Auditing theory day 09

241. Account-Based Audit Approach b. Set audit risk at a level that the auditor
In this audit approach, auditors first obtain believes will mitigate the likelihood that
an understanding of control and assess control risk the auditor will fail to identify material
for particular types of errors and frauds in specific misstatements.
accounts.
a. Management provides a set of accounts 249. Phases of the Risk-Based Audit Process
b. Management provides internal control
report (ICR) • Phase I: Risk Assessment
c. The auditor proceeds to test each line o Phase I-A: Performance of
item in the Financial Statement, and Preliminary Engagement Activities
sample of controls from ICR. o Phase I-B: Planning the Audit
o Phase I-C: Performance of Risk
242. Risk Assessment Procedures
• Phase II: Risk Response
It is the potential for uncontrolled loss of
o Phase II-A: Designing Overall
something of value.
Responses and Further Audit
Critical Components of Risk Procedures
o Phase II-B: Implementing
244. Audit Risk Responses to Assessed Risk of
It refers to the risk that an auditor may give Material Misstatement
an unqualified opinion on financial statements that • Phase III: Reporting
are materially misstated. o Phase III-A: Evaluating the Audit
Evidence Obtained
245. Engagement Risk o Phase III-B: Forming an Opinion
It pertains to the economic risk that a CPA Based on Audit Findings and
firm is exposed to simply because it is associated Preparing the Auditor’s Report
with a particular client including loss of reputation,
PHASE I: RISK ASSESSMENT
inability of the client to pay the auditor, or financial
loss because management is not honest and
Phase I-A: Performance of Preliminary
inhibits the audit process. It is controlled by careful
Engagement Activities to Decide whether to Accept
selection and retention of client.
or Continue an Audit Engagement
246. Financial Reporting Risk
252. Purpose of Performing Preliminary
It is the risk that relate directly to the
Engagement Activities
recording of transactions and presentation of
The main purpose of performing preliminary
financial data in an organization’s financial
engagement activities is to eliminate engagement
statements.
risks through the ensuring of the following:
247. Business Risk a. The auditor maintains necessary
It refers to the risk that affects the independence and ability to perform
operations and potential outcomes of the engagement;
organizational activities. b. There are no issues with management
*** integrity that may affect the auditor’s
willingness to continue the
248. Ways to Control Audit Risk engagement; and
c. There is no misunderstanding with the
a. Avoid audit risk by not accepting certain
client as to the terms of the
companies as client (i.e., reduce
engagement.
engagement risk to zero); and

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Auditing theory
253. Items to Be Assessed before Accepting an
Engagement
Before accepting an engagement with a new
client, the CPA firm shall assess whether it:
a. Is competent to perform the
engagement and has the capabilities,
including time and resources to do so;
b. Can comply with the relevant ethical
requirements;
c. Has considered the integrity of the client
and does not have information that
would lead it to conclude that the client
lacks integrity.
254. Preconditions for an Audit to Be Established
a. Whether the financial reporting
framework to be applied in the financial
statements are acceptable; and
b. Agreement of management that it
acknowledges and understands its
responsibilities.
255. Responsibilities of the Management
a. For the preparation of financial
statements in accordance with
applicable financial reporting
framework;
b. For the internal control as management
determines is necessary to enable the
preparation of financial statements that
are free from material misstatements
whether due to fraud or error; and
c. To provide the auditor with access to all
relevant information and persons for the
purpose of the audit.
256. Audit Engagement Letter
An engagement letter defines the legal
relationship (or engagement) between the audit firm
and its client(s). This letter states the terms and
conditions of the engagement, principally
addressing the scope of the engagement and the
terms of compensation for the firm (fees are
optional).
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257. Contents of an Engagement Letter
a. The objective and scope of the audit of
the financial statements;
b. The responsibilities of the auditor;
c. The responsibilities of the management;
d. Identification of the applicable financial
reporting framework for the preparation
of financial statements; and
e. Reference to the expected form and
content of any reports to be issued by
the auditor and a statement that there
may be circumstances in which a report
may differ from its expected form and
content.
258. Considerations Relating to Recurring Audits
a. The auditor shall assess whether
circumstances require the terms of the
audit engagement to be revised whether
there is a need to remind the entity of the
existing terms of the audit engagement.
b. The auditor shall not agree to the change
in the terms of the audit engagement
where there is no reasonable
justification for doing so.
c. If the terms of the audit are changed,
auditor and management shall agree on
and record the new terms of the
engagement in an engagement letter or
other suitable form of written
agreement.
259. Disagreement between the Auditor and
Management Regarding a Change in the Terms of
the Audit Engagement
If the auditor is unable to agree to a change
in the terms of the audit engagement and is not
permitted by management to continue the original
engagement, the auditor shall:
a. Withdraw from the audit engagement
where withdrawal is possible under
applicable law or regulation; and
b. Determine whether there is any
obligation, either contractual or
otherwise, to report the circumstances
to other parties, such as those charged
with governance, owners or regulators.
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Auditing theory
Phase I-B: Planning the Audit to Develop an
Overall Audit Strategy and Audit Plan
261. Audit Planning
It involves the establishment of the overall
audit strategy for the engagement and developing
an audit plan, in order to reduce audit risk to an
acceptably low level.
262. Overall Audit Strategy
It sets the scope, timing and direction of the
audit and guides the development of the more
detailed audit plan.
263. Aspects of Materiality
a. Quantitative considerations which relate
to the peso amount of the error to the
financial statements under examination.
b. Qualitative considerations which relate
to the causes of misstatement (e.g.,
attributed to an irregularity or an illegal
act by the client). In other words, small
amounts of misstatement may still be
considered material depending on its
nature.
264. Relevance of Materiality in Audit Planning
In planning the audit, materiality should be
considered by the auditor when:
a. Determining the nature, timing and
extent of audit procedures;
b. Identifying and assessing the risks of
material misstatement; and
c. Determining the nature, timing and
extent of further audit.
Levels of Materiality
266. Overall Materiality
It refers to the materiality for the financial
statements as a whole. It is based on the auditor’s
professional judgment as to the highest amount of
misstatements that could be included in the
financial statements without affecting the
economic decisions taken by a financial statement
user.
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267. Specific Materiality
It refers to materiality set for specific
aspects of financial information (especially for
sensitive areas such as particular note disclosures,
compliance with legislation or certain terms in a
contract, or transactions upon which bonuses are
based) which are intended to be lesser in amount
than overall materiality to put more caution in
dealing with said item.
268. Performance Materiality
It is set at a lower amount (or amounts) than
overall and specific materiality. The objective is to
perform more audit work than would be required by
the overall or a specific materiality to:
a. Ensure that misstatements less than
overall or specific materiality are
detected, so as to appropriately reduce
the probability that the aggregate of
uncorrected errors and undetected
misstatements exceed materiality for
the financial statements as a whole; and
thus
b. Provide a margin or buffer for possible
undetected misstatements. This buffer
is between detected but uncorrected
misstatements in the aggregate and the
overall or specific materiality.
269. Planning Materiality
Auditors make a preliminary assessment of
materiality of the financial statements as a whole by
determining the amount by which they believe the
financial statements could be misstated without
affecting users’ decisions. This planning materiality
is based on professional judgment and may change
during the engagement if circumstances change. It
is helpful to the auditor in a way that it allows him
or her to plan the appropriate evidence to
accumulate. If the auditor sets a low peso amount,
more evidence is required than for a high amount.
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Auditing theory day 09
270. Relationship between Materiality and Audit
Risk
The higher the level of audit risk, the lower
the materiality level can be set to and vice versa
(inverse relationship).

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High IR and CR Low IR and CR
Entity Entity

In the above illustration, the cylinders refer

to the accounting data, the shaded portions to the
appropriate level of materiality and the “x” marks to
the misstatements in the financial statements.
Observe that if the materiality level on the left side
is increased to the same level as the other, more
misstatements are going to be left undetected. The
higher the risk, the more thorough the tests should
be.