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Fundamentals of Auditing

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Introduction (Meaning of Internal Audit)

Internal audit is part of internal control, set by the management, delegating its supervisory functions
to specially assigned staff, with the objective to see that the internal controls are in operation and to
assist them in fulfilling their responsibilities such as
1. safeguarding of the assets
2. reliability of financial records and
3. efficiency in operation


“Internal auditing” means an appraisal activity established within an entity as a service to the entity.
Its functions include, amongst other things, examining, evaluating and monitoring the adequacy and
effectiveness of the accounting and internal control system.


Accounting system and internal
control are operating efficiently.
Report on Financial statements.


Responsibility to the management. Responsibility to the share holders.

Scope of work

Determined by management.
Determined by the statute; otherwise
determined through mutual agreement
between auditor and the client.

Scope and Objectives of the Internal Audit Function

Although the exact nature of internal audit function is determined by the management, however,
generally the aims and objectives of the internal audit function are:
i) Review and assessment of the internal control procedures and accounting system.
ii) Examination of financial and operating information for management, including detailed
testing of transactions and balances.
iii) Review of efficiency, economy and effectiveness of operation.
iv) Review of compliance with laws, regulations, management policy and other internal

Relationship between Internal Auditing and the External Auditor
Management’s Requirements Vs Independent Report on Financial Statements

Unlike the internal auditor who is an employee of the enterprise, the external auditor is required to be
independent of the enterprise, usually having a statutory responsibility to report on the financial
statements giving an account of management’s stewardship.

Common Means

Some of the means adopted by both the auditors to achieve their respective objectives are common,
e.g. evaluation of internal control. Therefore, certain aspect of internal auditing may be useful in
determining the nature, timing and extent of external audit procedures.

Dependence Vs Independence

Whatever be the degree of autonomy given by the management to internal auditing it cannot enjoy
the same degree of independence as external auditors. Moreover, the responsibility for the report is
that of the external auditor alone, and therefore is indivisible and is not reduced by the reliance on
internal auditing.

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As a result, all final judgments relating to matters which are material to the financial statements or
other aspects on, which he is reporting, must be made by the external auditor himself.

Understanding of Internal Auditing

The external auditors should obtain a sufficient understanding of internal audit activities to assist in
planning the audit and developing an effective audit approach.
Effective internal auditing will often allow a reduction in the procedures performed by the external
auditors but cannot eliminate them entirely. However, external auditor may decide not to use the
internal auditor’s work.

Preliminary Assessment of Internal Auditing

After obtaining understanding of internal auditing, if it appears that its work is relevant for external
auditors, the external auditor should, during the course of planning perform preliminary assessment
of internal auditing function. An effective internal audit may allow a modification in the nature, timing
and extent of procedures performed by external auditors.

Criteria while Obtaining Understanding and Preliminary Assessment of Internal Auditing

Before relying on the work performed by the internal auditor, it is necessary for the external auditor
to make an assessment of the effectiveness and relevance of the internal audit function by considering
the following:

Organizational status:

The internal auditor is an employee of the entity and therefore
cannot be independent, however the external auditor should evaluate to what extent he is
free in performing his duties and communicate with external auditor and consider any
constraints placed upon his work.
Ideally, internal auditor should be reporting to the highest level of management and should
be free from other operating responsibility.

Scope and Objectives of Internal Audit Function:

The external auditor should examine
the range and aim of the assignments assigned to internal auditors by the management and
whether management acts on internal audit recommendations.

Technical Competence:

The external auditor should ascertain whether staff of the internal
audit function has adequate technical training and proficiency as auditors.

Due Professional Care:

The external auditor should consider whether the internal auditor
has performed his work with reasonable care and skill i.e. work is properly planned,
supervised and reviewed. He should also consider existence of working papers, work
programs, audit manuals etc.

Liaison and Coordination

The extent of liaison would normally encompass the following:
i) Initial planning to formulate a joint approach to minimize the tests performed by the two
auditors i.e. tests level, sample selection, documentation of work performed, review and
reporting procedures.
ii) Regular meetings between the internal and external auditors during the year.
iii) Exchange of knowledge between the two auditors i.e. the external auditors should be
informed of any significant matter that comes to the knowledge of internal auditor which
he believes may affect to work of external auditor. Similarly the external auditor should
inform the internal auditor of any significant matters which may affect his work.

Evaluating Internal Audit Work/Review/Controlling

Where the external auditor has decided to place reliance on the work of internal auditor, he should
review the working papers to satisfy himself as to:-
i) Audit programs are adequate.
ii) The work is performed by trained staff and the work of assistants is properly
supervised, reviewed and documented.
iii) Sufficient appropriate audit evidence was obtained.
iv) Conclusions made are appropriate.
v) Reports prepared are based on the work done.

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vi) Exceptions or unusual items have been properly resolved. The external auditor
should record all the working he has received. The external auditor should also
test the work of internal auditor.

Testing the Work of Internal Auditing

It can be done in the following ways:
i) Re-performing the work done by internal auditor, on test basis, to ensure that the same
results are achieved;
ii) Selecting a few similar items and perform independent test; and
iii) Observation of internal auditing procedures.

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