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INTRODUCTION TO AUDITING
Overview of Auditing
Auditing, Defined:
Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions
about economic actions and events to ascertain the degree of correspondence between those assertions
and established criteria and communicating the results to the interested users.
Important Concepts:
1. Systematic process auditing involves structured/logical series of sequential steps or
procedures known as the audit process
3. Assertions about economic actions and events assertions are the subject matter of
auditing
In the context of audit of financial statements, assertions are representations of
management, explicit or otherwise, that are embodied in the financial statements. Assertions
include the accounts, balances/amounts and disclosures appearing on the face of the
financial statements (and in the notes to financial statements) and which the management
claims to be free of misstatements.
Audit evidence gathered and evaluated by the auditor may support or contradict the
assertions of management.
4. Established criteria the standards or benchmarks that are needed to judge the validity of the
assertions on the financial statements
In the context of audit of financial statements, the established criteria are the applicable
financial reporting framework (for example, the PFRS).
6. Communicating the results to the interested users The ultimate objective of audit is the
communication of audit findings/opinion on the fairness of the financial statements to interested
users.
Communicating results is achieved through issuance of a written audit report which contains
the audit opinion (or disclaimer of opinion).
Interested users are the wide variety of financial statements users who rely on the
auditors opinion such as the stockholders, creditors, potential investors and creditors,
management, government agencies, and the public (in general).
Four primary factors that contribute to information risk (causes of information risk):
1. Remoteness of information users from information providers
2. Potential bias and motives of information provider
3. Voluminous data, and
4. Complex exchange transactions
Another condition that gave rise to demand for audit of financial statements is the stewardship or
agency theory which means that management wants the credibility an audit adds to the financial
statement to enhance stewardship of the financial statement and to lessen the owners mistrust of
the management.
In an audit of financial statements, the entity subject to audit may be profit-oriented or not,
irrespective of size and legal form.
Synonymous terms:
Audit of financial statements is sometimes called:
Independent audit because in an audit of financial statements the auditor is independent
of the client subject to audit.
External audit because it is performed by an external auditor who is not an employee of
the client subject to audit.
Independent financial statement audit
Financial statement audit
Financial audit
Various descriptions:
Independent auditing has been described in a variety of ways, as follows:
It involves objective examination of and reporting on financial statements prepared by
management
It is a discipline which attests to the results of accounting and other functional operations
and data.
It lends credibility to the financial statements.
b. To report on the financial statements and to communicate such report in accordance with the
auditors findings.
Financial statement audit (or the audit opinion and auditors report) is:
NOT a certification or guarantee as to accuracy or fairness of the financial statements.
NOT an assurance as to future viability of the entity.
NOT an assurance as to efficiency or effectiveness of the clients business operations.
NOT attestation as to the financial strength of an entity, the wisdom of its management
decisions, or the risk of doing business with it.
Financial Statements:
Financial statements are a structured representation of historical financial information
(including related notes which comprise a summary of significant accounting policies and
other explanatory information), intended to communicate an entitys economic resources or
obligations at a point in time or the changes therein for a period of time in accordance with
a financial reporting framework.
The term financial statements ordinarily refers to a complete set of financial statements,
but can also refer to a single financial statement.
However, an auditor may make suggestions on the form and content of financial statements or may
draft statement.
Financial reporting frameworks encompass primarily the financial reporting standards established
by an organization that is authorized or recognized to promulgate standards to be used by entities for
preparing general purpose financial statements are often designed to achieve fair presentation, for
example, Philippine Financial Reporting Standards (PFRSs).
Where conflicts exist between the financial reporting framework and the sources from which
direction on its application may be obtained, or among the sources that encompass the financial
reporting framework, the source with the highest authority prevails.
In financial statements audit, financial reporting frameworks that are acceptable as valid criteria
include:
1. Philippine Financial Reporting Standards (PFRSs)
2. Philippine Accounting Standards (PASs)
3. International Accounting Standards (IASs)
4. Other authoritative basis
Financial statements need to be prepared in accordance with one, or a combination of the above-cited
financial reporting framework.
1. Relevant ethical requirements The auditor shall comply with relevant ethical requirements,
including those pertaining to independence, relating to financial statement audit engagements.
Compliance with the Code of Ethics is necessary in order to ensure the highest quality of
performance and to maintain public confidence in the profession and in the context of audit of
(1) Part A of the Code of Ethics establishes the fundamental principles of professional
ethics relevant to the auditor when conducting an audit of financial statements and
provides a conceptual framework for applying those principles
The fundamental principles of professional ethics are:
a) Integrity
b) Objectivity
c) Professional competence and due care
d) Confidentiality, and
e) Professional behavior
(2) Part B of the Code of Ethics illustrates how the conceptual framework is to be applied
in specific situations
(3) Independence requirements
It is in the public interest that the auditor be independent of the entity subject to the
audit.
The auditors independence from the entity safeguards the auditors ability to form an
audit opinion without being affected by influences that might compromise that opinion.
Independence enhances the auditors ability to act with integrity, to be objective and
to maintain an attitude of professional skepticism.
Independence requirements comprise of both:
a) Independence of mind
b) Independence in appearance
b. National requirements that are more restrictive
c. Philippine Standard on Quality Control (PSQC) require the CPA firm to establish
and maintain its system of quality control designed to provide it with reasonable assurance that
the firm and its personnel comply with relevant ethical requirements, including those pertaining
to independence
2. Professional scepticism The auditor shall plan and perform an audit with professional
scepticism recognizing that circumstances may exist that cause the financial statements to be
materially misstated.
Professional skepticism is necessary to the critical assessment of audit evidence. This includes:
a. Questioning contradictory audit evidence
b. Considering the reliability of documents and responses to inquiries and other information
obtained from management and those charged with governance
c. Considering the sufficiency and appropriateness of audit evidence obtained in the light of
the circumstances (for example, in the case where fraud risk factors exist and a single
document, of a nature that is susceptible to fraud, is the sole supporting evidence for a
material financial statement amount)
Maintaining professional skepticism throughout the audit is necessary to reduce the risks of:
Overlooking unusual circumstances.
Over generalizing when drawing conclusions from audit observations.
Using inappropriate assumptions in determining the nature, timing and extent of the
audit procedures and evaluating the results thereof.
3. Professional judgement The auditor shall exercise professional judgment in planning and
performing an audit of financial statements.
Professional judgment is essential to the proper conduct of an audit. This is because interpretation
of relevant ethical requirements and the PSAs and the informed decisions required throughout the
audit cannot be made without the application of relevant knowledge and experience to the facts
and circumstances.
4. Sufficiency and appropriateness of audit evidence and audit risk To obtain reasonable
assurance, the auditor shall obtain sufficient appropriate audit evidence to reduce audit risk to an
acceptably low level and thereby enable the auditor to draw reasonable conclusions on which to
base the auditors opinion.
Appropriateness is the measure of the quality of audit evidence; that is, its relevance
and its reliability in providing support for the conclusions on which the auditors opinion is
based. The reliability of evidence is influenced by its source and by its nature, and is
dependent on the individual circumstances under which it is obtained.
b. Audit risk
Audit risk is the risk that the auditor expresses an inappropriate opinion when the
financial statements are materially misstated. Audit risk is a function of the risks of material
misstatement and detection risk.
Audit risk does not include the risk that the auditor might express an opinion that the
financial statements are materially misstated when they are not. Audit risk is a technical
term related to the process of auditing; it does not refer to the auditors business risks such
as loss from litigation, adverse publicity, or other events arising in connection with the audit
of financial statements.
2. Detection risk is the risk that the procedures performed by the auditor to reduce audit
risk to an acceptably low level will not detect a misstatement that exists and that could be
material, either individually or when aggregated with other misstatements.
Detection risk relates to the nature, timing and extent of the auditors procedures that
are determined by the auditor to reduce audit risk to an acceptably low level. It is
therefore a function of the effectiveness of an audit procedure and of its application by the
auditor.
3) In addition, the auditor should also consider Philippine Auditing Practice Statements
(PAPSs). PAPSs provide interpretative guidance and practical assistance to auditors in
implementing the PSAs and to promote good practice in the accountancy profession.
The need for the auditor to depart from a relevant requirement is expected to arise only where
the requirement is for a specific procedure to be performed and, in the specific circumstances
of the audit, that procedure would be ineffective in achieving the aim of the requirement.
Note:
Physical limitations of auditors due to fatigue and stress are not a limitation of audit.
Because of the inherent limitations of an audit, there is an unavoidable risk that some material
misstatements of the financial statements may not be detected, even though the audit is
properly planned and performed in accordance with PSAs. Accordingly, the subsequent
discovery of a material misstatement of the financial statements resulting from fraud or error
does not by itself indicate a failure to conduct an audit in accordance with PSAs.
2. Audit Risk the risk that audit opinion is inappropriate when the financial statements are
materially misstated
Specifically, audit risk is the risk that the auditor expresses an unqualified (or clean) audit
opinion when the financial statements are materially misstated.
The concept of reasonable assurance acknowledges the existence of audit risk.
An of financial statements is the type of audit most frequently performed by CPAs (due to the
widespread use of audited financial statements) on a fee basis and for more than one client.
b. Compliance audit: a review of an entitys degree of compliance with applicable laws and
rules/regulations or contracts
Compliance audits are usually performed by government auditors
c. Operational audit involves a systematic review and evaluation of the specific operating units (or
procedures, methods or activities) of an organization in relation to specified objectives for the
purpose of measuring/assessing its performance in terms of efficiency and effectiveness of
operations, identifying opportunities for improvement and making recommendations to improve
performance (such as introduction of controls to reduce waste).
Also called performance audit or management audit
Example: Evaluation of a companys computerized accounting system
Operational audits are usually performed by internal auditors
2. According to types of auditor or their affiliation with the entity being examined:
a. External / Independent audit: performed by practitioners or independent CPAs who offer their
professional services for a fee to various clients on a contractual basis
Independent or external auditors are not employees of the client
External audit complements internal audit
b. Internal audit: audit performed by entitys own employees known as internal auditors;
internal auditors investigate and apprise the effectiveness and efficiency of operations and internal
controls of the firm
Internal auditing is an appraisal control that measures and evaluates other controls.
The increased complexity and sophistication of business operations have required
management to rely on this appraisal control.
Internal auditors review the adequacy of the company's internal control system
primarily to ascertain whether the system provides reasonable assurance that the
company's objectives and goals will be achieved efficiently and economically.
Internal auditors assist in the prevention of fraud by examining and evaluating the
system of internal control.
Internal auditors are required to review the means employed by the company to
safeguard its assets from various types of losses such as those resulting from fire, theft,
unscrupulous or illegal activities, and exposure to the elements.
ii) Overall objective of internal auditing: to assist the members of the organization,
particularly management and board of directors, in the effective discharge of their
responsibilities; in short, to provide assistance to or serve the needs of management or board
of directors
Scope of government audit: may extend beyond financial statements audit to include:
The Commission on Audit (COA) auditors perform financial audit and performance audit.
Performance audits include economy, efficiency, and program audits. Included in the scope of
financial and performance audits is determining whether the entity has complied with applicable
laws and regulations. Thus, government auditors are required to prepare a written report on
the entity's internal control and assessment of control risk made as part of a financial statement
audit.
However, the report should not give any form of assurance on the design and effectiveness of
the entity's internal control.
The audit of a government program involves obtaining information about the costs, outputs,
benefits, and effects of the program. Auditors attempt to measure the accomplishments and
relative success of the program based on the actual intent of the legislation that established the
program.
Types of Auditors:
1. Independent auditors or external auditors are CPA firms and individual practitioners who
perform audit services on contractual basis for more than one client
Independent auditor because the auditor is independent with respect to the client whose
FS are being audited; External auditor the auditor is an outsider (not an employee of the
client)
Practitioners perform operational audits and compliance audits as part of consultancy
services
2. Internal auditors they are employed by the entity thus they are not independent. However, to
operate effectively, an internal auditor must be independent of the line functions of the entity.
Internal auditors perform operational and compliance audits.
3. Government auditors employed in government agencies
BIR examiners perform compliance audits
BSP examiners perform compliance and operational audits
COA auditors perform compliance and operational audits
The relationship between an external auditor and an internal auditor is that both of them use
basically an identical approach; however, there are differences in the application of auditing techniques.