TOPIC #2: Introduction to Auditing

Introduction to Audit
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.”
Two processes of auditing:
1.Investigative process – involves the systematic gathering and evaluation of evidence as a basis for
determining whether assertions made by responsible person correspond with the established criteria

2.Reporting process – involves communicating the audit opinion to interested users

Important Concepts
1.Systematic process – auditing involves structured/logical series of sequential steps or procedures
known as the audit process
2. Objectively obtaining and evaluating evidence – auditing involves gathering and evaluating
sufficient appropriate audit evidence that will support the auditor’s opinion
Objectivity refers to the combination of impartiality, intellectual honesty and freedom from conflicts of
interest.
Audit evidence is the information obtained by the auditor in arriving at the conclusions on which the audit
opinion is based.

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 applicabl e financial reporting
framework (for example, the PFRS).
5. Ascertain the degree of correspondence between assertions and established criteria – The
auditor’s objective is to determine whether the assertions conform with established criteria, that is, whether
the financial statements are prepared, in all material respects, in accordance with the applicable financial
reporting framework (such as 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 auditor’s opinion such as
the stockholders, creditors, potential investors and creditors, management, government agencies, and the
public (in general).
Elements FS Audit Assurance Engagement

• Suitable Criteria - Applicable financial reporting framework / GAAP in the Philippines (PFRS) and Other
Authoritative Body
• Written assurance report in the form appropriate to a reasonable assurance engagement or a limited
assurance engagement - Independent auditor’s report contains the audit conclusion/opinion
a. Unmodified (unqualified) opinion—The opinion expressed when the FSs are prepared, in all
material respects, in accordance with the applicable FRF.
b. Modified opinion—The three types of are:
 i. Qualified opinion – the auditor is satisfied that the FSs are presented fairly, except for a
specific aspect of them.
ii. Adverse opinion – the auditor does not believe the FSs are fairly presented.
iii. Disclaimer of opinion – the auditor does not know if the FSs are presented fairly.
• Sufficient appropriate evidence - Auditor obtains sufficient appropriate audit evidence as a basis for
audit conclusion/opinion
• Appropriate subject matter - Assertions/Financial statements of the client company
• Three party relationship (involving a practitioner, a responsible party and intended users)
o Practitioner – CPA in public practice who performs the assurance engagement
o Responsible party – person/s who is responsible for the subject matter or the assertion (subject
matter information)
o Intended user/s – person, persons or class of persons f or whom the practitioner prepares the
assurance report; they are the users to whom the practitioner usually addresses the report

Why the need for Independent Financial Statement Audit?

• Potential conflict of interest between users and preparers of the financial information
• Remoteness of users
• Consequence for decision making
• Complexity of subject matter requires expertise
Elements of Theoretical Framework of Auditing:

• An audit benefits the public.

• Financial data and statements to be audited are verifiable
• The auditor should always maintain independence with respect to the client whose financial
statements are subject to audit
• Effective internal control system reduces the possibility of errors and fraud affecting the financial
statements
• There should be no long-term conflict between the auditor and the client management.
• Consistent application of GAAP results in fair presentation of FS
• What was held true in the past will continue to hold true in the future in the absence of known
conditions to the contrary

Importance of audit opinion/audit report

✓ It lends credibility to the FS.
✓ It provides increased assurance (reasonable assurance) to users as to the fairness of the FS.

An FS audit is:
✓ NOT a certification or guarantee as to accuracy or fairness of the FS.
✓ NOT an assurance as to future viability of the entity.
✓ NOT an assurance as to efficiency or effectiveness of the client’s 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.

Overall Objectives of the Independent Auditor:

1. To obtain reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud or error.
o Reasonable assurance means high, but not absolute, level of assurance
o Reasonable assurance is the basis for the auditor’s opinion. Reasonable assurance is achieved when
the auditor has obtained sufficient appropriate audit evidence to reduce audit risk to an acceptably low
level.
2. To report on the financial statements and to communicate such report in accordance with the auditor’s
findings.

Auditor’s opinion and reasonable assurance:

The auditor's opinion, as expressed in the auditor’s report, enhances the credibility of the
financial statements by providing a reasonable assurance that the financial statements are fairly
presented or free from material misstatement.
Audit opinion is based on whether reasonable assurance is obtained:
1. When reasonable assurance is obtained: Auditor shall express an unqualified opinion
2. When reasonable assurance cannot be obtained: The auditor is required to:
a. Express a qualified opinion in the auditor’s report
b. If qualified opinion is insufficient in the circumstances:
▪ Disclaim an opinion or
▪ Withdraw from the engagement, where withdrawal is legally permitted

End Products of Audit Engagement:

a. Independent auditor’s report – the primary product of audit engagement
b. Certain other communication and reports – other communication and reporting responsibilities to
users, management, those charged with governance, or parties outside the entity, in relation to
matters arising from the audit (as may be required by the PSAs or by applicable laws or regulations.
Examples:
Communication with those charged with governance
Auditor’s responsibilities relating to fraud in an audit of financial statements

Management Responsibility for the Financial Statements:

1.Responsibility for the preparation and presentation of the financial statements in accordance with the
applicable financial reporting framework which includes:
• Identification of applicable financial reporting framework, in the context of any relevant laws or
regulations
• Preparing the financial statements in accordance with that framework
• Adequate description of that framework in the financial statements
• Making reasonable accounting estimates
• Selecting and applying appropriate accounting policies
2. Responsibility for designing, implementing and maintaining internal control that is relevant or necessary to
enable the preparation of financial statements that are free from material misstatement, whether due to
fraud or error, and

3. Responsibility to provide the auditor with:

All information (such as records, documentation and other matters) that are relevant to the
preparation and presentation of the financial statements
Any additional information that the auditor may request from management for the purpose of the
audit; and
Unrestricted access to persons within the entity from whom the auditor determines it necessary to
obtain audit evidence.

Basic Distinction between Auditing and Accounting:

• Auditing involves verification of FS and its fairness of presentation while accounting involves
preparation and presentation of FS
• Accounting precedes auditing because without FS there could be no FS audit.
• Auditing begins when accounting ends.
• The end product of the accounting process is a set of FS while the end product of the audit process is
an auditor’s report.
• An auditor must be proficient/expert in accounting (since the auditor will use GAAP in evaluating the
fairness of the FS) as well as in auditing (specifically in accumulation and interpretation of audit
evidence); an accountant need not be proficient in auditing
• Separate disciplines: Auditing is a separate discipline or field of study
• With different frameworks/foundations:
• Accounting – Framework for Preparation of FS
• Auditing – a) Philippine Framework for Assurance Engagements, and b) Framework of Philippine
Standards on Auditing
• Auditing – governed by GAAS; Accounting – governed by GAAP/PFRS
• Dissimilar bodies of knowledge (accounting – GAAP; auditing – GAAS)
General Types of Audit:

According to objectives or nature of assertion

• Financial statement audit – an audit conducted to determine whether the financial statements of an
entity are fairly presented in accordance with an identified financial reporting framework (or PFRS)
• Compliance audit: a review of an entity’s degree of compliance with applicable laws and
rules/regulations or contracts; usually performed by government auditors

Examples: Examination conducted by:

I. BIR examiners: compliance of taxpayers with tax law, rules or regulations
II. BSP examiners: compliance of banks with banking laws, rules or regulations
III. COA auditors: compliance of government transactions/expenditures with the requirements of
applicable laws, rules or regulations
• 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).
o Also called performance audit or management audit
o Example: Evaluation of a company’s computerized accounting system
o Usually performed by internal auditors
o Efficiency relates to use of its resources, while effectiveness relates to accomplishing objectives.
Internal auditor's responsibilities in operational audits:
In operational audits, the company's management is responsible for setting operating standards. The
internal auditor's responsibilities are to determine that:
a. Management has established such standards.
b. The standards are being met.
c. Deviations from established standards are being identi-fied and corrected.
d. Corrective action has been taken.
Objective of operational auditing:

• To assess performance in terms of efficiency and effectiveness of operations

a. Effectiveness – To verify fulfillments of plans and sound business requirements
b. Efficiency – To determine whether the entity is managing or utilizing its resources economically
and efficiently
• To identify areas for improvement
• To develop recommendations to improve performance (example of such as introduction of controls to
reduce waste)

Operational audit includes:

Program or effectiveness audit: an audit to determine whether the entity has been effective in achieving the
desired results or benefits of the program or activity
Economy audit: an audit to determine whether company objectives or goals are met at a cost commensurate
with the task
Efficiency audit: whether company objectives or goals are met at the least or minimal Cost
General Types of Audit 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 entity’s 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 defined as "an independent, objective assurance and consulting activity designed
to add value and improve an organization's operations. It helps an organization accomplish its objectives by
bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management,
control, and governance processes."

Internal auditing includes the audit of:

o Financial and operating information;
o Compliance with policies, plans, procedures, laws, regulations, and contracts;
o The means of safeguarding assets and verifying their existence;
o The economy and efficiency with which resources are employed; and
o Operations or programs to ascertain whether results are consistent with established objectives and
goals and whether they are being carried out as prescribed.
o Internal auditors assist in the prevention of fraud by examin-ing 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.
I. Internal auditing: An independent appraisal function or control or activity established within an entity to
examine and evaluate its activities or other controls as a service to the entity. It is an independent, objective
assurance and consulting activity designed to add value and improve an organization’s operations. It helps an
organization to accomplish its objectives by bringing a systematic disciplined approach to evaluate and
improve the effectiveness of risk management, control, and governance processes.
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
management or board of directors (it serves the needs of management).
c. Government auditing: audit performed by government employees whose main concern is to
determine whether persons or entities comply with government laws, rules and regulations

Scope of government audit: may extend beyond FS audit to include:

I. FS audit
II. Performance audit (includes (a) program results (effectiveness) audit and (b) economy and efficiency
audit)
III. Compliance audit
A governmental audit is typically designed to determine whether the auditee has complied with
applicable laws and regulations.
The types of audits conducted by the Commission on Audit (COA) are 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.
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. The auditor's report should include the
following:
1. The scope of the auditor's work in obtaining an under-standing of the entity's internal control and in his/her
assessment of control risk.
2. The entity's significant controls including those that are established to ensure compliance with laws and
regulations that have a material impact on the financial
statements.
3. The conditions, including the identification of material weaknesses, identified as a result of the auditor's
work.
General 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
Distinction: Types of audit according to objectives or nature of assertion/data

Point of distinction FS Audit Compliance audit Operational audit

Primary objective To enable the auditor to To determine degree of To assess entity’s

express an opinion on compliance performance (in terms of
the fairness of the FS efficiency and
effectiveness)

Subject matter Assertion that the FS are Assertion that the Assertion that the
(Assertion) presented in accordance organization has organization’s
with identified financial complied with laws, activities/operations are
reporting framework regulations and specific conducted effectively
(GAAP) procedures and efficiently in relation
to specified objectives

Established criteria GAAP – Identified Applicable laws, Objectives (as set by the
financial reporting regulations and specific board of directors)
framework (as by procedures (as set by
standard setting bodies) authoritative bodies)

Sufficient appropriate Audit findings whether Findings on degree of Findings on assessment

evidence / outcome the FS are in accordance compliance of performance /
with Identified financial operations
reporting framework
(GAAP)
Communication of Auditor’s report Reports on the degree of Recommendations or
results to intended users containing an opinion compliance with suggestions on how to
whether the FS are fairly applicable laws, improve operations
presented in accordance regulations or specific
with identified financial procedures
reporting framework
(GAAP)
Users of audit report Different groups for Authoritative bodies that Management of the
different purposes; wide sets down the entity
variety of users (both regulations, rules and
internal and external procedures
users)
Type of auditor Independent / external Government auditors Internal auditors
performing the audit auditors – practitioners

Organizational Structure of a Listed Company

The following are some of the audit committee's functions:

• Select the external auditors.

• Review the external auditor's overall audit plan.
• Evaluate the results of external and internal audits.
• Review the internal auditing work schedule, budget, etc.
• Meet regularly with the internal auditing director.
• The above functions should increase public confidence on the fair presentation of the company's
financial statements.