NORTHERN LUZON ADVENTIST COLLEGE

DEPARTMENT OF BUSINESS EDUCATION

COURSE: ASSURANCE PRINCIPLE, GOOD GOVERNANCE, AND PROFESSIONAL ETHICS

LESSON 1: AUDITING – AN OVERVIEW

I. Introduction

This lesson discusses the definition of auditing, the assurance provided by

audit and its limitation, the need for an audit, the different types of audit and
auditors, the general principles governing an audit and the conceptual
framework of an audit.

II. Learning Outcomes

After reading this chapter, the students should be able to:

 Explain auditing and its role in today’s society
 Compare the different types of audit and auditors
 Identify the need of financial statement audit and its limitation
 Distinguish the governing principle of audit and its theoretical framework

III. Integration of Faith:

The greatest want of the world is the want of men – men who will not be
bought or sold; men who in their inmost souls are true and honest; men who do
not fear to call sin by its right name; men whose conscience is as true to duty as
the needle to the pole; men who will stand for the right though the heavens fall.
– Ellen G. White

IV. Integration of Value:

Values of Being Truthful

V. Topics for Reading:

Book: Auditing Theory – a guide in understanding PSA

Additional Readings:
Introduction to auditing
https://bit.ly/3hLUugJ
https://bit.ly/2X7Sl7j
https://pwc.to/33093cx
https://bit.ly/2BBnJDs
 TOPIC: AUDITING – An Overview

Dependable financial information is essential to our society. We often rely upon

information provided by others in making economic decisions. The need of various users
for more reliable financial information has created demand for an independent audit
of financial statements.

The primary function of an independent audit is to lend credibility to the financial

statements prepared by the entity. The auditor’s opinion enhances the value and
usefulness of the financial statements. By attaching a report to the financial statements,
the auditor provides increased assurance to users that the financial statements are
reliable.

 Auditing Defined

The Philippine Standards on Auditing (PSA) defines auditing by stating the objective of a
financial statement audit, that is, to enable the auditor to express an opinion whether
the financial statements are prepared, in all material respects, in accordance with an
identified financial reporting framework.

This definition confines the audit to examination of the financial statements. Although
the great majority of audit work today deals with audit of financial statements,
operational and compliance auditing are becoming more and more important.

A more comprehensive definition of auditing is given by the American Accounting

Association:

“An audit is a systematic process of objectively obtaining and evaluating

evidence regarding assertions about economic actions and events to ascertain
the degree of correspondence between these assertions and established criteria
and communicating the results to interested users.”

This definition conveys the following thoughts:

1. Auditing is a systematic process

Auditing proceeds by means of an ordered and structured series of steps.

2. An audit involves obtaining and evaluating evidence about assertions regarding

economic actions and events
Assertions are representations made by an auditee about economic actions and
events. The auditor’s objective is to determine whether these assertions are valid.
To satisfy this objective, the auditor performs audit procedures and gathers
evidence that corroborates or refutes the assertions.
 3. An audit is conducted objectively
The auditor should conduct the audit without bias. Impartial attitude must be
maintained by the auditor when evaluating evidence and formulating his
conclusion.

4. Auditors ascertain the degree of correspondence between assertions and

established criteria
Established criteria are needed to judge the validity of the assertions. These
criteria are important because they establish and inform the users of the basis
against which the assertions have been evaluated or measured. In an audit, the
auditor determines the degree by which the assertions conform to the
established criteria. For example, when auditing financial statements, the auditor
judges the fair presentation of the financial statements (assertions) by comparing
the statements with an identified financial reporting framework (criteria).

5. Auditors communicate the audit results to various interested users

The communication of audit findings is the ultimate objective of any audit. For
the audit to be useful, the results must be communicated to interested users on a
timely basis.

 Types of Audit

Based on primary audit objectives, there are three major types of audit. – financial,
compliance and operational audits.

 Financial Statement audit

This is an audit conducted to determine whether the financial statements of an

entity are fairly presented in accordance with an identified financial reporting
framework. This type of audit will be the focus of the discussion in this text.

 Compliance audit

Compliance audit involves a review of an organization’s procedures to

determine whether the organization has adhered to specific procedures, rules or
regulations. The performance of compliance audit is dependent upon the
existence of verifiable data and recognized criteria established by an
authoritative body. A common example of this type of audit is the examination
conducted by the BIR examiners to determine whether entities comply with tax
rules and regulations.

 Operational audit

An operational audit is a study of a specific unit of an organization for the

purpose of measuring its performance. The main objective of this type of audit is
to assess entity’s performance, identify areas for improvements and make
 recommendations to improve performance. This type of audit is also known as
performance audit or management audit.

It should be noted that, although there are different types of audit, all audits possess the
same general characteristics. They all involve:

1. Systematic examination and evaluation of evidence which are undertaken to

ascertain whether assertions comply with established criteria; and
2. Communication of the results of the examination, usually in a written report, to
the party whom, or on whose behalf, the auditor was appointed.

Unlike compliance and financial statement audits, where the criteria are usually
defined, criteria used in operational audit to evaluate the effectiveness and efficiency
of operations are not clearly established.

 Types of Auditors

Auditors can be classified according to their affiliation with the entity being
examined.

 External auditors

These are independent Certified Public Accountants who offer their professional
services to different clients on a contractual basis. External auditors are the ones
who generally perform financial statement audits.

 Internal auditors

Internal auditors are entity’s own employees who investigate and appraise the
effectiveness and efficiency of operations and internal controls. The main
function of internal auditors is to assist the members of the organization in the
effective discharge of their responsibilities. Internal auditors usually perform
operational audits.

 Government auditors

These are government employees whose main concern is to determine whether

persons or entities comply with government laws and regulations. Government
auditors usually conduct compliance audits.
 The Independent Financial Statement Audit

The objective of an audit of financial statements is to enable the auditor to express an

opinion whether the financial statements are prepared in all material respects, in
accordance with an identified financial reporting framework or acceptable financial
reporting standards.

 Responsibility for the financial statements

The management is responsible for preparing and presenting the financial

statements in accordance with the financial reporting framework.

The auditor’s responsibility is to form and express and opinion on these financial
statements based on his audit. An audit of financial statement does not relieve
management of its responsibilities. Hence, it is management’s responsibility to
adopt and implement adequate accounting and internal control systems that
will help ensure, among others, the preparation of reliable financial statement.

 Assurance provided by the auditor

The auditor’s opinion on the financial statements is not a guarantee that the
financial statements are dependable. An audit conducted in accordance with
Philippine Standards on Auditing (PSAs) is designed to provide only reasonable
assurance (not absolute assurance) that the financial statements taken as a
whole are free from material misstatements. In every audit, there are always
inherent limitations that affect the auditor’s ability to detect material
misstatements. These limitations results from such factors as:

1. The Use of testing / Sampling risk

For practical reasons, auditors do not examine all evidence available. Many
audit conclusions are made by examining only sample of evidence.
Whenever a sample is taken, there is always a possibility that the auditor’s
conclusion, based on the sample, may be different from the conclusion that
would have been reached if the auditor examines the entire population.

2. Error in application of judgment / Non-sampling risk

The work undertaken by the auditor to form an opinion is permeated by
judgment. Human weakness can cause auditors to commit mistakes in the
application of audit procedures and evaluation of evidence.

3. Reliance on management’s representation

Some evidence supporting the financial statements must be obtained by
obtaining oral or written representations from management. For example, it is
difficult for the auditor to determine the proper valuation of accounts
 receivable without management’s honest assessment. If the management
lacks integrity, management may provide the auditor with false
representations causing the auditor to rely on unreliable evidence.

4. Inherent limitations of the client’s accounting and internal control systems

Although the auditor performs procedures to detect material misstatements
when auditing financial statements, such procedures may not be effective in
detecting misstatements resulting from collusion among employees or
managements circumvention of internal control.

5. Nature of evidence
Evidence obtained by the auditor does not consist of “hard facts” which
prove or disprove the accuracy of the financial statements. Instead, it
comprises pieces of information and impressions which are gradually
accumulated during the course of an audit and which, when taken together,
persuade the auditor about the fairness of the financial statements. Thus,
audit evidence is generally persuasive rather than conclusive in nature.

 Need for an independent financial statement audit

The need for an independent audit of financial statements stems from the
following interrelated sources:

1. Conflict of interest between management and users of financial statements

In a sense, financial statements may be viewed as the report by
management as to how the entity performed under their direction and
supervision. Managers are frequently placed in positions where they can
benefit by providing outside parties with overly optimistic or even false
financial information. Outside parties, however, want unbiased realistic
financial statements. Recognizing the inherent conflict of interest, users of
financial statements have become skeptical of unaudited financial
statements.

2. Expertise
The complexity of accounting and auditing requires expertise in verifying the
quality of the financial information. Since most of the user s of financial
information are not equipped with the necessary skills and competence to
determine whether the financial statements are reliable, a qualified person is
hired by users to verify the reliability of the financial statements on their
behalf.

3. Remoteness
Users of financial information are usually prevented from directly assessing the
reliability of the information. Most of the users do not have access to the
 entity’s records to personally verify the quality of the financial information.
Consequently, an independent auditor is needed to assist them in verifying
the reliability of the financial information.

4. Financial consequences
Misleading financial information could have substantial economic
consequences for a decision maker. It is therefore important that financial
statements be audited first before they are used for making important
decisions.

 General principles governing the audit of financial statement

1. Auditor should comply with relevant ethical requirements.

2. The auditor should conduct an audit in accordance with PSA.
3. The auditor should exercise PROFESSIONAL JUDGMENT in planning and
performing audit.
4. The auditor should obtain SUFFICIENT APPROPRIATE EVIDENCE to reduce audit
risk to an acceptably low level to enable the auditor to express an opinion.
5. Having an attitude of PROFESSIONAL SKEPTICISM.

 Theoretical framework of Auditing

The audit function operates within a theoretical framework. Below are selected
postulates, assumptions or ideas that support many auditing concepts and
standards.

1. Audit function operates on the assumption that all financial data are
verifiable
All balances reported in the financial statements must have supporting
documents or evidence to prove their validity. If no evidence exists in relation
to the financial statements on which an auditor is to express an opinion, then
there can be no audit to perform.

2. The auditor should always maintain independent with respect to the financial
statements under audit
Independence is essential for ensuring the credibility of the auditor’s report.
The report of the auditor will be of little or no value to the readers of the
financial statements if the readers are aware that the auditor is not
independent with respect to the client.

3. There should be no long-term conflict between the auditor and the client
management
 Short-term conflicts may exist regarding the application of auditing
procedures and accounting principles, but in the end, both the auditor and
the management must be interested in the fair presentation of the financial
statements.

4. Effective internal control system reduces the possibility of errors and fraud
affecting the financial statements
The condition of the entity’s internal control system directly affects the
reliability of the financial statements. The stronger the internal control is, the
more assurance it provides about the reliability of the accounting data and
financial statements.

5. Consistent application of generally accepted accounting principle (GAAP) or

Philippine Financial Reporting Standards (PFRS) results in fair presentation of
financial statements
We often use different criteria to verify the validity of an assertion. In the case
of an independent audit of financial statements, the criteria are usually the
PFRS.

6. What was held true in the past will continue to hold true in the future in the
absence of the known conditions to the contrary
Experience and knowledge accumulated from auditing a client in prior years
can be used to determine appropriate audit procedures that need to be
performed.

7. An audit benefits the public

Financial statements are ordinarily prepared and presented in order to meet
the common information needs of a wide range of users. These users who rely
on the financial statements as their major source of information are the
primary beneficiary of the financial statement audit.
VI. ACTIVITY/ASSESSMENT:

I. Essay.

Explain auditing and its role in today’s society

1. Introduction (5 pts)

2. Main Body (20 pts)

3. Conclusion (5 pts)

4. What is your opinion about auditing (5 pts)

II. Fill in the blanks: Comparison among the different types of audit.

Different types of
audit

Assertions made by
the auditee

Established criteria

Content of the
auditor’s report

Auditors who
generally perform
the audit (Types of
Auditors)
III. Multiple Choice.

_______1. Which of the following is not one of the limitations of an audit?

a. The use of testing
b. Limitations imposed by client
c. Human error
d. Nature of evidence that the auditor obtains

_______2. Which of the following statements does not properly describe a limitation of
an audit?
a. Many audit conclusions are made on the basis of examining a sample
of evidence
b. Some evidence supporting peso representation in the financial
statements must be obtained by oral or written representation of
management
c. Fatigue can cause auditors to overlook pertinent evidence
d. Many financial statement assertions cannot be audited

_______3. Which of the following is one of the limitations of an audit?

a. The possibility that management may prevent the auditor from
performing the necessary audit procedures
b. The likelihood that the auditor may not be able to detect material
misstatements in the financial statements because the auditor is
engaged only after year-end
c. The fact that most audit evidence is persuasive rather than conclusive
in nature
d. The risk that the auditor may not possess the training and proficiency
required by the engagement

_______4. Financial statement users often receive unreliable financial information from
companies. Which of the following is NOT a common reason for this?
a. Complex exchange transactions
b. Voluminous data
c. Bias in the preparation of financial statement
d. Each of these choices is a common reason for unreliable financial
information

_______5. Which of the following is not among the conditions that give rise to a demand
by external users for independent audits of financial statements?
a. remoteness of users
b. complexity of making economic decisions
c. potential conflict of interest between users and preparers of the
statements
d. consequence for making decisions
_______6. Which one of the following would not represent one of the primary problems
that would lead the users to demand for independent audits of a company’s financial
statements?
a. The downsizing of business and financial markets
b. Management bias in preparing financial statements
c. The complexity of transactions affecting financial statements
d. The remoteness of the user to directly obtain financial information from
the company

_______7. The need for independent audits of financial statements can be attributed to
all of the following conditions except:
a. remoteness
b. consequence
c. complexity of subject matter
d. validity

_______8. Which of the following statements does not describe a condition that creates
a demand for auditing?
a. Conflict between an information preparer and a user can result in
biased information
b. Information can have substantial economic consequences for a
decision maker
c. Expertise is often required for information preparation and verification
d. Users can directly assess the quality of information

_______9. Which of the following statements does not properly describe limitation of an
audit?
a. Many audit conclusions are made on a basis of examining a sample of
evidence
b. The work undertaken by the auditor is permeated by judgment
c. The auditor might misinterpret the evidence obtained
d. Most of the items in the financial statements do not have supporting
evidence

_______10. Which of the following is one of the limitations of an audit?

a. Nature of evidence obtained
b. Inadequacy of the accounting records
c. Confidentiality of information
d. Scope limitations imposed by the entity
IV. Research
Search for a specific Philippine Standard on Auditing (PSA) and identify the conceptual
framework use as the basis of that standard. Give 3.

Link for the copy of Philippine Auditing Standard:

https://aasc.org.ph/downloads/PSA/PSA.php

Example:

Standard: PAS 210 no. 18

18. If financial reporting standards established by an authorized or

recognized standards setting organization are supplemented by law or regulation, the
auditor shall determine whether there are any conflicts between the financial reporting
standards and the additional requirements. If such conflicts exist, the auditor shall
discuss with management the nature of the additional requirements and shall agree
whether: (a) The additional requirements can be met through additional disclosures in
the financial statements; or (b) The description of the applicable financial reporting
framework in the financial statements can be amended accordingly. If neither of the
above actions is possible, the auditor shall determine whether it will be necessary to
modify the auditor’s opinion in accordance with PSA 705 (Revised and Redrafted).3
(Ref: Para. A34)

Related Conceptual Framework:

 There should be no long-term conflict between the auditor and the client
management
 Consistent application of generally accepted accounting principle (GAAP) or
Philippine Financial Reporting Standards (PFRS) results in fair presentation of
financial statements