| nn Aaa | we yer ww psy TR pee Chapter 4 _ THE AUDIT PROCESS Preliminary Engagement Activities An audit of financial statements generally begins with the financial statements prepared by the entity. Without these financial statements, there would be no audit to perform. A general approach to auditing finan cial Statements would require consideration of financial statement assertions, audit procedures, and audit evidence. Figure 4.1- General Approach When Auditing Financial Statements Financial Statement Assertions \—> Existence or Occurrence Rights and Obligations ler ‘Completeness Audit Valuation and allocation| Procedures Presentation and Disclosure Audit Evidence 89 Scanned with CamScannerFinancial statement assertions Management is responsible for the fair presentation of financial statements that reflect the nature and operations of the entity. In representing that the financial statements in accordance with the applicable financial reporting framework, management implicitly or explicitly makes assertions regarding the recognition, measurement, . presentation and disclosure of the various elements of financial statements and related disclosures. "These assertions may fall into the following categories: te Assertions about dasses of transactions and ecerts for the pericd under audit; acre = Occurrence - transactions and events that have been recorded have occurred and pertain to the entity. =. Completeness - all transactions and events that should have been recorded have been recorded. = Accuracy - amounts and other data relating to recorded transactions and events have been recorded appropriately. * Cutoff - transactions and events have been recorded in the correct accounting period. «Classification - transactions and events have been recorded in the proper accounts. he Assertions about account balances at the period end: CER Existence - assets, liabilities, and equity interests exist. Rights and obligations - the entity holds or controls the rights to assets, and liabilities are the, obligations of the entity. ‘ Completeness - all assets, liabiliti ity i assets, ies and e terest that should have been recorded have been coded 90 Scanned with CamScanner64 ccs ree . ‘ squily and allocation - assets, liabilities, and eq) ‘ ; “ancial statements at ite included in the financial statemet or appropriate allocation i valuation “Mounts and any resulting rare adjustments are appropriately recorded. Assertions abwvt prsornation anddisdeum: — cco * Occurrence and ri events, tran: ions, and ott and pertain to the entity. " Completeness - all disclosures that should have been included in the financial statements have been included. * Classification and understandability - financial information js appropriately presented and described, and disclosures are clearly expressed. na closed ights and obligations - disclos Es matters have occurre " Accuracy and yaluation - financial and other information are disclosed fairly and at appropriate amounts, = Audit procedures The auditor should use assertions for classes of transactions, account balances, and presentation and disclosures in suffic ent detail to form a basis for the_assessment_of tisks of material | misstatement and the design and performance of further audit procedures. ‘The auditor uses assertions in assessing risks by considering the different types of potential misstatements that may occur, and thereby designing audit procedures that are responsive to the assessed risks. Selection of the appropriate procedures to satis 4 particular assertion is affected by a nuinber of facto S including the auditor's assessment of materiality and risk. Regardless of the Procedures selected, there is only one basic criterion, The Scanned with CamScannerof pelfem oF fr op aktyr iPkemel cot procedures selecte should ood the auditor to gathe; sufficient appropriate evidence about a particular assertion. nga ark Ww relnt es én ee an ‘ape vi, & ch Some of the audit procedures used by the auditor to gather sufficient appropriate evidence include: ied sr 4 Inspection. involves examining of records, documents, or tangible assets. Ahrecler 4 Observation- consists of looking at a process or procedure being performed by others. awe sy + Inquiry- consists of seeking information from knowledgeable persons inside or outside the entity. sr Confirmation- consists of the response to an inquiry to corroborate information contained in the accounting records. st? Computation- consists of checking the arithmetical accuracy of source documents and accounting records or performing independent calculations. Ral or Analytical Procedures- consist of the analysis of significant ratios ad trends including the resulting investigation of fluctuations and relationships that are inconsistent with other relevant information or deviate from predicted amounts. f3 Evidence i Audit procedures are the means used by the auditor to obtain i sufficient appropriate evidence. Audit evidence refers to the f information obtained by the” auditor in arriving at the conclusions on which the audit opinion is based. ee evidence will comprise source documents and accau 1 ce d ting records underlying the financial statements ~and corroborating - Scanned with CamScanner folis evidence will either prove sertions. At the information from other sources. ‘Th or disprove the validity of management ass conclusion of the audit, the auditor should fully evaluate the audit evidence obtained in order to come up with an appropriate opinion, @ Overview of the audit process The audit process is the sequence of different activities involved in an audit. The emphasis and order of certain activities may vary depending upon a particular audit, but basically this process should include the following audit activities: Figure 4.2- The Audit Process Issuing a Report Completing the Audit EE ae Performing Substantive Tests Considering Internal Control Audit Planning Preliminary Engagement Activities 93 Scanned with CamScanner£2 Preliminary Engagement Activities Before performing any significant audit activities, PSA 300 requires the auditor to undertake the following preliminary engagement activities: a. Performing procedures regarding the continuance of the client relationship and the specific audit engagement. b. Evaluating compliance with ethical requirements, including independence. c. Establishing an understanding of the terms of the engagement. 7 Performing the preliminary engagement activities at the beginning of the current audit engagement assists the auditor in e Planning the audit; and ¢ Identifying areas that may adversely affect the auditor's ability to perform the audit engagement. £2 Audit Planning In planning an audit, the auditor obtains sufficient understanding of the entity and its environment to understand the transactions and events affecting the financial statements and to identify potential problems. A preliminary assessment of risk and materiality is made to be able to develop an overall audit strategy and a detailed approach for the expected conduct and scope of the examination. ey £3 Considering the Internal Control The auditor considers the entity’s internal control because the condition of the entity’s intemal control directly affects th reliability of the financial statements. The stronger the inter control, the more assurance it provides about the reliability accounting data and financial statements, 94 Scanned with CamScannerConsideration Of intemal control involves obtaining un ees of the entitys control systems and assessing the level of control risk. that is, the risk that the client's internal control yay NOt prevent or detect material misstatements in the financial statements, ae auditor wants to assess control risk at less than high level, si iclent appropriate evidence must be obtained to prove that the internal control is functioning effectively and that it can be relied upon. This evidence can be obtained by performing tests of controls. nm 2 Performing Substantive Tests Using the information obtained in audit planning and consideration of internal control, the auditor performs substantive tests to determine whether the entity’s financial statements are presented fairly in accordance with financial reporting standards. Performing substantive tests involves examination of the documents and evidence supporting the amounts and disclosures in the financial statements, The extent of the substantive tests is highly dependent on the results of the auditor’s consideration of internal control. If based on the evaluation of internal control, the auditor has obtained evidence that the internal control is functioning effectively; the scope of the auditor’s substantive tests can be reduced. On the other hand, if the results of tests of control prove that the internal control cannot be relied on, the auditor will have to compensate for this weakness by performing more extensive substantive tests. © Completing the Audit 95 Scanned with CamScannerent appropriate evidence in Orde, at the fairness © the financia} aditor bas completed testing the accoun, forms additional audit procedures t~ ne satisfied that the evidence the auditor’s report. These subsequent events and concem assumption dures, and obtaining rust have suffici The auditor ™ \ Jusion abou to reach a conc! statements. After the ay balances, the auditor per complete the audit and becon gathered is consistent with procedures include review of | contingencies, assessing, the going performing overall analytical review proce written representations from the client's management. Issuing a Report idence gathered and evaluated, the bout the financial statements. This inion) is communicated to On the basis of audit evi auditor forms a conclusion a conclusion (in the form of an op’ various interested uses through an audit report. ® Preliminary Engagement Activities Preliminary Engagement Activities are performed to determine whether the auditor is qualified to handle the engagement and to evaluate whether the client’s financial statements are auditable or not. In this assessment, the firm should consider (1) its competence, (2) its independence, (3) its ability to serve the client properly, and (4) the integrity of the prospective client’s management. Competence One i . F On of rn oso tore aeping ao a necessary skills and perme whether the auditor has the According to the Caren to handle the engagement. should not portray the: " Ethics, professional accountants y themselves as having expertise which they 40 not possess. Competence j E education, traini ipetence is acquired through Salt } training and experience, igh a combination © 96 Scanned with CamScannerBefore accepting an audit engagement, the auditor should obtain a preliminary knowledge of the client's business and industry 10 eee whether the auditor has the degree of competence required by the engagement or whether such competence can be obtained before the completion of the audit. £1 Independence Essential to the credibility of the auditor's report is the concept of independence. Before accepting an audit engagement, the auditor should consider whether there are any threats to the audit team’s independence and objectivity and, if so, whether adequate safeguards can be established. £1 Ability to serve the client properly Closely related to competence is the auditor’s ability to serve the client properly. An engagement should not be accepted if there are no enough qualified personnel to perform the audit. PSA 220 suggests that audit work should be assigned to personnel who have the appropriate capabilities, competence and time to perform the audit engagement in accordance with professional standards. In addition, there should be sufficient direction, supervision and review of work at all levels in order to provide reasonable assurance that the firm’s standard of quality is maintained in the performance of the engagement. & Integrity of management The recent wave of litigation involving auditors has made pre- acceptance investigation procedures very important. PSA 220 are that the * yuditors should conduct a background investigation of the prospective client in order to minimize the likelihood of association with clients whose management lacks integrity. This task would involve: 97 Scanned with CamScanner+ Making inquiries of appropriate Pe jin the business community such as prospective © jent’s ba r, legal counsel, or underwriter to ‘obtain information about the reputation of the client. 4 Communicating with the predecessor auditor 4 Communication with predecessor auditor is not only a matter of courtesy tO the predecessor auditor. This communication allows the incoming auditor to obtain information about the client that will be useful in determining whether the engagement will be accepted. But before the incoming auditor contacts the predecessor auditor, the incoming auditor should obtain client's permission to communicate with the predecessor auditor, This is a necessary procedure because the code of ethics prevents an’ auditor from disclosing any information Obtained about the client without the client’s explicit permission. Refusal of the prospective client’s management to permit this will raise serious questions as to whether the engagement will be accepted. Once permission of the client is obtained, the incoming auditor should inquire into matters that may affect the decision to accept the engagement. This includes questions regarding: * The predecessor audit 5 ae the client. tween the predecessor auditor and ie aa have a bearing on the integrity of noncompliance with awe and eee ue faa 98 Scanned with CamScanneror auditor tO and advise | reasons The Code of Ethics requires the predecess respond fully to the incoming auditor's inquiry the incoming auditor if there are any profession why the engagement should not be accepted. Retention of Existing Clients consideration. nn occurrence directors, The auditor’s evaluation of clients is not a one-time Clients should be evaluated at least once a year or upO! of major events such as changes in management, ownership, nature of client’s business, or other changes that may affect the scope of the examination. nting firm In general, conditions which would have caused an accoul lecision of to reject a prospective client may also result or lead to a d terminating an audit engagement. Engagement letter After accepting the audit engagement, an engagement letter should be prepared. This serves as the written contract between the auditor and the client. This letter sets forth: "The objective of the audit of financial statements which is to express an opinion on the financial statements. = The management's responsibility for the fair presentation of the financial statements «The scope of the audit. * The forms or any reports or other communication that the auditor expects to issue. : . = The fact that because of the limitations of the audit, there is an unavoidable risk that material misstatements may remain undiscovered. "The responsibility of the client to allow the auditor to have unrestricted access to whatever records, documentation and other information requested in connection with the audit. 99 Scanned with CamScannerIn addition, the auditor may also include the following items in the engagement letter: nn eH iy Billing arrangements ie Expectations of receiving management repress ( Arrangements concerning the involvement of others che other auditors, internal auditors and other client personnel) Request for the client to confirm the terms of the engagement Importance of the engagement letter Itis in the interest of both the auditor and the client that the auditor sends engagement letter in order to: «Avoid misunderstandings with respect to the engagement. * Document and confirm the auditor’s acceptance of the appointment. ; Recurring audits The auditor does not normally send new engagement letter every year. However, the following factors may cause the auditor to send a new engagement letter. * Any indication that the client misunderstands the objective and scope of the audit "Any revised or special terms of the engagement A recent change of senior management, board of directors or ownership A significant change in the nature or size of the client’s business «Legal requirements and other government pronouncements Whe: i i hoes Sea not send a new engagement letter, it ay r the auditor to i i original sttanemeris to remind the client of the agencies’ 100 Scanned with CamScannerft Audits of Components When the auditor of a parent entity is aso the auditor ol its " subsidiary, braneh or division (component), the auditor shouk consider the following, factors in making a decision of whether to send a separate letter to the component: * Who appoints the auditor of the component. * Whether a separate audit report is to. be issued on component, * Legal requirements, * The extent of any work performed by othe = Degree of ownership by parent. * Degree of independence of the component's management. the sr auditor. Asample engagement letter is presented on the next page: 101 Scanned with CamScanner‘Yo the Board of Directors of ACE Company. You have requested that we audit the balance sheet of ACE Company as of December 31, 20]; and the related statements of income and cash flows for the year then ended, We are pleased tg confirm our acceptance and our understanding of this engagement by means of this letter. Ou audit will be made with the objective of our expressing an opinion on the financial statements, We will conduct our audit in accordance with Philippine Standards on Auditing, ‘Those Standard require that we plan and perform the audit to obtain reasonable assure about whether the firvncial statements are free of material misstatements. An audit includes examining, on a tes basis, evidence supporting the amounts and disclosures in the financial staremenss. An audit abo includes assessing the accounting principles used and significant estimates mace DY management, as well as evaluating the overall financial statement presentation. Because of the test nature and other inherent limitations of an audit togeniel athe inherent limitations of any accounting and internal control system, there is an unavoidable ris that even some material misstatements may remain undiscovered. In addition to our report on the financial statements, we expect to provide you with a separate Jewer concerning any material weaknesses in accounting and internal control systems which come to our notice. We remind you that the respotisiblity for the preparation of financial statements including adequate disclosure is that of the management of the company. This includes the maintenance of adequate accounting records and internal controls, the selection and application of accounting polices, and the safeguarding of the assets of the company. As part of out audit process, we wil fequest’ from management written confirmation concerning representation made to ws in connection with the audit. We look forward to full cooperation with your staff and we trust that they will make available to us whatever records, documentation and other information are requested in connection with our audit, Our fees, which will be billed as work progresses, are based on the time required by th individuals assigned to the engagement plus out-of-pocket expenses. Individual hourly rates ¥) according to the degree of responsibilty involved and the experience and skill required. , This letter will be effective for future years unless it is terminated, amended or superseded. Please sign and return the attached his letter to ii copy of this letter to indicate that it is i rd. it i s at it is ina ith your understanding of the arrangements for our audit of the financial statements foe REYES TACANDONG & COMPANY Acknowledged on behalf 7 (pred) en eta of ACE Company by ‘Name and Title Date Scanned with CamScanner