Chapter 1 BASIC CONCEPTS OF FINANCIAL ST! Peererrocrrrororor: FEE EE GE ISIE IAI II EXPECTED LEARNING OUTCOMES After reading this chapter, you should be able to a a recall he purpose of a financial statement audit; \e management's asserti i identify the ssertions when presenting the financial c " . 3 a each major phase in financial statement audit; lentify the most common procedures applied in financial statement audit; (e) understand the purpose of audit documentation; (f) identify the different types of audit reports and state the type appropriate for each conclusion drawn based on assessment of audit documentation; (g) formulate appropriate audit adjusting entries; and (h) complete a working trial balance. THE PURPOSE OF FINANCIAL STATEMENT AUDIT AND MANAGEMENT'S ASSERTIONS An entity's financial statements are the representations and responsibility of the entity’s management. External users, mainly investors and other stakeholders, ined in the financial statements in making judgments use the information contai is formulate decisions. A certified public accountant, acting @s ds credibility to the financial statements by expressing an ess by which financial statements are presented. Financial ine whether the financial statements are prepared in ‘opriate financial reporting framework. At present, the ting principles in most parts of the world are the eporting Standards. the auditor addresses each management's tement audit, as follows: assertions, which are gement asserts that all assets, liabilities and statements actually existed at the reporting e financial reported expenses are orted income is earned and porting period.LL Her J - Bas nce] ‘Financial ‘Statement Audit nit asserts that all transactions and accounts financial statements are the results of the ally occurred during the reporting management * ted in resvents that act Completeness ~ that should be present transactions and other e period. ions - management asserts that the entity has property ea oblgatlver all recorded assets, and that all liabilities represent righ obligations at the reporting date. + Measurement and allocation — management asserts that the measurement bases of all assets, liabilities, equities, income and expenses are appropriate in accordance with the reporting standards and that revenucs, costs and expenses are recognized during the proper reporting perios based on the appropriate revenue and expense recognition principles. Presentation and disclosure - management asserts that all financial statement components are presented, classified and described properly and all relevant and required disclosures are included and that the financial statement elements presented and the related notes represent the substance and not merely the legal form of the recorded transactions. THE AUDIT PROCESS The audit process involves both an investigation and a report. This process starts when a reporting entity engages the services of an independent auditor and ends when the auditor issues an audit report. The auditor evaluates the internal control procedures of the client to determine the extent and types of audit procedures necessary to gather evidence as basis for the audit opinion. Major Phases in Financial Statement Audit The following are the major phases in a financial statement audit: (a) _ pre-engagement activities; audit planning and evaluation of internal control; evidence gathering; and agement activities include procedures conducted to determine not to accept a new engagement or retain an existing client. The pre- activities are designed to manage conflicts and threats to the auditor. should not accept an engagement, when based on his or herConcepts of Financial Statement Audit assessment, his or her independence would be compromised. In repeat engagements, subsequent relationships established shall be assessed to determine whether independence has not been compromised. In making an assessment as to whether to accept oF reject a prospective client, the auditor should consider the client's business reputation, the changes in client’s ownership or management and the clent’s reporting practices, Likewise, the auditor should determine whether he oF she and his or her audit team possess the necessary skills, resources and competence to complete the audit within the period specified by the engagement ee {s accepted or retained, the terms shall be documented in an (b) Audit Planning Audit planning involves evaluation of internal control to determine the extent of audit procedures necessary to be perfortned. The audit planning phase requires active involvement of the whole audit team, from the partner in charge down to the audit staff. It includes the following tasks: (1) obtaining an understanding of the client, its business, industry and accounting policies; (2) obtaining an understanding of the client's internal control system; (3) assessing materiality and audit ris (4) identifying audit objectives; (5) determining whether reliance can be placed on certain controls in the system; (6) determining the nature, extent and timing of substantive tests to be performed; and (7) designing and finalizing the audit program. (©) _Evidence-Gathering or Audit Documentation ‘The evidence-gathering (audit documentation) phase must accomplish the objective of documenting the fact that the audit was adequately planned and sufficient, evidential matter is obtained that serves as the basis for the audit opinion reached (International Standards on Auditing 230 Audit Documentation par. 5). The evidence gathered must both be sufficient and competent Sufficiency + Fefers to the quantity of evidence an auditor acquires and competence refers to the - rélevance, validity and reliability of the evidence acquired. Audit evidence consists both accounting data (business documents, journals and ledgers) and ‘(cancelled checks, invoices, contracts, promissory notes, rs and vendors, etc.) that supports accounting ent involved in completing the audit, the na test basis. The auditors test samples ofit Statement Audi of Financial which the samples m an population fro! e rather thi 1e results to the ersuasiv and generali ; . jathered i eralize th be pr transactions and g e gi the evidenc juires that were drawn. This req Merely convincing. the audit based on “ elected iality and the te le aoe available, eg on or more cs the quontty- ond pes of evidence ured may addre dures may be sessed lel of bat fan eae of audit reese common assessed level of audit ris! eet series ofa I proce oes sy te ae es one audit objective. The Necessary to address a audit procedures applied by the audito its from a third party; * Confirmation ~ obtaining written statement Physical count and observation; Nt, i i from manageme: a btaining written and oral information Inquiry - obtainin employees and others; ind external evidence (for ocum - evi ternal evit De ining internal evidence ai : i . cI aoe ee ae El &xample: contracts, minutes of mee ings, — ers, bank statements, etc,); i i i lation; Comparisons establishing trends and valid relationships of inform: Recalculation - establishing correctness of account balances; and Mechanical tests of data — verifying mathematical accuracy of accounting data (tracings, footings and Cross-footings). cted to assess the i controls to prevent pr ‘detect material ed vbstantive tests, on the other hand, are tests of details and analytical Procedures Performed to detect terial misstatements IN account balance, ‘ansaction class Or financial statement Presentation and disclosure Substantive tests m; Y be Classifieg into tests of ils analytical pl ‘cedures ms F details are j tended to detect terial Misstateme, t and allow IN auditor to -{99regated ¢, ta. An; lytical ures are ‘aluations fi information mi ast Plausible rey hips “anal 'on-financial da lytical S all i = eo both fi ncial and Ch a cone auditor to test *99regated dats Audit evide, Shall Contain the ain ean Perfc led,Chapter 1 = Basic Concepys of Financi Documentati lon must be made immediately after completing an audit procedure. T ypical examples of audit documents are (a) i ) information that enables the auditor to accept or reject an entity as @ lent (information relating to the prospective dlient’s Industry, FS of the Board of Directors, products manufactured, etc); (b i ea that enables the auditor to determine the audit Sppreach(lefomaton reling to the flectvenes of internal ae 8 edures are bei cana rcedres and wheter ont sch procedures are being (©) i 4 en as to whether a particular financial statement account lance is complete, valid and accurate and id. information relating to the completeness, validity and accuracy of financial statements taken as a whole including inforrnation relating to the consistency of the financial statements with the auditor's knowledge of the business The form, content and extent of audit documentation depend on factors, such as (ISA 230 A2) + the size and complexity of the entity; + the nature of the audit procedures to be performed; + the identified risks of material misstatements; +. the significance of the audit evidence obtained; + the nature and extent of exceptions identified; = the need to document a conclusion or the basis for a conclusion not readily determinable from the documentation of the work performed or evidence obtained; + the audit methodology and tools used. Specifically, the audit fle documentation serves to: ize and coordinate all phases of the audit engagement, evidence to demonstrate that the planned audit procedures fact performed; in reviewing the work performed by audit staff members; idence that the auditors complied with the auditingConcepts of Financlal Statement Audit (e) document the judgments involved In forming the audit opinion, (f) aid in planning and conducting future audite of Khe cient; ana (9) provide information In rendering additional wervices to Hie audit iene (say, In preparing Income tax return and in making Fecornimendations for improvement of the cllent’s Internal control procedures.) In the risk response phase, typical audit doc urmentation HorTally Weludes, the following items: an audit plan that addresses all material nancial otatervers areas, the assessed risk of material misstatement at the financial staternent aru assertion levels, the nature, timing and extent of the further audit procedures Performed that respond to the assessed audit risks, and significant risks identified Also documented are the nature and extent of consultation with others, significance and nature of the evidence obtained al the assertion belng tested, a dese explanation of the results obtained from the test and the exceptions followed uy, actions taken as a result of auditing procedures, changes If any to the overall aude Strategy, use of significant judgments applled in performing work and evaluoting Fesults, discussions with management on significant matters, memoranda and details of assumptions used, establishment of validity of assumptions established, Cross references to supporting documentation and evidence that the finanria statements agree with the underlying accounting records, The auditors usually maintain two files of audit documentation for each Glent: (1) current files for each year's engagement and pertain 1, documentation relating to that year’s examination and (2) the permanent file ct relatively unchanging data (for example, articles of incorporation), The following are examples of current files in the audit documentation * working trial balance; J 2summary of audit adjusting and classifying entries; * — lead schedule; * bank reconciliation; * aged accounts receivable; * minutes of meetings during the reporting period (; and * Narrative documentation summarizing bases for resolutions involving uncertainties, Examples of permanent file in audit documentation a 5 follows: * articles of incorporation; * — Corporate by laws; * copy of pension contract with funding agency; * — Copy of trust indentures for long-term debt; and * Copy of the effective collective bargaining agreement. The audit documentation, which generally is in the form of audit working Must be organized in a logical manner using an indexing system so that‘napter I~ B g ic Concepts of Financial Statement Audit the working papers audit team menses one documents can be easily located and shared among organized in a manner Pdi working papers and other documents should be orgmanaget, engagem facilitates file review and quality control monitoring by lent partner, quality control reviewer/monitor. Audit docum carat Woranc Wace oe ee However, much of the r 's is confidential, ly 3 available to outsiders without the consent of the aan neal must not be made Under no cit fee cee pes etaebard should the working papers be destroyed after they involving an naneaene after an announcement has been made for litigation working papers serv If the auditors are charged with negligence, their audit /@ as a major basis to refute or substantiate such @ charge. The major types of audit worki i it working papers include administrative working porate ae adjusting journal entries and reclassification entries, , analyses, reconciliation: io papers, and corroborating documents. ales een eae : ‘Administrative working papers aid the auditors in the planning and administration of engagements, and include the audit plans and audit programs, time budgets, internal control questionnaires ‘and flowcharts and engagement letter. They may take the form of a narrative documentation that summarizes the phases of audit work performed on the engagement. the documentation relates to preengagement sment, terms of engagement, team discussions which may ‘he financial statements, risk In the risk assessment phase, procedures, independence and ethics asses: materiality consideration, overall audit strategy, audit include possible causes of material misstatements in t assessment procedures performed and the results, assessed risk of material misstatement identified based on the understanding of the entity and related internal control, signi ‘ation with management and those ificant risks, and communici charged with governance. (Guide to Using ISAs in the Audits of SMEs) (d) Reporting r should review and assess the conclusions drawn from the audit as the basis for the expression of an opinion on the financial iditor’s report should contain a clear written expression of an | statements taken as @ whole. sults of the evaluations made, the auditor would determine js appropriate in the circumstances.The auditor should evaluate the conclusions drawn from the audit evidence obtained as the basis for forming an opinion on the financial statements. (ISA 700, The Independent Auditor's Report on the Financial Statements, par. 4). There are two general types of audit report: unmodified and modified. (1) Unmodified opinion les that the financial statements are presented fairly, in all material respects, with the applicable financial reporting framework (at the present time, the International Financial Reporting Standards or the International Financial Reporting Standards for ‘Small and Medium Sized Entities), ‘an unmodified (or unqualified) opinion would be appropriate. An unqualified opinion should be expressed when the auditor concludes that the financial statements give a true and fair view (or are presented fairly, in all material respects) in accordance with the applicable financial reporting framework (par. 35 ISA 700). When the auditor concludi (2) Modified opinion When based on the audit evidence obtained, the financial statements as 2 whole are not free from material misstatement or when sufficient appropriate audit evidence could not be obtained to conclude that the financial statements as a whole are free from material misstatement, a modified opinion is expressed. A modified opinion may take the form of a qualified opinion, adverse opinion or disclaimer of lion. A. qualified opinion should be expressed when either (1) sufficient ropriate audit evidence was obtained, but the auditor concludes that atements exist, individually or in the aggregate, that are material but not asive to the financial statements or (2) the auditor is unable to obtain ent appropriate audit evidence on which to base the opinion and that the ible effects on the financial statements of undetected misstatements, if any, ld be material but not pervasive. A qualified opinion should be worded as being relates. ‘An adverse opinion should be expressed when the effects of misstatements material and pervasive. This opinion applies where sufficient appropriate _was obtained, but the auditor concludes that misstatements, individually ite, are both material and pervasive to the financial statements. jon states that the financial statements do not present fairly the , financial performance, and cash flows of the entity audited.Comes Financial Statement Au 4 discigumer of opinion (which basically means giving no opinion) should be aqgressed when the possible effects of undetected misstatements, if any, could be path materel anc pervasive. This opinion is expressed when the auditor is unable ain sufficient apgropriate audit evidence on which to base the opinion, and ues Tat the possible effects of undetected misstatements, if any, could be aterai and pervasive. This opinion also applies to extremely rare = in conditions of major uncertainties and their possible effects "| Statements, it is not possible to form an opinion. The Working Tria! Balance and the Audit Adjusting Entries The working tial belance is a schedule listing the balances of accounts in for the current and previous year, with columns for adjusting ‘cation entries, and the financial statement amounts. ‘tral balance is of two types: (2) one-section trial balance, which looks like an ordinary worksheet ¢ lists all ledger accounts. A pair of columns is maintained for of the following: trial balance, adjustments and ‘eciassifications, adjusted profit or loss accounts and adjusted ition accounts. 2) twc-section trial balance, which is divided into two components: working comprehensive income and the working financial . Each section provides a separate column for unadjusted Selences, adjustments and reclassifications and adjusted balances. trial balance shows the results of all adjustments and 2 result of detailed audit of account balances. Thus, audit ‘ped from a cash count of petty cash, bank reconciliation ion and analysis of accounts receivable, analysis of property, summarized in the working trial balance. ¢ reclassifying entries are a list of auditors’ adjustments in the nancial statements to bring the account balances to correct When the auditors discover errors or irregularities in the accounting client, they propose adjusting entries to correct the accounting records. < auditors develop reclassification entries for items that, although correctly corded in the accounting records, must be reclassified for fair presentation of the francial statements. A lead schedule is used to combine several amounts which total to a line ‘the financial statements. For example a-lead schedule is prepared to list the ‘cash on hand and cash in bank that is | as a single line item “Cash”nancial Statement Audit Chapter 1 - Basi Mlustrative Working Trial Balance Below is the trial balance as of December 31, 2017 of Clarity Company, as prepared by its accountant. Clarity Company Trial Balance December 31, 2017 Debit Credit Cash P 191,000 Accounts receivable 615,000 Allowance for doubtful accounts P 71,000 Inventory, December 31, 2013 584,000 Prepaid expenses 8,000 Investments 110,000 Furniture and Equipment 312,000 Miscellaneous Equipment 90,000 Accumulated Depreciation 76,400 Accounts Payable 543,000 Accrued Expenses 51,000 Unearned Rent Income 12,800 Ordinary Share Capital 600,000 Retained Earnings 182,800 Sales 3,500,000 Rent Income 48,000 Purchases 2,424,000 Salaries Expenses 400,000 Advertising Expense 124,000 Commission Expense 80,000 Utilities Expense 32,000 Supplies Expense 12,000 Transportation Expense 14,000 Repairs and Maintenance 16,000 Miscellaneous Expenses 23,000 Pp 5,035,000 _P___5,035,000_ You have gathered the following information for adjustment: 1, The Cash account included equipment acquisition fund amounting to P60,000. Ph A physical inventory taken on December 31, 2017 revealed goods costing P600,000. 3; Goods purchased under FOB shipping point and verified to have been shipped by the supplier on December 28, 2017 were received and recorded by Clarity on January 4, 2018, P50,000. 10inancial Statement Audit 4. The allowance for doubtful accounts should be adjusted to 5% of accounts receivable. 5. The company purchased 100 shares of its P100 par value ordinary share capital for P30,000, the amount having been charged to the Investment account. 6. Except for equipment purchased on June 30, 2017 for P20,000 cash, all equipment were acquired at the inception of the company three years ago. Depreciation for 2014 has not been recorded. 7. Prepaid expenses include P4,800 insurance premium on @ one-year insurance policy taken on October 1, 2017. 8. Unearned rent income on December 31, 2017 amounted to P10,000. 9. Accrued expenses on December 31, 2017 amounted to P54,000. REQUIRED: (a) Prepare audit adjusting entries. () Prepare a working trial balance to facilitate the preparation of the financial statements for the year ended December 31, 2017. Solutions: (a) Audit Adjusting Entries: Equipment Acquisition Fund 60,000 Cash 60,000 Purchase counts Payable ae 50,000 Doubfil Accomm EPO coms asi FT ohelih oe 30,000 Depreciation Expense 39,200 a ‘Accumulated Depreciation iChapter 1 - Basie Concepts of Financial Statement Audit Total Furniture and Equipment P402,000 Acquired June’30, 2014 (20,000) Acquired at inception P382,000 Annual depreciation = P 76,400/2 = P38,200 Annual depreciation rate = 38,200/382,000 = 10% 2014 Depreciation: on beginning balance P38,200 on new (10% x 20,000 x 6/12) =__1,000 Total P39,200 Insurance Expense 1,200 Prepaid Expenses 1,200 Unearned Rent Income 2,800 Rent Income 2,800 12,800 ~ 10,000 = 2,800 decrease Miscellaneous Expenses 3,000 Accrued Expenses 3,000 54,000 — 51,000 = 3,000 increase Inventory, end 650,000 Cost of Goods Sold 2,408,000 Purchases 2,474,000 584,000 Inventory, beg. The audit adjusting and reclassification entries are not necessarily posted in the books of the client, Audit adjustments and reclassifications are still effected through the nominal accounts and real accounts of the client, regardless as to whether the client’s books have been closed or are still open, because as pres, stated, because their purpose is to correct the client-prepared financial statements. leaf is a one-section trial balance, listing 7 one-section both the profit or loss accounts and the balance eg ad fe working trial balance may also be prepared in a two-section form sepotme aud Profit or loss accounts from the balance sheet accounts. Notice | mt roprateY adjustments and reclassifications listed on pages 1 and 11 a posted to the adjustment colurnns of the working trial balance. The trial balance shown overlCLARITY COMPANY WORKING TRIAL BALANCE FOR THE YEAR ENDED DECEMBER 31, 2017 Trai Bala 7 — a i Profi or oss Financial Postion Cash 491,000 a Debit | Credit Debit | __ Credit ‘Accounts receivable, 15,000 | 131,000 / ‘Alowance for SoubttT Fa 616,000 accounts . 9,750 30,750 inventoy, Das. ST, 2016 5 ae ae am Investments 770,000 a 6800 Fumaure and equipment 312,000 = 80,000 Miscellaneous equipment 90,000 312,000 ‘Accumulated depreciation 76,400 39,200 a [ Accounts payable 543,000 50,000 15 ~ Ascuad expenses Tt a 28 "Uneamed rent income 72,800 2,800, ; 70.000. ~Orsinary share capital 00,000 . $00,000 "Retained earings 62,800 ee "Seles 500,000 3500000, : Rent income 48,000 20 50,800 Purchases. 7424000, sooo [274.000 [ Salaries expense 400,000 700,000, ‘Advertsing expense 24,000 124000 Commission expens® 20,000 20,000 Uses expense, 32,000 32,000 Supplies expensé 12,000, 12,000 r Transportation expense 4,000, 14000 Repeirs and mainlenance 16,000 16,000 Miscelaneous expenses 3,000 3000 26,000 57035,000 | 5,035,000 Eqspment aquisition fond 000, 0,000 Doubtful accounts expense 9.750 9,150 Inventory. Dec. 31, 2017 650,000 850,000. Cast of goods sid 7,406,000 708,000 Tessin shares 30,000 st 000 Depreciation expense at fo Seserance expense 255.950 | 3258860 | 3.162.160 | 3560.800 | 388,650 Prot before income tat 3.550.900 | 3,550,800 Profit before income tax 716505 0.80 Income tax expense : T1655 Income tax payable TOs 212,055 Pelt an.650 | sues | 1.97400 | 1974.00