Audit of Historical Financial Information

SOURCES: Philippine Framework for Assurance Engagements, PSA 120, PSA 200, Public Accountancy
Profession (Cabrera 2013-2014 Edition)

AUDITING
- Defined by the American Accounting Association, Auditing is a systematic process by
which a competent, independent person objectively obtains and evaluates 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 interested users.

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 applicable 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).

Assurance, Attestation and Audit Services Distinguished

- Similarity: These services are often used interchangeably because they encompass
the same decision-process
- Differences: Scope of services
a. “Assurance services” is broader in scope and in concept than either auditing
or attestation. It encompasses both audit and attestation services. Otherwise
stated, attestation and audit services are subsets of assurance services.
b. “Attestation services” is broader than audit because attest function is beyond
historical FS. Attestation services cover even non-GAAP FS.
c. Auditing, particularly FS audit, is a type of assurance and attestation service
that involves examination of historical FS prepared in accordance with GAAP.

Types of Audits
1. 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)
○ An audit of financial statements is the type of audit most frequently
performed by CPAs (due to the widespread use of audited financial
statements) on a fee basis and for more than one client.
Financial audit is also called:
■ External audit – because it is performed by external auditors,
whether individual CPAs or CPA firms, who are not employees
of the client
■ Independent audit – because the auditor is independent of the
client subject to audit
■ Financial Audit
● Compliance audit: a review of an entity’s degree of compliance with applicable
laws and rules/regulations or contracts; usually performed by government
auditors.
● 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).
- Also called performance audit or management audit
- Usually performed by internal auditors
- Efficiency relates to use of its resources, while effectiveness relates to
accomplishing objectives.

Major differences between financial and operational auditing:

 ● The financial audit is oriented to the past whereas an operational audit
concerns performance for the future.
● The financial audit report is distributed to many readers whereas the
operational audit report goes to a few managers.
● Financial audits are limited to matters that directly affect the financial
statements whereas operational audits cover any aspect of efficiency and
effectiveness.

2. According to types of auditor or their affiliation with the entity being examined:
● 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
● Internal Audit
- performed by the entity's own employees known as internal auditors.
- internal auditors investigate and appraise 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:

● Financial and operating information
● Compliance with policies, plans, procedures, laws, regulations, and contracts
● The means of safeguarding assets and verifying their existence
● The economy and efficiency with which resources are employed; and
● Operations or programs to ascertain whether results are consistent with
established objectives and goals and whether they are being carried out as
prescribed.

- Internal auditing is an appraisal control that measures and evaluates other

controls. The increased complexity and sophistication of business operations
have required management to rely on this appraisal control.
- Internal auditors review the adequacy of the company's internal control system
primarily to ascertain whether the system provides reasonable assurance that
the company's objectives and goals will be achieved efficiently and
economically.
a. Efficient performance implies the use of minimal resources to meet
the company's objectives and goals.
b. Economical performance is the accomplishment of objectives and
goals at a cost commensurate with the task.
The overall objective of Internal Auditing is to assist the members of the
organization, particularly management and board of directors, in the effective
discharge of their responsibilities

● Government Auditing
- A governmental audit is typically designed to determine whether the
auditee has complied with applicable laws and regulations.

The scope of government audit may extend beyond FS audit to include:

A. FS audit
B. Performance Audit (includes: program results (effectiveness) audit and
economy and efficiency audit)
C. Compliance Audit

- 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 understanding

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.

- The Government Auditing Standards require auditors to prepare a

written report on the entity's internal control. This report should include
the conditions, including the identification of material weaknesses,
discovered as a result of the auditor's work. However, the report should
not give any form of assurance on the design and effectiveness of the
entity's internal control.
- Government auditors are required to obtain an understanding of the
possible financial statement effects of laws and regulations having
direct and material effects on amounts reported. Also, they are required
to make an assessment whether management has identified such laws
that might have such effects.
- The audit of a government program involves obtaining information
about the costs, outputs, benefits, and effects of the program. Auditors
attempt to measure the accomplishments and relative success of the
program based on the actual intent of the legislation that established
the program.
Objective, Scope and Limitations of 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. The phrase used to
express the auditor’s opinion is “present fairly, in all material respects”. A similar
objective applies to the audit of financial or other information prepared in accordance
with appropriate criteria.
- The purpose of an audit is to enhance the degree of confidence of intended users in
the financial statements. This is achieved by the expression of an opinion by the auditor
on whether the financial statements are prepared, in all material respects, in
accordance with an applicable financial reporting framework. In the case of most
general purpose frameworks, that opinion is on whether the financial statements are
presented fairly, in all material respects, in accordance with the framework. An audit
conducted in accordance with PSAs and relevant ethical requirements enables the
auditor to form that opinion.

Scope of the Audit

- The auditor’s opinion on the financial statements deals with whether the
financial statements are prepared, in all material respects, in accordance with
the applicable financial reporting framework. Such an opinion is common to all
audits of financial statements. The auditor’s opinion therefore does not assure,
for example, the future viability of the entity nor the efficiency or effectiveness
with which management has conducted the affairs of the entity.
- In some jurisdictions, however, applicable laws and regulations may require
auditors to provide opinions on other specific matters, such as the effectiveness
of internal control, or the consistency of a separate management report with
the financial statements.

Overall Objectives of the Auditor

In conducting an audit of financial statements, the overall objectives of the auditor are:
I. To obtain reasonable assurance about whether the financial statements as a
whole are free from material misstatement, whether due to fraud or error,
thereby enabling the auditor to express an opinion on whether the financial
statements are prepared, in all material respects, in accordance with an
applicable financial reporting framework; and
II. To report on the financial statements, and communicate as required by the
PSAs, in accordance with the auditor’s findings.
In all cases of when reasonable assurance cannot be obtained and a qualified opinion
in the auditor’s report is insufficient in the circumstances for purposes of reporting to
the intended users of the financial statements, the PSAs require that the auditor
disclaim an opinion or withdraw from the engagement, where withdrawal is legally
permitted.

Ethical Requirements Relating to an Audit of Financial Statements

The auditor shall comply with relevant ethical requirements, including those
pertaining to independence, relating to financial statement audit engagements.
 The auditor is subject to relevant ethical requirements, including those
pertaining to independence, relating to financial statement audit engagements.
Relevant ethical requirements ordinarily comprise Parts A and B of the Code
of Ethics for Professional Accountants in the Philippines (the Code of Ethics)
related to an audit of financial statements together with national requirements
that are more restrictive.

Part A of the Code of Ethics establishes the fundamental principles of

professional ethics relevant to the auditor when conducting an audit of financial
statements and provides a conceptual framework for applying those principles.
The fundamental principles with which the auditor is required to comply by the
Code of Ethics are:
● Integrity
● Objectivity
● Professional competence and due care
● Confidentiality
● Professional behavior.
Part B of the Code of Ethics illustrates how the conceptual framework is to be
applied in specific situations.

In the case of an audit engagement it is in the public interest and, therefore,

required by the Code of Ethics, that the auditor be independent of the entity
subject to the audit. The Code of Ethics describes independence as comprising
both independence of mind and independence in appearance. The auditor’s
independence from the entity safeguards the auditor’s ability to form an audit
opinion without being affected by influences that might compromise that
opinion. Independence enhances the auditor’s ability to act with integrity, to be
objective and to maintain an attitude of professional skepticism.

Professional Skepticism
The auditor shall plan and perform an audit with professional skepticism
recognizing that circumstances may exist that cause the financial statements
to be materially misstated.

Professional skepticism includes being alert to, for example:

● Audit evidence that contradicts other audit evidence obtained.
● Information that brings into question the reliability of documents and
responses to inquiries to be used as audit evidence.
● Conditions that may indicate possible fraud.
● Circumstances that suggest the need for audit procedures in addition
to those required by the PSAs.

Maintaining professional skepticism throughout the audit is necessary if the

auditor is, for example, to reduce the risks of:
● Overlooking unusual circumstances.
● Over generalizing when drawing conclusions from audit observations.
● Using inappropriate assumptions in determining the nature, timing, and
extent of the audit procedures and evaluating the results thereof.
 The auditor cannot be expected to disregard past experience of the honesty
and integrity of the entity’s management and those charged with governance.
Nevertheless, a belief that management and those charged with governance
are honest and have integrity does not relieve the auditor of the need to
maintain professional skepticism or allow the auditor to be satisfied with less-
than- persuasive audit evidence when obtaining reasonable assurance.

Professional Judgment
The auditor shall exercise professional judgment in planning and performing an
audit of financial statements.

Professional judgment is essential to the proper conduct of an audit. This is

because interpretation of relevant ethical requirements and the PSAs and the
informed decisions required throughout the audit cannot be made without the
application of relevant knowledge and experience to the facts and
circumstances. Professional judgment is necessary in particular regarding
decisions about:
● Materiality and audit risk.
● The nature, timing, and extent of audit procedures used to meet the
requirements of the PSAs and gather audit evidence.
● Evaluating whether sufficient appropriate audit evidence has been
obtained, and whether more needs to be done to achieve the objectives
of the PSAs and thereby, the overall objectives of the auditor.
● The evaluation of management’s judgments in applying the entity’s
applicable financial reporting framework.
● The drawing of conclusions based on the audit evidence obtained, for
example, assessing the reasonableness of the estimates made by
management in preparing the financial statements.

Professional judgment needs to be exercised throughout the audit. It also

needs to be appropriately documented. In this regard, the auditor is required to
prepare audit documentation sufficient to enable an experienced auditor,
having no previous connection with the audit, to understand the significant
professional judgments made in reaching conclusions on significant matters
arising during the audit.

Inherent Limitations of an Audit

The auditor is not expected to, and cannot, reduce audit risk to zero and cannot
therefore obtain absolute assurance that the financial statements are free from
material misstatement due to fraud or error. This is because there are inherent
limitations of an audit, which result in most of the audit evidence on which the
auditor draws conclusions and bases the auditor’s opinion being persuasive
rather than conclusive. The inherent limitations of an audit arise from:
● The nature of financial reporting
The preparation of financial statements involves judgment by
management in applying the requirements of the entity’s
applicable financial reporting framework to the facts and
 circumstances of the entity. In addition, many financial
statement items involve subjective decisions or assessments or
a degree of uncertainty, and there may be a range of acceptable
interpretations or judgments that may be made.
● The nature of audit procedures
There are practical and legal limitations on the auditor’s ability to obtain
audit evidence. For example:
- There is the possibility that management or others may not
provide, intentionally or unintentionally, the complete
information that is relevant to the preparation and presentation
of the financial statements or that has been requested by the
auditor. Accordingly, the auditor cannot be certain of the
completeness of information, even though the auditor has
performed audit procedures to obtain assurance that all relevant
information has been obtained.
- Fraud may involve sophisticated and carefully organized
schemes designed to conceal it. Therefore, audit procedures
used to gather audit evidence may be ineffective for detecting
an intentional misstatement that involves, for example, collusion
to falsify documentation which may cause the auditor to believe
that audit evidence is valid when it is not. The auditor is neither
trained as nor expected to be an expert in the authentication of
documents.
- An audit is not an official investigation into alleged wrongdoing.
Accordingly, the auditor is not given specific legal powers, such
as the power of search, which may be necessary for such an
investigation.
● The need for the audit to be conducted within a reasonable period of
time and at a reasonable cost.
- The matter of difficulty, time, or cost involved is not in itself a
valid basis for the auditor to omit an audit procedure for which
there is no alternative or to be satisfied with audit evidence that
is less than persuasive. Appropriate planning assists in making
sufficient time and resources available for the conduct of the
audit. Notwithstanding this, the relevance of information, and
thereby its value, tends to diminish over time, and there is a
balance to be struck between the reliability of information and its
cost.

Because of the inherent limitations of an audit, there is an unavoidable risk that

some material misstatements of the financial statements may not be detected,
even though the audit is properly planned and performed in accordance with
PSAs. Accordingly, the subsequent discovery of a material misstatement of the
financial statements resulting from fraud or error does not by itself indicate a
failure to conduct an audit in accordance with PSAs.
However, the inherent limitations of an audit are not a justification for the auditor
to be satisfied with less-than-persuasive audit evidence. Whether the auditor
has performed an audit in accordance with PSAs is determined by the audit
 procedures performed in the circumstances, the sufficiency and
appropriateness of the audit evidence obtained as a result thereof and the
suitability of the auditor’s report based on an evaluation of that evidence in light
of the overall objectives of the auditor.

Information Risk
The primary economic reason for an audit of financial statements is the demand
by external users for reliable or fairly stated financial statements that they will
use in making economic decisions. Thus, the market for auditing services is
driven by demand by external financial statements users.

An audit can help reduce information risk - risk that the financial statements
that will be used for decision-making are materially misleading, unreliable or
inaccurate.

Four conditions/reasons that gave rise to a demand for independent audit of

financial statements:
- Potential conflict of interest between users and preparers of the financial
information can result in biased information – Client management may
not be objective in financial reporting. It may provide impressive but
biased, unrealistic, or misleading financial statements to obtain benefits
that it seeks. On the other hand, financial statement users need
unbiased, realistic, or reliable financial statements.
- Remoteness of users – Users do not have access to entity’s records to
personally verify the reliability of the financial information.
- Complexity of subject matter requires expertise – Expertise is often
required for information preparation and verification. Users of financial
statements are not equipped with the necessary skills, competence, and
knowledge of complexities of accounting and auditing to determine
whether the financial statements are reliable.
- Consequence for decision making – Financial statements are used for
important decisions that involve significant amount of money. If a
decision is based on misleading financial information, it could have
substantial financial or economic consequences on decision makers.

Another condition that gave rise to demand for audit of financial statements is
the stewardship or agency theory which means that management wants the
credibility an audit adds to the financial statement to enhance stewardship of
the financial statement and to lessen the owner’s mistrust of the management.

To reduce Information Risk:

The management or users of their financial statements may adopt any or all of
the following approaches:
1. Allow users to verify information.
 The user may go to the business establishment to examine
records and obtain information about the reliability of the
statement. Although impractical because of costs, this is usually
adopted by BIR examiners or a business intending to purchase
another business.
2. Users share information risk with management.
If users rely on inaccurate financial statements and as a
consequence incurs a financial loss, a lawsuit may be brought
against management to recover part of such loss.
3. Have the financial statements audited.
As an expert in the application of financial reporting standards,
the independent auditor further enhances the quality of financial
reporting.