Chapter 1

Nature, objectives, and scope of Audit

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 CHAPTER-1
NATURE, OBJECTIVE & SCOPE OF AUDIT

“
“Audit evidence” is the very core on the basis of which conclusions are drawn and
opinion is formed by an auditor. In fact, it is the foundation upon which An Audit is
independent examination of financial information of any entity, whether profit oriented or
not, and irrespective of its size or legal form, when such an examination is conducted with a view
to expressing an opinion thereon”.

1. Origin of Audit:
Why there has been so much talking about the “audit” process everywhere? Does anyone know
the origin of this process! Though some “Old time” connections were found, but word “audit”
means “Audire” meaning “to hear” and in medieval time, auditors used to hear the accounts
read out to them. In India, under the Britishers, First Auditor General of India was appointed in
British India in 1860 to perform both accounting and auditing functions.
Presently, Comptroller and Auditor General (CAG) of India is an independent
constitutional authority responsible for auditing government receipts & expenditures. The
Institute of Chartered Accountants of India was established as a statutory body under an Act of
Parliament in 1949 for regulating the profession of Chartered Accountancy in the country.

2. Meaning and nature of auditing:

An audit is independent examination of financial information of any entity, whether profit
oriented or not, and irrespective of its size or legal form, when such an examination is conducted
with a view to expressing an opinion thereon. We can divide the above definition in to 3 parts-

Independent, implies that judgement of a person is not impacted by

An audit is
independent wishes or direction of person who might have engaged him.
examination of E.g., Mr. A requested his CA brother to conduct the audit of his
financial information company. Is it OK!! NO, since result of examination of records are
subject to influence from brother.

Entity whose financial It can be a non-profit organization like an NGO or a charitable

information is
trust. Audit can be undertaken in respect of any organization be it
examined need not
a small, medium, or large. Entity can be an OPC, LLP, private or
necessarily be profit
oriented. public company etc.

Opinion of auditor shall be based on thorough understanding &

Purpose of audit is to checking of the accounts of a business. He must ensure that books
express an opinion on of accounts are complete in all aspects and are supported by
the financial statements adequate evidence. Financial statement including disclosures and
classification as per applicable Accounting Standards are done.
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3. Relationship of auditing with other disciplines:
Auditing is interdisciplinary in nature. It draws from diverse subjects i.e. accountancy, law,
behavioural science, statistics, economics, & financial management & makes use of these subjects.
Suppose you are an auditor of a company & have been entrusted with the task of checking
not only the taxation and accounting aspects, but also secretarial compliances and other things
including interaction with different stakeholders. So, here you need to have strong knowledge of
taxation & of accounting rules, but also need to interact with lot of people for seeking
information and making inquiries. Since, an auditor cannot check each and every transaction and
for this sampling is done by him. Auditors use statistical methods to draw samples in a scientific
manner. Knowledge of subjects like economics helps auditors to be familiar with overall economic
environment in which business is operating. Financial management deals with issues Like funds
flow, working capital management, ratio analysis etc.

Auditing and
Accounting Auditing and Behavioural Science
Auditing reviews the Knowledge of human behaviour is
financial statements
essential for an auditor to effectively
which are nothing but
a result of the overall discharge his duties
accounting process
Auditing &
Economics Auditing and Law
Auditing and Data Processing
Auditor is expected An auditor should
to be familiar with have a good EDP auditing in itself is developing as a
the overall economic Audit discipline in itself
knowledge of
environment of the business laws
client
affecting the entity
Auditing and Financial Auditing and Statistics & Mathematics
Mgmt.
Auditor is expected to
Auditor is also expected to have the
have knowledge about knowledge of statistical sampling for
various financial meaningful conclusions and mathematics
techniques such as for verification of inventories.
working capital, ratio
analysis, capital budgeting
etc.

4. Objectives of Audit:
Checkbox Objectives of audit
✓ Obtaining a reasonable assurance that financial statements as a whole are free from
material misstatement due to fraud or error.
✓ Gaining reasonable assurance leads to formation of opinion whether financial
statements are prepared in accordance with applicable FRF.
✓ To report on the financial statements.
✓ Reporting of opinion in accordance with audit findings.
✓ Communication of reporting.
✓ Reporting and communication in accordance with Standards on Auditing.

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5. Scope of audit – Inclusion:
Scope refers to “range” or “reach” of something. The purpose of an audit is to enhance degree of
confidence of intended users in the financial statements. Users – Government, employees, trade
unions, banks, creditors, debtors etc. Below are the considerations related to scope of audit:

Code to Remember: C.A.R.D.S.

(What is on the tarot cards will happen in life, similarly what is in the scope of audit, will be done)

• Constraints on scope of audit of financial statement that impair auditor’s ability to express
opinion on financial statement should be set out in his report.
• The audit should cover adequately all aspects of the enterprise relevant to the financial
statements being audited.
• Auditor assesses reliability & sufficiency of the information contained in the underlying
accounting records.
• Auditor should also decide whether the relevant information is properly disclosed in the
financial statements.
• The auditor should be reasonably satisfied as to whether the information contained in the
underlying accounting records and other source data is reliable.

6. Scope of audit – Exclusion:

Scope refers to “range” or “reach” of something. However, auditor will not do anything which is
not in the scope of audit. Following conclusion can be drawn in respect of exclusion from the
scope of audit and auditor cannot be held wholly responsible.

• Physical condition of certain assets cannot be determined by him.

• An auditor is not an expert in authentication of documents.
• An audit is not an official investigation into alleged wrong doing. He does not have any
specific legal powers of search or recording statements of witness on oath which may be
necessary for carrying out an official investigation.
Below is the summary of POINT 5 & 6 above:

Checkbox Scope of audit of financial statements

✓ Coverage of all aspects of entity relevant to financial statements being audited
✓ Reliability and Sufficiency of financial information
✓ Proper disclosure of financial information
✓ Expression of an opinion on financial statements
X Responsibility of preparation & presentation of financial statements.
X Duties outside scope of competence of auditor
X Expertise in authentication of documents
X Investigation

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7. Inherent limitation of audit:
As per SA 200 “Overall Objectives of the Independent Auditor and the Conduct of an Audit in
Accordance with Standards on Auditing –

“There are various inherent* limitations to internal controls because of which auditor is not
expected to, & cannot, reduce audit risk to zero and cannot therefore obtain absolute assurance
that the financial statements are free from material misstatement due to fraud or error”.
* Inherent meaning - स्वाभाविक or पैदायशी

These fundamental limitations arise due to the following factors –

Timeliness of Financial
Nature of Financial Reporting and the Nature of Audit
Reporting Balance between procedures
Benefit and Cost

The preparation of financial Appropriate planning There are practical and legal
statements involves judgment assists in making limitations on auditor’s ability
by management in applying sufficient time and
requirements of the entity’s to obtain audit evidence like-
resources available for * Possibility that management
applicable financial reporting the conduct of the audit.
framework. Many financial or others may not provide,
statement items involve There is a balance to be the complete information.
subjective decisions. There struck between the
may be range of acceptable reliability of information * Fraud may involve carefully
interpretations. and its cost organised schemes.

Not in nature of
Future events
investigation

Adverse future events may seriously

affect ability of an entity to continue its Audit is not an official
business. The business may cease to exist investigation. Hence, auditor
in future due to change in market cannot obtain absolute
conditions, emergence of new business assurance that financial
models etc. Therefore, an auditor cannot
statements are free from
provide a guarantee that financial
material misstatements due to
statements are free from material
frauds or errors.
misstatements due to errors

8. Engagement & External audit engagement:

Meaning - means an arrangement to do something. In auditing, it means a formal agreement
between auditor & client under which auditor agrees to provide auditing services. It takes the shape
of engagement letter.

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 External audit Engagement – The main purpose of external audit engagement is to enhance degree
of confidence of intended users of financial statements. This includes audit of the accounts of a
company by a external auditors.

9. Benefit of Audit:
We can remember the benefits of the audit in below manner:
Insiders – Employees, internal fraud, or errors, shareholders.
Outsiders – Government (taxes), Bankers/lenders (financial health).

They are partners or

shareholders, bankers, FI’s,
Government may require
audited and certified
public at large etc.
statement before it gives
assistance or issues a
license.
It acts as a
moral check on
the employees
from
committing
frauds or
embezzlement.

Helpful in settling
liability for taxes,
negotiating loans
& for determining
An audit reviews existence the purchase
and operations of various Useful for settling trade consideration for a
controls operating in any disputes for higher wages or business.
` entity. Hence, it is useful at bonus as well as claims in
pointing out deficiencies. respect of damage suffered by
property, by fire.

10. More about the audit:

Most of us will wonder why there is a requirement for an audit of financial statements although
it is prepared by experts! Also, is audit of accounts mandatory for all the entities?

IS AUDIT MANDATORY?
No, it is not mandatory for all entities to get their accounts audited by the professional members.
Audit is required in case a company crosses the turnover limit as per law or a school may
require to gets its account audited if any grant(s) is receivable from the government, or some
companies may get their account audited as per established internal controls of that company.

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WHO APPOINTS AUDITOR-
In case of privately owned companies : Owner of the company
In case of public owned companies : Shareholder approves appointment in AGM
In case of government companies : Auditor is appointed by Comptroller and
Auditor General of India (CAG).

TO WHOM REPORT IS SUBMITTED BY AN AUDITOR-

1. Who submits report – Auditor. The outcome of an audit is written audit report in which
auditor expresses an opinion.

2. To whom the report is submitted –

• To person making the appointment.
• So, in case of-
Companies : Shareholders
A firm : To partners who have engaged him.

CASE STUDY 1
A, B, C and D are friends since their school days based in Delhi. They have cleared CA
foundation exams in same attempt and now plan to appear for CA Intermediate exams. All of
them are keen news listeners and regularly keep track of business news even on social media.
They are trying to understand new subjects including auditing. A, B and C have also started
attending Live Coaching Classes (LCC) being conducted by Board of studies of ICAI. D has not
been able to join Live Coaching Classes yet as she was away on a holiday with her parents.
However, she plans to catch-it up with her friends very soon. C had also joined the classes, but
he had skipped some lectures.
During one informal get together, their discussions centred around new subject of auditing.
They discussed many things regarding its nature, scope, benefits, and other general practical
issues. D was regular in keeping track of audited results of companies being published in
leading newspapers. Her view was that audited financial statements of companies give 100%
guarantee to different stake holders. It is the main reason behind so much reliance upon
auditing. But she could not understand why wrong doings in financial matters are being
discovered after many years have gone by.
C also concurred with her view and added that when financial statements are audited, each
and every transaction appearing in books of accounts is verified. However, he could not give
clarity to D. B was of the opinion that audit was conducted on the basis of sample checking. He
was also of the view that audited financial statements are not a guarantee against probable
wrong doings in financial matters of the companies. Not to be left behind, A also jumped in the
fray. He supported B and also added something of his own.

Based on the above, answer the following questions:

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1. B is of the view that audited financial statements are not a guarantee against probable
wrong doings in financial matters of companies. What kind of assurance does audit of
financial statements provide?
a. It provides reasonable assurance, meaning a moderate level of assurance.
b. It provides reasonable assurance meaning a low level of assurance.
c. It provides reasonable assurance meaning a high level of assurance.
d. It provides reasonable assurance meaning an absolute level of assurance.

2. A added that auditor can force an employee of the company to provide him required
information and documents. Can he do so?
a. Yes, he can do so. It is necessary to obtain audit evidence.
b. Yes, he can do so. There are express rights given to him in this respect.
c. No, he cannot do so. He can only request for providing him with necessary
information and documents. But it cannot be forced by him.
d. No, he cannot do so. He has no right of seeking information and documents. Therefore,
question of forcing does not arise.

3. C had listened in one of the classes that audit covers all aspects of an entity and
concluded that each and every transaction of entity is verified by auditor. D also seemed
to be in agreement with him, but she was of the view that besides this, it also meant that
audit should be so organized to cover all areas of an entity. Which of following
statements is appropriate in this regard?
a. Yes, he can do so. It is necessary to obtain audit evidence.
b. Yes, he can do so. There are express rights given to him in this respect.
c. No, he cannot do so. He can only request for providing him with necessary information and
documents. But it cannot be forced by him.
d. No, he cannot do so. He has no right of seeking information and documents. Therefore,
question of forcing does not arise.

4. All of them also discussed about benefits of auditing. Which of the following is not a
likely benefit of auditing?
a. Since auditing is connected to future events, audited information can be easily relied upon.
b. Errors or frauds may be discovered during audit.
c. Government authorities can make use of audited accounts for different purposes.
d. It can help in bringing out deficiencies in maintenance of financial records.

5. D told her friends that she had read a news report about how a company had misled its
auditors by producing some fabricated documents. Which of following statements
seems to be appropriate in this regard?
a. It was wrong on the part of auditor to rely upon fabricated documents. He must have
discovered it as the same falls within the scope of his duties.
b. Although it was wrong on the part of auditor to rely upon fabricated documents, he cannot
do anything in the matter. He has to report on the basis of documents provided to him. He
has no duty in this regard.

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 c. Auditor has to conduct audit by exercising professional skill. But he is not an expert in
discovering genuineness of documents. Hence, management consisting of dishonest
persons may have led him to rely upon fabricated documents deliberately.
d. Management cannot mislead auditor due to high level of knowledge and expertise
possessed by him. The above is an outlier case-one of the rare, odd cases.

Solution to Case Study 1:

1. (c) 2. (c) 3. (d) 4. (a) 5. (c)

11. Meaning of assurance engagement:

It is an engagement in which-
- Practitioner expresses a conclusion designed to enhance,
- The degree of confidence of intended user,
- About the outcome of evaluation or measurement of subject matter against criteria.

----- Elements of assurance engagement-----

Auditee/Company Auditor User of Information

(Responsible Party) (Practitioner) (Intended User)

1. A 3-party relationship involving a practitioner, a responsible party & intended user:

In such engagement, three parties are involved.
Practitioner - A practitioner is a person who provides the assurance.
Responsible Party – Who prepares the subject matter (E.g. -Financial statement).
Intended Users- are the persons for whom an assurance report is prepared. These persons
may use the report in making decisions.

2. Sufficient appropriate evidence:

The practitioner performs an “assurance engagement” to obtain sufficient appropriate
evidence. It is on the basis of evidence only that conclusions are arrived, and an opinion is
formed by auditor. Sufficient - quantity of evidence obtained by auditor & Appropriate -
quality of evidence obtained by auditor.

3. A written assurance report in appropriate form:

A written report is provided containing conclusion that conveys the assurance about the
subject matter. A written assurance report is the outcome of an assurance engagement.

4. An appropriate subject matter:

It refers to the information to be examined by practitioner and this includes financial
statements, or any engagement undertaken by him.

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12. Meaning of review:
However, review is a limited assurance engagement.
(a) It provides lower level of assurance than audit.
(b) Review involves less procedures & gathers sufficient appropriate evidence on the basis of
which limited conclusions can be drawn up.

Code to remember: P - A.C.E2

(A company after audit, can Professionally ACE in terms of financials)

Points Reasonable assurance engagement Limited assurance engagement

(AUDIT) (REVEIW)
Procedures It performs elaborate & extensive It performs fewer procedures as
adopted procedures to obtain sufficient compared to reasonable assurance
appropriate evidence. engagement.
Assurance Such engagement provides high Limited assurance engagement
level of assurance. provides lower level of assurance.
Conclusion It draws reasonable conclusions It involves obtaining sufficient
on the basis of sufficient appropriate evidence to draw
appropriate evidence. limited conclusions.
Example Example - Audit engagement. Example - Review engagement.
Emphasis Emphasis is on the examination & Emphasis in review is given to
verification of financial statements over-viewing of the accounting
& accounting records. records.

While doing audit, most of the activities are directed towards the obtaining assurance of
financials of the company which are based on historical financial information. But there
exists 1 more type of financial information which relates to events in the future.

“Prospective financial information” means financial information based on assumptions

about events that may occur in the future and possible actions by an entity. It can be in the
form of a forecast or projection or combination of both.

“Historical financial information” relates to information expressed in financial terms of an

entity about economic events, conditions or circumstances occurring in past periods.

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 S
U
M
M
A
R
Y

13. Qualities of auditor:

An auditor is concerned with the reporting on financial matters of business and as such should
possess the following qualities:
Code to remember : A – U.P.I.
(Always UPI)

1. An exhaustive knowledge of accounting principles and techniques.

2. The auditor should be equipped with an understanding of the special features peculiar to a
particular business.
3. Patience, caution, firmness, good temper, integrity, discretion, industry, judgment, clear
headedness, and reliability.
4. He must have the highest degree of integrity backed by adequate independence.

14. Engagement and quality control standards:

The following Standards issued under authority of ICAI Council are collectively known as
Engagement Standards:
SA 100-899
Standards on
• It apply in audit of historical financial information
auditing
SA 2000-2699
Standards on
review • It apply in review of historical financial information
engagement
SA 3000-3699
Standards on
• It apply in assurance engagements other than audits and
Assurance
review of historical financial information
engagements
SA 4000-4699
Standards on •It apply in agreed upon procedures to information,
Related Services compilation engagements & other service engagements.
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 BEFORE ATTEMPTING BELOW QUESTIONS, PLEASE READ ABOUT ASSURANCE
ENGAGEMENT

CASE STUDY 2
Me & You Private Limited has been newly incorporated. The plant of the company has recently
started production with the help of funds provided by a bank for purchase and installation of
machinery. Further, the company is also utilizing working capital credit facilities from the same
bank for meeting its day-to-day working capital requirements like for purchase of raw materials,
labour payment etc. However, just within 6 months of its operations, the management feels that
working capital funds are inadequate and situation is creating liquidity issues in the company.
The management of the company has approached its bankers and requested for enhancement
in working capital credit facilities. The bank manager has been insisting upon financial statements
of the company for half year along with report providing assurance in this respect duly signed by
Chartered Accountant as audit is far away. It also requires projected financial statements for
coming years along with a report from CA providing assurance regarding these projections to
consider request of management. The management approaches CA P, who has qualified recently
and started practicing. Reports providing assurance for half yearly results and projected financial
statements are sought from CA P. The Management provides necessary information and records to
him in this regard.
Assume, in above case, the company only provides trial balance, financial statements in
draft/preliminary form along with accompanying records for the relevant half year to CA P and
requests him to provide duly signed financial statements with a report for mutually agreed
professional fees.

Based on above, answer the following questions-

1. Management of company has engaged CA P to issue a duly signed report for half year.
Which of the following standards, if any, issued by ICAI are relevant for CA P?
(a) Standards on Review Engagements
(b) Standards on Auditing
(c) Standards on Related Services
(d) There are no standards for issuing report in such situation.

2. Which of the following statements is MOST APRROPRIATE in given case situation?

(a) CA P can assist management in preparation of financial statements of the company.
However, issue of a report in such a case is outside the scope of work.
(b) CA P can assist management in preparation of financial statements of the company and
he can issue an audit report.
(c) CA P can assist management in preparation of financial statements of the company and
he can issue a compilation report in this respect.
(d) The responsibility of preparation of financial statement is of company’s management.
CA P cannot assist management in preparation of financial statements of the company.
However, he can issue a review report.

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3. In the above said scenario for issuance of signed financial statements for half year by CA
P, as discussed in last para of Case Study, identify the MOST APPROPRIATE statement?
(a) Standard on Quality control (SQC 1) is not applicable as CA P cannot issue audit report.
(b) Standard on Quality Control (SQC 1) is not applicable as CA P cannot issue review report.
(c) Standard on Quality Control (SQC 1) is applicable in such type of engagement.
(d) Standard on Quality Control (SQC 1) is not applicable as CA P is barred from issuing any
report in such type of engagement.

4. The banker of company has also requested for projected financial statements for coming
years along with a report from CA regarding these projections to consider request of
management. Which of the following standards issued by ICAI are relevant for CA P in
such a situation, if any?
(a) Standards on Review Engagements
(b) There are no standards for issuing such type of reports.
(c) Standards on Related Services
(d) Standards on Assurance Engagements

5. Suppose CA P also accepts work of issuing projected financial statements with a report to
be signed by him. The management has projected turnover of Rs. 100 cores for the next
year, Rs. 150 crore and Rs. 200 crores for following years respectively as compared to
present turnover of Rs. 25 crores in current half year. Identify the MOST APPROPRIATE
statement in this situation?
(a) CA P has to satisfy himself regarding arithmetical accuracy of projected data.
(b) CA P has to satisfy himself regarding reasonableness of assumptions underlying
projected turnover and its consistency with actuals.
(c) CA P has to satisfy himself regarding arithmetical accuracy of data along with its
proper presentation to banker.
(d) CA P has to satisfy himself regarding reasonableness of assumptions underlying
projected turnover, its consistency with actuals, disclosure and presentations.

Solution to Case Study 2:

1. (c) 2. (c) 3. (c) 4. (d) 5. (d)

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STATE WITH REASONS (IN SHORT) WHETHER THE FOLLOWING STATEMENTS ARE
CORRECT OR INCORRECT:

(i) Basic objective of audit does not change with reference to nature, size or form of an entity.
(ii) The purpose of an audit is to enhance the degree of confidence of intended users in the financial
statements.
(iii) The auditor is not expected to, and cannot, reduce audit risk to zero and cannot therefore obtain
absolute assurance that the financial statements are free from material misstatement due to
fraud or error.

Solution-
(i) Correct: An audit is an independent examination of financial information of any entity, whether
profit oriented or not, and irrespective of its size or legal form, when such an examination is
conducted with a view to expressing an opinion thereon. It is clear that the basic objective of
auditing, i.e., expression of opinion on financial statements does not change with reference to
nature, size or form of an entity.

(ii) Correct: As per SA 200 “Overall Objectives of the Independent Auditor and the Conduct of an
Audit in Accordance with Standards on Auditing”, the purpose of an audit is to enhance the
degree of confidence of intended users in the financial statements. This is achieved by the
expression of an opinion by the auditor on whether the financial statements are prepared in
accordance with an applicable financial reporting framework.

(iii) Correct: As per SA 200 “Overall Objectives of the Independent Auditor and the Conduct of an
Audit in Accordance with Standards on Auditing”, the auditor is not expected to, and cannot,
reduce audit risk to zero and cannot therefore obtain absolute assurance that the financial
statements are free from material misstatement due to fraud or error. This is because there are
inherent limitations of an audit, which result in most of the audit evidence on which the auditor
draws conclusions and bases the auditor’s opinion being persuasive rather than conclusive.

GENERAL MCQS
1. Which of the following is not an advantage of audit?
(a) It provides high quality financial information.
(b) It acts as a moral check on employees.
(c) It enhances risk of management bias.
(d) It helps in safeguarding interests of shareholders.

2. Which of the following is NOT TRUE about an assurance engagement?

(a) It relates to providing assurance about historical financial information only.
(b) The practitioner obtains sufficient appropriate evidence.
(c) There is some information to be examined by practitioner.
(d) A written assurance report in appropriate form is issued by practitioner.

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3. Which of the following is TRUE about Engagement Standards?
(a) Engagement standards ensure proper rights to practitioners in course of performance of
their duties.
(b) Engagement standards ensure preparation and presentation of financial statements in a
standardized manner.
(c) Engagement standards ensure uniformity by practitioners in course of performance of
their duties.
(d) Engagement standards ensure savings in resources of clients.

4. Consider following statements in relation to “Limited assurance engagement”:

Statement I - It involves obtaining sufficient appropriate evidence to draw reasonable
conclusions.

Statement II - Review of interim financial information of a company is an example of

limited assurance engagement.

a. Statement I is correct. Statement II is incorrect.

b. Both Statements I and II are correct.
c. Both Statements I and II are incorrect.
d. Statement I is incorrect. Statement II is correct.

Solutions to general MCQ:

1. (c) 2. (a) 3. (c) 4. (d) – We can draw limited conclusion only.

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