

procedures, which are known as the organization's overall system of internal control. During the 1990s, business

process "reengineering" and downsizing, removed layers of management and flattened organizational hierarchies.

Traditional controls were loosened or dismantled to improve efficiency and lower costs. In response, internal

auditing's control orientation moved away from evaluating individual process controls toward assessing the overall

control environmentintegrated control frameworks, corporate governance, and the ethical climatewithin the

organization. Internal auditors increased their use of risk assessments and aligned their activities with broaderorganizational goals to deploy their own scarce audit resources. Internal auditing's focus shifted to risk prevention

and to promoting change. Even so, control assessment and fraud detection, the "roots" of internal auditing, still

retained a place in the internal audit function.

INTERNAL AUDITING VS. EXTERNAL AUDITING


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The industrial engineer studies methods of performing work, suggests improvements, designs and installs work

systems, and evaluates results. Internal auditors do utilize some of the analytical techniques belonging to industrial

engineers, but do not focus on them. Further, internal auditors do not design and install systems.

Internal auditors and external auditors both audit, but have different objectives. Internal auditors generally consideroperations a whole relative to objectives. External auditors focus primarily on financial systems that have a direct,

significant effect on the amounts reported in financial statements. Internal auditors consider even small amounts of

fraud, waste, and abuse as symptoms of underlying issues. The external auditor considers just what materially affects

the financial statements since that is the nature of their engagement. Sawyer's Internal Auditing summarizes the

differences in the following way.

Management controls over financial activities have been greatly strengthened throughout the years. The same cannot

always be said of controls elsewhere in the enterprise. Embezzlement can hurt a corporation; the poor management

of resources can bankrupt it. Therein lies the basic difference between external auditing and modern internal

auditing; the first is narrowly focused and the second is comprehensive in scope. True, the external auditor performs

services for management and submits letters to management, which recommend improvement in systems and

controls. By and large, however, these are financially oriented. Also, the external auditor's occasional sally into

nonfinancial operations may not benefit from the same depth of understanding as does the resident internal auditor,

who is intimately familiar with the organization's systems, people, and objectives.

"OUTSOURCING" OR "CO-SOURCING" THE INTERNAL AUDIT FUNCTION

The previous comparison of internal auditing to external auditing considers only the external auditors' traditional role

of attesting to financial statements. During the 1990s a number of the large professional service firms (the "Big 5"

public accounting firms) began establishing divisions offering internal auditing services in additional to tax, financial

planning, actuarial, external auditing, and management consulting. New firms also emerged offering internal auditing

services but not attestation (external audits) of financial statements. Predictably, the arrival of "outside" consultants

ready to do "internal" audits caused a flurry of debate about independence, objectivity, depth of organizational

knowledge, operational effectiveness, and long run costs to the organization. Regardless, the trend continued


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throughout the rest of the decade. Initial protests gave way to acknowledgment that non-employees can indeed

perform internal audits. Orderly analyses of outsourcing's pros and cons followed. "Co-sourcing" (using outsiders for

selected projects) became a useful compromise. That option provided access to an outside firm's resources while

retaining a knowledgeable core of internal auditors to direct and manage co-sourced projects.

However, perceptions of impaired independence continued when public accounting firms providing opinions on

financial statements also staffed the internal auditing function. In 1998, the American Institute of Certified Public

Accounts (AICPA) decided that professionals from the same CPA firm could serve as external auditors of the

financial statements and still perform internal auditing functions (called "extended services") without impairing

independence if certain conditions were met. The AICPA required that outside professionals not act as employees

and not assume ongoing control or other functions. It required management to retain responsibility for internal audit

scope, planning, and risk assessments and to designate a competent executive to retain responsibility for the overall

internal audit function. In New Zealand and several European countries, external auditors of financial statements in

public sector companies may not provide internal audit services to the same company.

TYPES OF AUDITS

Various types of audits are used to achieve particular objectives. The types of audits briefly described below

illustrate a few approaches internal auditing may take. The examples are not all inclusive.

OPERATIONAL AUDIT.

An operational audit is a systematic review and evaluation of an organizational unit to determine whether it is

functioning effectively and efficiently, whether it is accomplishing established objectives and goals, and whether it isutilizing all of its resources appropriately. Resources in this context include funds, personnel, property, equipment,

materials, information, intellectual property, or space. Operational audits often include evaluations of the work flow

and propriety of performance measurements. These audits are tailored to fit the nature and objectives of the

operations being reviewed.

PROGRAM AUDIT.


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A program audit evaluates whether the stated goals or objectives for a project or initiative have been achieved. It may

include an appraisal of whether an alternative approach can achieve the desired results at a lower cost. These types of

audits are also called performance audits or management audits.

FRAUD AUDIT.

A fraud audit investigates whether the organization has suffered through misappropriation of assets, manipulation of

data, omission of information, or illegal acts. It assumes that deceptions were intentional.

ETHICAL BUSINESS PRACTICES AUDIT.

An ethical business practices audit determines the extent to which the organization, management, and employees

support established codes of conduct, policies, and standards of ethical practices. Topics that may fall within the

scope of such audits include procurement policies, conflicts of interest, gifts and gratuities, entertainment, political

lobbying, patents, copyrights, and licenses (including software use), or fair trade practices

COMPLIANCE AUDIT.

A compliance audit determines whether a process or transaction is or is not following applicable rules. Such rules can

originate internally as corporate bylaws, policies, and procedures or externally as laws and regulations. Characteristic

of compliance audits are the yes/no aspects of the evaluation. For each process or transaction examined, the auditor

must ultimately decide whether it complies with the rule or not. Reaching that conclusion is not necessarily simple in

domains governed by complex regulations (e.g. occupational health and safety, environmental, federal grants and

contracts, employee pensions and benefits, or federal tax). Compliance auditors and attorneys specializing in thesefields may be engaged to assist with evaluations if such specialists are not part of the internal audit staff.

SYSTEMS DEVELOPMENT AND LIFE CYCLE REVIEW

A systems development and life cycle review is an information systems audit conducted in partnership with

operating personnel who are implementing a new information system. The objective is to appraise and independently

test the system at various stages throughout the design, development, and installation. The approach intends to


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identify issues and correct problems early because modifications made during developmental stages are less costly.

and some problems can be avoided altogether. The concern about this type of audit is that the internal auditor could

lose objectivity through extended participation in the system design and installation.

CONTROL SELF-ASSESSMENT AUDIT.

A control self-assessment audit enlists management to share audit responsibility by evaluating and reporting on the

state of controls and levels of risks under their supervision. Internal auditors provide training and act as facilitators.

In effect this become a problem solving partnership and can be a cost-effective. Its inherent risk is that management's

self-evaluation may be biased. Although, the internal auditor can retain the right to independently verify any reported

conclusions.

FINANCIAL AUDIT.

A financial audit is an examination of the financial planning and reporting process, the conduct of financialoperations, the reliability and integrity of financial records, and the preparation of financial statements. Such a review

includes an appraisal of the system of internal controls related to financial functions.

SCOPE OF EXAMINATION

The scope of a statutory audit us required by legislature. The auditor has right to all information and explanation, he

may require and has access to books of account. The auditor report is also guided by legislature. While the extent of

examination to be carried out in the private audit can be limited by the person and persons who appointed the auditor.

It is usually determined by the terms of appointment. Some documents or pieces of information could be withheldfrom the auditor as the contract could exclude any aspect of the account.

AUDIT PLANNING AND SUPERVISION

The first standard of field work requires that "the work is to be adequately planned and assistants, if any, are to be

properly supervised." This section provides guidance to the independent auditor conducting an audit in accordance

with generally accepted auditing standards on the considerations and procedures applicable to planning and


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supervision, including preparing an audit program, obtaining knowledge of the entity's business, and dealing with

differences of opinion among firm personnel. Planning and supervision continue throughout the audit, and the related

procedures frequently overlap.

The auditor with final responsibility for the audit may delegate portions of the planning and supervision of the auditto other firm personnel. For purposes of this section, (a) firm personnel other than the auditor with final

responsibility for the audit are referred to as assistants and (b) the term auditorrefers to either the auditor with final

responsibility for the audit or assistants.

Planning

Audit planning involves developing an overall strategy for the expected conduct and scope of the audit. The nature,

extent, and timing of planning vary with the size and complexity of the entity, experience with the entity, and

knowledge of the entity's business. In planning the audit, the auditor should consider, among other matters:

a. Matters relating to the entity's business and the industry in which it operates (see paragraph .07).b. The entity's accounting policies and procedures.c. The methods used by the entity to process significant accounting information (see paragraph .09), including

the use of service organizations, such as outside service centers.

d. Planned assessed level of control risk. (See section 319.)e. Preliminary judgment about materiality levels for audit purposes.f. Financial statement items likely to require adjustment.g. Conditions that may require extension or modification of audit tests, such as the risk of material error or fraud

or the existence of related party transactions.h. The nature of reports expected to be rendered (for example, a report on consolidated or consolidating financial

statements, reports on financial statements filed with the SEC, or special reports such as those on compliance

with contractual provisions).

Procedures that an auditor may consider in planning the audit usually involve review of his records relating to the

entity and discussion with other firm personnel and personnel of the entity. Examples of those procedures include:


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a. Reviewing correspondence files, prior year's working papers, permanent files, financial statements, andauditor's reports.

b. Discussing matters that may affect the audit with firm personnel responsible for non-audit services to theentity.

c. Inquiring about current business developments affecting the entity.d. Reading the current year's interim financial statements.e. Discussing the type, scope, and timing of the audit with management of the entity, the board of directors, or its

audit committee.

f. Considering the effects of applicable accounting and auditing pronouncements, particularly new ones.g. Coordinating the assistance of entity personnel in data preparation.h. Determining the extent of involvement, if any, of consultants, specialists, and internal auditors.i. Establishing the timing of the audit work.j. Establishing and coordinating staffing requirements.

The auditor may wish to prepare a memorandum setting forth the preliminary audit plan, particularly for large and

complex entities.

In planning the audit, the auditor should consider the nature, extent, and timing of work to be performed and should

prepare a written audit program (or set of written audit programs) for every audit. The audit program should set forth

in reasonable detail the audit procedures that the auditor believes are necessary to accomplish the objectives of the

audit. The form of the audit program and the extent of its detail will vary with the circumstances. In developing the

program, the auditor should be guided by the results of the planning considerations and procedures. As the audit

progresses, changed conditions may make it necessary to modify planned audit procedures.

The auditor should obtain a level of knowledge of the entity's business that will enable him to plan and perform his

audit in accordance with generally accepted auditing standards. That level of knowledge should enable him to obtain

an understanding of the events, transactions, and practices that, in his judgment, may have a significant effect on the

financial statements. The level of knowledge customarily possessed by management relating to managing the entity's

business is substantially greater than that which is obtained by the auditor in performing his audit. Knowledge of the

entity's business helps the auditor in:


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a. Identifying areas that may need special consideration.b. Assessing conditions under which accounting data are produced, processed, reviewed, and accumulated within

the organization.

c. Evaluating the reasonableness of estimates, such as valuation of inventories, depreciation, allowances fordoubtful accounts, and percentage of completion of long-term contracts.

d. Evaluating the reasonableness of management representations.e. Making judgments about the appropriateness of the accounting principles applied and the adequacy of

disclosures.

The auditor should obtain a knowledge of matters that relate to the nature of the entity's business, its organization,

and its operating characteristics. Such matters include, for example, the type of business, types of products and

services, capital structure, related parties, locations, and production, distribution, and compensation methods. The

auditor should also consider matters affecting the industry in which the entity operates, such as economic conditions,

government regulations, and changes in technology, as they relate to his audit. Other matters, such as accounting

practices common to the industry, competitive conditions, and, if available, financial trends and ratios should also be

considered by the auditor.

Knowledge of an entity's business is ordinarily obtained through experience with the entity or its industry and inquiry

of personnel of the entity. Working papers from prior years may contain useful information about the nature of the

business, organizational structure, operating characteristics, and transactions that may require special consideration.

Other sources an auditor may consult include AICPA accounting and audit guides, industry publications, financial

statements of other entities in the industry, textbooks, periodicals, and individuals knowledgeable about the industry.

The auditor should consider the methods the entity uses to process accounting information in planning the auditbecause such methods influence the design of the internal control. The extent to which computer processing is used

in significant accounting applications,fn 2

as well as the complexity of that processing, may also influence the nature,

timing, and extent of audit procedures. Accordingly, in evaluating the effect of an entity's computer processing on an

audit of financial statements, the auditor should consider matters such as

a. The extent to which the computer is used in each significant accounting application.b. The complexity of the entity's computer operations, including the use of an outside service center.fn 3
http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn2http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn2http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn2http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn3http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn3http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn3http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn3http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn2


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c. The organizational structure of the computer processing activities.d. The availability of data. Documents that are used to enter information into the computer for processing,

certain computer files, and other evidential matter that may be required by the auditor may exist only for a

short period or only in computer-readable form. In some computer systems, input documents may not exist at

all because information is directly entered into the system. An entity's data retention policies may require theauditor to request retention of some information for his review or to perform audit procedures at a time when

the information is available. In addition, certain information generated by the computer for management's

internal purposes may be useful in performing substantive tests (particularly analytical procedures).fn 4

e. The use of computer-assisted audit techniques to increase the efficiency of performing audit procedures. [fn 5]Using computer-assisted audit techniques may also provide the auditor with an opportunity to apply certain

procedures to an entire population of accounts or transactions. In addition, in some accounting systems, it may

be difficult or impossible for the auditor to analyze certain data or test specific control procedures without

computer assistance.

The auditor should consider whether specialized skills are needed to consider the effect of computer processing on

the audit, to understand the controls, or to design and perform audit procedures. If specialized skills are needed, the

auditor should seek the assistance of a professional possessing such skills, who may be either on the auditor's staff or

an outside professional. If the use of such a professional is planned, the auditor should have sufficient computer-

related knowledge to communicate the objectives of the other professional's work; to evaluate whether the specified

procedures will meet the auditor's objectives; and to evaluate the results of the procedures applied as they relate to

the nature, timing, and extent of other planned audit procedures. The auditor's responsibilities with respect to using

such a professional are equivalent to those for other assistants.

Supervision

Supervision involves directing the efforts of assistants who are involved in accomplishing the objectives of the audit

and determining whether those objectives were accomplished. Elements of supervision include instructing assistants,

keeping informed of significant problems encountered, reviewing the work performed, and dealing with differences

of opinion among firm personnel. The extent of supervision appropriate in a given instance depends on many factors,

including the complexity of the subject matter and the qualifications of persons performing the work. [Paragraph

renumbered by the issuance of Statement on Auditing Standards No. 48, July 1984.]
http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn4http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn4http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn4http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn5http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn5http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn5http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn5http://pcaobus.org/Standards/Auditing/Pages/AU311.aspx#ftn.au_311_fn4


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Assistants should be informed of their responsibilities and the objectives of the procedures that they are to perform.

They should be informed of matters that may affect the nature, extent, and timing of procedures they are to perform,

such as the nature of the entity's business as it relates to their assignments and possible accounting and auditing

problems. The auditor with final responsibility for the audit should direct assistants to bring to his attention

significant accounting and auditing questions raised during the audit so that he may assess their significance.

The work performed by each assistant should be reviewed to determine whether it was adequately performed and to

evaluate whether the results are consistent with the conclusions to be presented in the auditor's report.

The auditor with final responsibility for the audit and assistants should be aware of the procedures to be followed

when differences of opinion concerning accounting and auditing issues exist among firm personnel involved in the

audit. Such procedures should enable an assistant to document his disagreement with the conclusions reached if, after

appropriate consultation, he believes it necessary to disassociate himself from the resolution of the matter. In this

situation, the basis for the final resolution should also be documented.

Effective Date

Statements on Auditing Standards generally are effective at the time of their issuance. However, since this section

provides for practices that may differ in certain respects from practices heretofore considered acceptable, this section

will be effective for audits made in accordance with generally accepted auditing standards for periods ending after

September 30, 1978.

In summary, the review of the historical development of auditing has evolved the audit function through a number of

stages. Auditing first emerged in the form of ancient checking activities in the ancient civilizations of China, Egyptand Greece. However, the practice of modern auditing did not become firmly established until the advent of the

industrial revolution in the mid nineteenth century in the UK. The audit practice in the mid 1800s to early 1900s can

be regarded as traditional conformance role of auditing as auditing was mainly concerned with ensuring the

correctness of accounts and detecting frauds and errors. Over the past 30 years or so, the auditor played an

enhancing role by enhancing the integrity and credibility of financial information. Today, auditors are expected not

only to enhance the credibility of the financial statement, but also to provide value-added services, such as reporting

on irregularities, identifying business risks and advising management on the internal control environment (Cosserat,


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2004). However, extensive reforms were implemented in various countries as a result of the collapse of big

corporations; it is expected that the role of auditors will converge. Leung, et al (2004, p. 23) claimed that the role of

auditors has moved from mere conformance through an enhancing role to a convergence role. It is evident that the

paradigm of independent auditing has shifted over the years. It is believed that it may continue to shift in the future.

CONCLUSIONA review of the historical development of auditing has shown that the objective of auditing and the role of auditors

are constantly changing as they are highly influenced by contextual factors such as the critical historical events (e.g.

the collapsed of big corporations), the verdict of the courts, and technological developments (e.g. advancement of

computing systems and CAATs). It can be observed that any major changes in these contextual factors are likely to

cause a change in the audit function and the role of auditors. As a result, auditing is seen to be evolving at all times.

Mautz (1975, p. 2) claimed that the audit function in a market economy ultimately evolved by social consent

because: Society either accepts or rejects the role of a professional group assumes for itself, in time the group either

finds a role acceptable to society or the group disappears. As conditions and apparent needs change, society may

reject roles formerly considered accepted so professional groups must continually be alert to the desirability of role

modification and revision.

However, it is important to note that the change in societys expectation and the response of the auditing professiontowards these changes are not always at the same pace. Hence there is a natural time gap between the changing

expectation of the users and the response by the profession and due to this time gap there arises what has been stated

as the expectation gap or audit expectation gap (Saha & Baruah, 2008). Even though the existence of such a natural

time gap is inevitable, Flint (1998) advises that auditors should be sensitive to the changing expectation of therelevant groups while at the same time containing these expectations within the constraints of what is possible. He

also claims that there are inevitably economic and practical limitations on what an audit can do, and this is something

which those who wish the benefit must understand.

REFERENCES


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F. C. Paula & F. A. Attwood (1982): Auditing: Principles and Practices. Pitman Books Limited, 128 Long Acre,

London WC2E 9An

Ndibe, N. B. & Okoye E. I. (1998): Auditing & Investigations. Futuretech Publishers, 96 Nnamdi Azikiwe Avenue,P. O. Box 202, Awka, Anambra, Nigeria

Journal of Modern Accounting and Auditing, Dec., 2008, Vol. 4

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