Business Education Department APC 301-Auditing & Assurance Principles

St. Anthony’s College 1st Semester, A.Y. 2020-2021

AUDIT PLANNING ▪ It allows the work to be completed expeditiously.

▪ It assists in the proper assignment and coordination of work.
▪ It helps ensure that the audit is conducted effectively and efficiently.

PSA 315 requires the auditor to obtain sufficient understanding of the entity and its
environment including its internal control. Such understanding involves obtaining
knowledge about the entity’s:
a. Industry, regulatory, and other external factors, including financial reporting
framework;
b. Nature of the entity, including entity’s selection and application of accounting
policies;
c. Objectives and strategies and the related business risks that may result in a
material misstatement of the financial statements;
d. Measurements and review of the entity’s performance, and
e. Internal Control.

● Understanding the entity and its environment

Audit Planning involves developing a general audit strategy and a detailed approach
for the expected conduct of the audit. The auditor’s main objective in planning the
audit is to determine the scope of the audit procedures to be performed.
The auditor should plan the audit work so that audit will be performed in an effective
and efficient manner. The extent of planning will vary according to the size of the
entity, the complexity of the audit and the auditor’s experience with the entity,
knowledge of the business.
Knowledge of the client’s business and industry – how and why a client does what
it does – is essential if the audit is to be carried out effectively and efficiently. The
auditor should obtain a sufficient level of knowledge of the entity’s business to
identify and understand the events, transactions and practices that may have a
significant effect on the financial statements. The better the auditor understands
the client’s operations, the more efficient the examination is likely to be, and the
greater the value to the client of the auditor’s services.

Adequate planning of the audit work is important because:
▪ Planning helps ensure that appropriate attention is devoted to important areas
of the audit.
▪ It helps identify potential problems.
If the auditor understands the operations of the client, the auditor is often able to
evaluate the reasonableness of the client’s estimates. In addition, procedures can
be selected with more assurance, or perhaps uniquely applicable procedures can
be designed.

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Knowledge of the entity would also include understanding the entity’s objectives
and strategies, and the related business risks. An auditor’s understanding of
business risks encountered by the entity increases the likelihood of identifying
risks of material misstatement and helps the auditor design appropriate audit
procedures. Furthermore, the auditor should obtain understanding of entity’s
measurement of performance as this may create pressures on the entity that may
either motivate management to take action to improve the business performance
or to manipulate the financial statements.
❖ Sources of information
The auditor can obtain knowledge of the industry and the entity from a
number of sources. These may include:
▪ Review of prior years’ working papers
▪ Tour of client’s facilities
▪ Discussion with people within and outside the entity
▪ Reading books, periodicals, and other publications related to the client’s
industry
▪ Reading corporate documents and financial reports
❖ Uses of the information obtained
Knowledge of the client’s business is a frame of reference within which the
auditor exercises professional judgment. Understanding the business and
using the information appropriately assists the auditor in:
▪ Assessing risks and identifying the potential problems
▪ Planning and performing the audit effectively and efficiently
▪ Evaluating audit evidence as well as the reasonableness of client’s
representations and estimates
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1st Semester, A.Y. 2020-2021
▪ Providing better service to the client
To make effective use of knowledge about the client’s business and industry, the
auditor should consider how it affects the financial statements and whether the
assertions in the financial statements are consistent with the auditor’s knowledge of
business.
Obtaining understanding of the client’s business is a continuous and cumulative
process. For continuing engagements, the auditor should update and re-evaluate
information gathered previously, including information in the prior year’s working
papers.
❖ Additional Consideration on New Engagements
A first-time audit requires more work than a repeat engagement because of the
problem associated with the verification of the opening balances of the balance sheet
accounts. In this regard, PSA 510 requires the auditor obtain sufficient appropriate
audit evidence that:
▪ the opening balances do not contain misstatements that materially affect
the current year’s financial statements;
▪ the prior period’s closing balances have been correctly brought forward to
the current period or, when appropriate, have been restated; and
▪ appropriate accounting policies are consistently applied or changes in
accounting policies have been properly accounted for and adequately
disclosed
The auditor may be able to obtain sufficient appropriate evidence regarding opening
balances by reviewing the predecessor auditor’s working papers. In these
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circumstances, the auditor would also consider the independence and professional
reputation of the predecessor auditor.
● Understanding the Internal Control
Another very important step in planning an audit is to obtain an understanding of
the entity’s accounting and internal control systems. The auditor should obtain an
understanding of the accounting and internal control systems sufficient to plan the
audit and develop an effective audit approach. Procedures to obtain
understanding of the accounting and internal control systems will be discussed
thoroughly in Consideration of Internal Control.
● Developing an Overall Audit Strategy
Once the auditor has gained a sufficient understanding about the entity and its
environment including its internal control, the auditor should formulate an overall
audit strategy for the upcoming engagement. The best audit strategy is the
approach that results in the most efficient audit – that is, an effective audit
performed at the least possible cost. An audit plan should be made regarding:
▪ how much evidence to accumulate;
▪ how and when this should be done.
When developing an audit strategy, the auditor must consider carefully the
appropriate levels of materiality and audit risk.
❖ Materiality
Materiality is defined in the Financial Reporting Standard Council’s
“Framework for the Preparation and Presentation of Financial Statements,” in
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1st Semester, A.Y. 2020-2021
the following terms: “Information is material if its omission or misstatement
could influence the economic decision of users taken on the basis of the
financial statements.”
In designing an audit plan, the auditor should make a preliminary estimate of
materiality for use during the examination. The concept of materiality recognizes that
some matters are important for fair presentation of financial statements while other
matters are not important. Materiality may be viewed as:
▪ the largest amount of misstatement that the auditor could tolerate in the
financial statements, or
▪ the smallest aggregate amount that could misstate the financial
statements
Materiality is a matter of professional judgment and necessarily involves quantitative
factors (amount of the item in relation to the financial statements) and qualitative
factors (the nature of misstatement)
● Importance of materiality in planning an audit
The auditor should make a preliminary estimate of materiality to determine
the amount of evidence to accumulate. There is an inverse relationship
between materiality and evidence. This means, more evidence will be
required for a low peso amount of materiality than for a high peso amount.
● Uses of materiality
According to PSA 320, materiality should be considered by the auditor:
▪ In the planning stage, to determine the scope of audit procedures; and
▪ In the completion phase of the audit, to evaluate the effect of
misstatements on the financial statements.
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● Using Materiality Levels
The following steps may be used as a guide when using materiality levels.
Step 1 and 2 are performed in the planning phase while step 3 is performed
in the completion phase of the audit.
Step 1 Determine the Overall Materiality – Financial Statement Level
The auditor should determine the amount of misstatement that could be material to
the financial statements taken as a whole. If the materiality level is set too low,
auditor will be wasting his time auditing accounts that are not important. However, if
materiality level is set too high, auditor may not detect misstatements that could be
material to the readers of the financial statements.
When establishing materiality levels on a financial statement level, the auditor should
consider that the financial statements are interrelated- that is, a misstatement on one
financial statement usually affects the other statement. For this reason, the auditor
should consider materiality in terms of the smallest aggregate level of misstatement
that could distort any one of the financial statements.
For example, assume that the auditor believes that misstatements aggregating
P40,000 would have a material effect on the client’s income statement and that these
misstatements would have to aggregate P60,000 to materially affect the balance
sheet. When designing audit procedures, it is wiser for the auditor to design audit
procedures that will be expected to detect misstatements aggregating P40,000. By
using P40,000 as the materiality level, the auditor will have a reasonable assurance
that both financial statements are not materially misstated.
A common method of estimating materiality at the financial statement level is to
multiply a statement base (total assets, sales, or net income) by a certain percentage.
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Step 2 Determine the tolerable misstatement – Account Balance Level
Once the overall materiality is established, the auditor determines materiality at the
account balance level. This is done by allocating the overall materiality to the financial
statement account balances. This allows the auditor to determine the audit
procedures that will be applied to specific accounts. The allocated materiality to an
account is called the tolerable misstatement for that account. This is also known as
the performance materiality.
The professional standards do not provide specific guidelines as to how the allocation
should be done. This process is highly subjective and requires the exercise of great
level of judgment by the auditor.
Step 3 Compare the aggregate amount of uncorrected misstatements with the overall
materiality.
After performing audit procedures, the auditor will have to compare the aggregate
uncorrected misstatements with the overall materiality (preliminary estimate of
materiality or revised materiality level) to determine whether or not the financial
statements are materially misstated.
● Bases that can be used to determine the materiality level
Since audit planning is often performed before year-end, annual financial statements
are usually not available. As a result, the auditor uses alternative bases to compute for
the materiality levels, such as:
▪ Annualized interim financial statements
▪ Prior years’ financial statements
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St. Anthony’s College 1st Semester, A.Y. 2020-2021

▪ Budgeted financial statements of the current year possibly expect to detect all material misstatements; instead, the auditor should
perform audit procedures to increase the likelihood of detecting these misstatements.
Figure 5-1 – Using Materiality in an Audit
The auditor should use professional judgment t asses audit risk and to design audit
procedures to ensure it is reduced to an acceptably low level. When designing
substantive audit procedures, the auditor should consider three main issues:
Determine the Overall Materiality
(Financial Statement Level) 1. What level of assurance does the auditor wish to attain that the financial
Planning statements do not contain material misstatements? As this level of
stage assurance increases, the scope of the auditor’s substantive tests increases.
Determine the tolerable misstatement
(Account Balance Level) 2. How susceptible is the account to material misstatement? As the
susceptibility of the account to material misstatement increases, the scope
of the auditor’s substantive tests also increases.

3. How effective is the client’s internal control in preventing or detecting

Perform audit procedures misstatements? As the effectiveness of the client’s internal control
increases, the scope of auditor’s substantive tests decreases.
Completion
stage Compare the aggregate amount of ❖ Audit Risk Model
misstatement with the overall materiality
These three issues are the preliminary basis for the development of the audit
risk model:

Audit Risk = Inherent Risk * Control Risk * Detection Risk

❖ AUDIT RISK
After determining the materiality levels, the auditor should design the audit to
provide reasonable assurance that the financial statements taken as a whole are free
from material misstatements. Reasonable assurance means that the auditor can not
❖ Audit risk refers to the risk that the auditor gives an inappropriate audit
opinion on the financial statements. This occurs because the auditor believes
that the financial statements are fairly stated when in fact the financial
statements are materially misstated.

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Audit risk is the complement of audit assurance. If the auditor is willing to accept a 5%
audit risk, he must design the audit to have a 95% assurance or confidence level that
his opinion is correct.
Because of the inherent limitations of the audit, the auditor cannot totally eliminate
the audit risk. The auditor should, therefore, perform audit procedures in order to
limit his or her exposure to this risk to low level. Thus, as the desired level of audit
risk decreases, the auditor should design more effective substantive procedures.
❖ Inherent risk is the susceptibility of an account balance or class of transactions
to a material misstatement assuming that there were no related internal
controls. This concept recognizes that some account balances, by nature, are
more susceptible to misstatement than others. For example, those accounts
that are subject to complex calculations such as pensions are more likely to be
misstated compared to other accounts.
PSA 315 requires the auditor to assess inherent risk at the financial statement and
account balance or transaction class levels. Factors that affect the risk of
misstatement at the financial statement level include:
1. The management integrity
2. Management Characteristics (e.g. aggressive attitude toward financial
reporting)
3. Operating Characteristics (e.g. profitability of the entity relative to its
industry is inadequate)
4. Industry Characteristics (e.g. the industry is experiencing a large
number of business failures)
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Factors affecting inherent risk at the account balance level include:
1. Susceptibility of the account to theft.
2. Complexity of calculations related to account.
3. The complexity underlying transactions and other events.
4. The degree of judgment involved in determining account balances.
As the assessed level of inherent risk increases, the auditor should design more
effective substantive procedures.
❖ Control risk is the risk that a material misstatement that could occur in an
account balance or class of transactions will not be prevented or detected and
corrected on a timely basis by accounting and internal control systems. Control
risk is related to the effectiveness of the client’s internal control. Like inherent
risk, control risks exists independently of the audit of financial statements and
is assessed using the auditor’s judgment. If the entity’s internal control is
effective, the assessed level of control risk decreases (and vice versa).
Holding other planning considerations equal, as the assessed level of control
risk increases, the auditor should design more effective substantive
procedures.
❖ Detection risk is the risk that an auditor’s substantive procedure will not
detect a material misstatement. Detection risk is a function of the
effectiveness of the auditor’s substantive procedures.
As the acceptable level of detection risk decreases, the assurance directly
provided from substantive tests increases. Hence, the auditor should design
more effective audit procedures in order to achieve the desired level of
assurance.
Unlike inherent and control risks, the auditor can control the level of detection
risks by performing more effective substantive procedures. The acceptable
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St. Anthony’s College 1st Semester, A.Y. 2020-2021

level of detection risk is inversely related to the assessed level of both inherent control risk would involve studying and evaluating the effectiveness of
and control risks. the client’s accounting and internal control systems.

❖ Steps in using the audit risk model
Step 1 Set the desired level of Audit Risk.
There are no specific guidelines for setting individual audit risk. The
auditor uses his judgment in determining the risk that he is willing to
take of accepting an assertion as fairly stated when in fact it is
materially misstated. The auditor should plan the audit in such a way
that, after performing audit procedures, an opinion can be issued on
the financial statements at a low level of audit risk.
Step 2 Assess the Level of Inherent Risk
When assessing the level of control risk, the auditor should recognize
that some control risk will always be present because of the inherent
limitations of the internal control. However, if a client maintains
effective internal control systems, the risk of material misstatements in
the financial statements can be minimized.
Step 4 Determine the Acceptable Level of Detection Risk.
Based on the desired audit risk level (Step 1) and the auditor’s
assessment of inherent and control risks (Steps 2 and 3), the auditor
determines the acceptable level of detection risk. By rearranging the
audit risk model,

Every account or assertion has a built-in risk of being misstated. Audit Risk = Inherent Risk * Control Risk * Detection Risk
However, there are some accounts that, by nature, are more likely to
misstated compared to other accounts. These are the accounts that the acceptable level of detection risk can be determined as follows:
have high inherent risks.
Detection Risk = Audit Risk
When assessing inherent risks for each account, the auditor must Inherent Risk * Control Risk
consider specific factors related to the client that may affect the risk of
a material misstatement for a particular account. In making this
assessment, the auditor will rely primarily on his knowledge of the
client’s business and industry, and the results of his preliminary Step 5Figure 5.2Design
– UsingSubstantive Tests.
The Audit Risk Model
analytical procedure.
Unlike inherent risk and control risk, detection risk can be increased or
Step 3 Asses the Level of Control Risk decreased by the auditor by performing substantive tests. Detection
risk can be looked at as the complement of the assurance provided by
Determine
As stated earlier, control risk is the risk that the client’s internal control the substantive tests. A 10% acceptable level of detection risk means
Acceptable
may not detect or prevent a material misstatement. Assessment of Set Desired
Assess
Assess
Level of
Level
Inherent of
Control Risk
Risk
Detection Risk
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Audit
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that substantive tests must be designed to provide a 90% assurance of

detecting material misstatements.
Thus, a lower acceptable level of detection risk increases the
assurance to be provided by substantive tests. To obtain greater
assurance, the auditor will have to modify the scope of his substantive
tests such as:
Of the three components, only the detection risk can be controlled by the
auditor. The inherent and control risks are functions of management and its
environment, and as such, the auditor can not change the levels of inherent and
control risks. The auditor can only assess their levels. On the other hand,
detection risk is a function of the auditor. Accordingly, the level of detection risk
can be controlled by the auditor by performing substantive procedures.

▪ performing more effective substantive procedures (nature) During an audit, the auditor performs procedures to assess the levels of inherent
and control risks. Audit
Based on the results of suchConsideration
assessment, the auditor
Performing
▪ performing year-end procedures (timing) Planning of Internal Substantive
determines the acceptable level of detection risk and modifies the scope of his
Control Tests
substantive tests.
▪ using larger sample size (extent)
For example, if the assessed level of inherent and control risk is high, the auditor
On the other hand, if the acceptable level of detection risk is high, the MATERIALITY
should minimize the level of detection risk to be able to maintain the planned
Planning Materiality
assurance provided by substantive tests will decrease. As a result, the overall audit risk level. Conversely, if the assessed level of inherent and control
and/or tolerable
auditor could reduce the scope of his substantive procedures like: risk is low, the auditor could accept a high level of detection risk and still maintain
error
the desired audit risk level.
▪ performing less effective substantive procedures (nature)
❖ Relationship between materiality and risk
▪ performing the test at interim (timing)
▪ using smaller sample size (extent) LOW
When planning the audit, the auditor considers what would make the financial
statements misstated. The auditor’s assessment of materiality related to specific
account helps the auditor select the audit procedures that can be expected to
reduce audit risk to an acceptable level. LOW
HIGH

There is an inverse relationship between materiality and the level of audit risk,
❖ Relating inherent, control, and detection risk to the overall audit risk that is, the higher the materiality level, the lower the audit risk and vice versa.

The inherent, control, and detection risks are components of the overall audit The auditor takes the inverse relationship between materiality and audit risk into
risk. Therefore, an increase or decrease in any of these components would cause account when determining the nature, timing and extent of audit procedures. For
a corresponding increase or decrease in the overall audit risk. example, if, after planning for specific audit procedure, the auditor determines
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that the acceptable materiality level is lower, audit risk is increased. The auditor ▪ reducing detection risk by modifying the nature, timing and extent of planned
would compensate for this by either: substantive procedures.

▪ reducing the assessed level of control risk, where this is possible, and Figure 5.3 – Effect of materiality on audit risk and planned audit procedures
supporting the reduced level by carrying out extended or additional tests of
control; or
AUDIT RISKS PLANNED
Risks of material error AUDIT
occurring and/or not PROCEDURES
being determined

HIGH More Extensive

Less Extensive

● Risk Assessment Procedures

The procedures performed by auditors to obtain an understanding of the entity

and its environment including its internal control and to assess the risks of
material misstatements in the financial statements are called “risk assessment
procedures”. These include
a. Inquiries of management and others within the entity
b. Analytical procedures; and
c. Observation and inspection
Figure 5.4 – Steps in Applying Analytical Procedures

Information obtained in performing these risk assessment procedures may be

used by the auditor as evidence to support assessment of risk of material
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Develop expectations regarding financial statements
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St. Anthony’s College 1st Semester, A.Y. 2020-2021

misstatement. In addition, in performing risk assessment procedures, the auditor o Anticipated results such as budgets or forecasts
may obtain audit evidence about the fair presentation of the financial statements o Industry averages (Financial statements of other entities
or about the operating effectiveness of internal control even though such operating within the same industry)
procedures were not specifically planned as substantive tests or tests of control. o Non-financial information
o Typical relationships among financial statement account
❖ ANALYTICAL PROCEDURES balances

Analytical procedures involve analysis of significant ratios and trends, including
the resulting investigation of fluctuations and relationships that are
inconsistent with other relevant information or deviate from predicted
amounts. A basic premise underlying the use of analytical procedures is that
plausible relationships among data may reasonably be expected to exist and
continue in the absence of known conditions to the contrary.
PSA 520 requires the auditor to use analytical procedures in the planning
and overall review stages of the audit. In the planning stage of the audit, the
application of analytical procedures helps the auditor assess the risk of
material misstatements in the financial statements.
▪ Steps in Applying Analytical Procedures
Analytical procedures help the auditor in identifying unusual transactions
and events that may affect the fair presentation of the financial
statements. Application of analytical procedures involves the following
steps:
❖ Uses of analytical procedures
Step 2
Investigate significant differences Compare
the
expectations with the financial statements under audit.
The auditor compares the financial statements with his
expectations to identify significant fluctuations that are
inconsistent with the auditor’s knowledge or that deviate from
predicted amounts.
Step 3 Investigate significant unexpected differences (unusual
fluctuation) to determine whether financial statements contain
material misstatements.
Investigation of unusual fluctuations ordinarily begins with
inquiries of management, followed by corroboration of
management responses and applying other appropriate audit
procedures.

Analytical procedures may be used for the following purposes:

Step 1 Develop expectations regarding financial statements using: ● As a planning tool, to determine the nature, timing, and extent of other
auditing procedures
o Prior years’ financial statements
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● As a substantive test to obtain corroborative evidence about particular
assertions related to the account balance or transaction class
● As an overall review of the financial statements in the completion phase
of the audit
❖ Analytical procedures in planning an audit
Analytical procedures used in planning an audit should focus on
o Enhancing the auditor’s understanding of the client’s business
o Identifying areas that may represent specific risks

The auditor’s understanding of the client’s business enables the auditor to

develop certain expectations regarding the client’s financial position and
performance during the period. If the figures reflected in the financial
statements do not conform to the auditor’s expectations, questions can be
raised about the reliability of the financial statements or about the accuracy of
information obtained about the entity’s business. Thus, analytical procedures
performed in the planning phase of the audit are useful for conforming or
challenging the auditor’s understanding of the client’s business.
Figure 5.5 – The Use of Analytical Procedures in an Audit
Figure 5.6 – Using Analytical Procedure as a Planning Tool
Stage of the Audit Objective

Planning the audit ▪ To understand the client’s business Compare financial statements with
▪ To identify areas that may represent specific risks expectations

Substantive Tests ▪ To obtain evidence to confirm (or refute) individual

account balances
Determine the difference between
Overall Review ▪ To identify unusual fluctuations that were not the expected and recorded balances
identified in the planning and testing phases of the
audit
▪ To confirm conclusions reached with respect to the
fairness of the financial statements

Design more
In the difference
extensive substantive
significant
tests
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In addition, analytical procedures can be used to draw the auditor’s attention
to those accounts in the financial statements that are likely to be misstated.
Once the auditor has identified the areas representing specific risks, the
auditor can direct audit effort to these accounts and plan the nature, timing
and extent of audit procedures.
● Documenting the Audit Plan
The final step in the planning process is the documentation of the audit planning
process by preparing an overall audit plan, audit program, and time budget.
❖ Audit Plan
❖ Time Budget
A time budget is an estimate of the time that will be spent in executing the
audit procedures listed in the audit program. This provides a basis for
estimating audit fees and assist the auditor in assessing the efficiency of the
assistants.
Changes to audit plan and program
Planning is continuous throughout the engagement because of changes in
conditions or unexpected results of audit procedures. The overall audit plan and
the audit program should be revised as necessary during the course of the audit
and the reasons for significant changes would be recorded.

An audit plan is an overview of the expected scope and conduct of the audit.
The overall audit plan sets out in broad terms the nature, timing and extent of
the audit procedures to be performed. While the audit plan varies for each End of Week 2
client, it should be sufficiently detailed to guide in the development of an audit
program.

❖ Audit Program

The auditor should develop and document an audit program setting out the
nature, timing and extent of planned audit procedures required to implement
the overall audit plan. In effect, audit program executes the audit strategy. It
sets out in detail the audit procedures to be performed in each segment of the
audit. The audit program serves as a set of instructions to assistants involved in
the audit and as a means to control and record the proper execution of the
work.

The form and content of the audit program may vary for each particular
engagement but it should always include a detailed list of audit procedures
that the auditor believes are necessary to accomplish the audit objectives.
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