AUDITING

In Philippine Standards on Auditing (PSA) 200.11, the objectives of the auditor in undertaking an audit of
a financial report are stated as follows:

a. To obtain reasonable assurance about whether the financial report as a whole is

free from material misstatement, whether due to fraud or error, thereby enabling the auditor

to express an opinion on whether the financial report is prepared, in all material respects, in

accordance with an applicable financial reporting framework; and

b. To report on the financial report, and communicate as required by the Philippine

Auditing Standards, in accordance with the auditor’s findings.

While these objectives describe the expected outcomes, they do not describe the process.

A useful definition is that developed by the American Accounting Association (AAA) in A

Statement of Basic Auditing Concepts (ASOBAC). It defines auditing as:

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 contains several ideas important in a wide variety of audit practices. The

attributes of auditing contained in this definition that merit special comment are as follows:

1. A systematic process – connotes a purposeful and logical step and is based on the

discipline of a structured and organized series of procedures to decision making. It is not

haphazard, unplanned, or unstructured.

2. Objectively obtaining and evaluating evidence – means examining the underlying support

for assertions or representations and judiciously evaluating the results without bias or
prejudice either for or against the individual or entity making the assertions.

3. Assertions about economic actions and events – are the information or representations

made by the individual or entity. They comprise the subject matter of auditing. Assertions

include information contained in the financial statements, management internal operating

reports, and tax returns.

4. Degree of correspondence – refers to the closeness with which the assertions can be

identified with the established criteria. The expression of correspondence may be quantified,

such as the amount of a shortage in a petty cash fund, or it may be qualitative, such as the

fairness of financial statements.

5. Established criteria – are the standards against which the assertions or representations

are judged. Established criteria may be specific rules prescribed by a legislative or regulatory

body, budgets and other measures of performance set by management, or the Philippine

Financial Reporting Standards (PFRS).

6. Communicating the results – is the communication of the auditor’s findings to users and

is achieved through a written report, called audit report, that inform readers of the degree of

correspondence between the assertions and established criteria. The communication of

results either enhances or weakens the credibility of the representations made by another

party. The goal of the audit process is to add credibility to management’s representations so

that interested users can use the information with reasonable assurance that it is free of

material misstatement.

7. Interested users – are individuals or entities who rely on the auditor’s findings. In a

business environment, they include stockholders, management, employees, creditors,

governmental agencies and the general public.

OBJECTIVE OF A 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”.

An audit of financial statements is intended to provide an opinion on whether the financial statements
have been prepared in accordance with a predefined financial reporting structure. The auditor's point of
view is "fairly represented in all material areas."

Although the auditor's opinion adds credibility to the financial statements, it should not be interpreted
as a guarantee of the entity's future viability or the efficiency or effectiveness of management.

Although the auditor’s opinion enhances the credibility of the financial statements, the user

cannot assume that the opinion is an assurance as to the future viability of the entity nor the

efficiency or effectiveness with which management has conducted the affairs of the entity.

GENERAL PRINCIPLES OF A FINANCIAL STATEMENT AUDIT

The auditor should comply with the “Code of Professional Ethics for Certified Public

Accountants” promulgated by the Board of Accountancy and approved by the Philippine

Professional Regulation Commission. Ethical principles governing the auditor’s professional

responsibilities are:

• Independence.

• Integrity.

• Objectivity.

• Professional competence and due care.

• Confidentiality.

• Professional behavior.

• Technical standards.
The auditor should conduct an audit in accordance with Philippine Standards on Auditing

(PSA). These contain basic principles and essential procedures together with related guidance

in the form of explanatory and other material.

The auditor should plan and perform the audit with an attitude of professional skepticism

recognizing that circumstances may exist which cause the financial statements to be materially

misstated. For example, the auditor would ordinarily expect to find evidence to support

management representations and not assume they are necessarily correct.

SCOPE OF A FINANCIAL STATEMENT AUDIT

The term “scope of an audit” refers to the audit procedures deemed necessary in the

circumstances to achieve the objective of the audit. The procedures required to conduct an audit

in accordance with Philippine Standards on Auditing should be determined by the auditor having

regard to the requirements of Philippine Standards on Auditing, relevant professional bodies,

legislation, regulations and, where appropriate, the terms of the audit engagement and reporting

requirements.

DEMAND FOR FINANCIAL STATEMENT AUDIT

Users of financial statements look to the independent auditor’s report for assurance about

reliability of information and its conformance to the applicable financial reporting framework (e.g.,

Philippine Financial Reporting Standards). The need for independent audits of financial

statements can further be attributed to four conditions as follows: (1) complexity of transactions,

(2) remoteness of information, (3) biases and motives of the provider, and (4) consequence.

1. Complexity of Transactions – Both the transactions between organizations and the

process of preparing financial statements have become numerous and increasingly complex

and therefore more difficult to record properly. As the level of complexity increases, the risk
of misinterpretations and of intentional or unintentional misstatements also increases.

Finding it impossible to evaluate the quality of the financial statements themselves, users

rely on the independent auditors to assess the reliability of the information contained in the

statements.

The volume and complexity of economic activities in business and related authoritative

pronouncements often require the assistance and objective evaluation of professional

accountants to properly record the transactions related to those economic activities.

2. Remoteness of Information – In today’s global economy, it is virtually impossible users of

financial information to have much firsthand knowledge about the organization with which

they do business. Distance, time, cost, as well as lack of expertise, make it impractical for

decision makers to seek direct access to the underlying accounting records to perform their

own verifications of the financial statement. Rather than accept the quality of the financial

data provided by others, users rely on the independent auditor’s report to meet their needs.

The separation between the transactions details (e.g., supporting documents of the journal

entries) that produce financial statements and the users who need to make decisions based

on those financial statements creates a demand for an independent party to examine the

information for multiple users.

3. Biases and Motives of the Provider – If the information is provided by someone whose

goals are inconsistent with those of the user of the financial statements, the information may

be biased in favor of the provider. Many users of financial statements are concerned about

conflict of interest between themselves and the management of the reporting entity. The

apprehension extends to a fear that the financial statements prepared by management may

be significantly biased in favor of the management and do not represent the actual results of

operations of the reporting entity. Users seek assurance from independent auditors that

financial statements are free of management biases.

Biases and potential conflicts of interests of persons who provide information about the
economic activities create a demand for an independent party to lend credibility to the

provider’s information.

4. Consequences – Financial statements represent an important and, in some cases, the

only source of information used in making significant business decisions. Thus, users want

the financial statement to contain as much relevant and reliable information as possible. This need is
recognized by the extensive disclosure requirements imposed by the Securities and

Exchange Commission and other regulatory agencies such as Insurance Commission and

Bangko Sentral ng Pilipinas. It is also recognized by the relevance of the financial statements

disclosures to many lenders. Financial statement users look to the independent auditor for

assurance that the financial statements have been prepared in conformity with the applicable

financial reporting framework, including all the appropriate disclosures.

These four conditions collectively contribute to information risk, which is the risk that the

information used to assess business risk is not accurate or misleading. Information risk includes

the possibility that the financial statements may be incorrect, incomplete, or biased. Thus, it can

be said that financial statement audits enhance the credibility of financial statement by reducing

information risk.

REDUCING INFORMATION RISK

After comparing costs and benefits, managers and financial statement users may

conclude that the best way to deal with information risk is simply to have it remain reasonably

high. A small company may find it less expensive to pay higher interest costs than to increase

costs of reducing information risk. For larger businesses, it is usually practical to incur costs to

reduce information risk. Three main ways to do so are as follows: (1) user verifies information, (2)

user shares information risk with management, and (3) user are provided with audited financial

statements.
1. User Verifies Information – The user may go to business premises to examine books of

accounts and other accounting records in order to obtain information about the reliability of

the financial statements. Normally, this is impractical because of costs of doing so. In

addition, it would be economically inefficient for all users to verify the information individually.

2. User Shares Information Risk with Management – Management is responsible for

providing reliable information to users. If users rely on inaccurate financial statements and

as a result incur financial loss, they may have a basis for a lawsuit against management. A

difficulty with sharing information risk with management is that users may not be able to

collect on losses. If a company is unable to repay a loan because of bankruptcy, it is unlikely

that management will have sufficient funds to repay users.

3. User Are Provided with Audited Financial Statements – The most reasonable and common

way for users to obtain reliable information is to have it audited. Decision makers can then

use the audited information on the assumption that it is reasonably complete, accurate, and

unbiased.

THE PHILOSOPHY OF AN AUDIT AND NOTION OF ACCOUNTABILITY, STEWARDSHIP

AND AGENCY

Principals (i.e., business owners) appoint agents (i.e., managers) and delegate some

decision-making authority to them. In doing so, principals place trust in their agents to act in the

principals’ best interest. However, as a result of information asymmetries between principals and

agents and differing motives, principals may lack trust in their agents and may therefore need to

put in place mechanism, such as the audit, to reinforce this trust. The philosophical theories that

explain the demand for auditing and support the performance of an independent audit are as

follows: (a) stewardship or agency theory, (2) motivational theory, (3) information theory.

1. Stewardship or Agency Theory – Stewardship or agency theory implies that the

manager (as well as the owners or investors) wants the credibility an audit adds to
the financial statement assertions. The manager is the agent or steward of the owners

or investors, but each party acts in his or her own self-interest and the goals or

objectives of each party are different. This situation inevitably creates conflict

between the owner and manager. The owner perceives that the manager’s goals or

objectives may be detrimental to the owner’s own goals. Thus, the manager wants

financial statement representations audited by an independent party to enhance his

or her stewardship of these financial statements and to lessen the owner’s mistrust

of the manager.

2. Motivational Theory – Preparers of financial statements know that their assertions

will be subjected to an audit; thus, financial statements will be brought more in line

with accounting standards. The motivational benefits of an audit are difficult to prove

conclusively, but some believe that management’s knowledge that an audit will be

performed mitigates against improper financial statement preparation.

3. Information Theory – An assurance service is a means of improving the quality of

information. For example, investors require information to make an assessment of

expected returns and risks associated with their investment. An assurance service is

also valued as a means of improving financial and non-financial data for internal

decision making, detecting errors and motivating employees to exercise more care in

preparing records.

The information theory also states that investors benefit through the increased

confidence of external users of the information. For example, for private companies

seeking funds from lending institutions, the costs incurred in audit fees were more

than recompensed by the increased savings associated with lower interest rates

when compared with the interest rates charged to similar companies that weren’t

audited.
ECONOMIC BENEFITS OF A FINANCIAL STATEMENT AUDIT

Among the economic benefits of financial statement audits are the following: (1) access

to capital markets, (2) lower cost of capital, (3) deterrent to inefficiency and fraud, and (4) control

and operational improvements.

1. Access to Capital Markets – public companies must satisfy statutory audit

requirements under the securities acts in order to register securities and have them

traded on securities markets. In addition, stock markets may impose their own

requirements for listing securities. Without audits, companies would be denied access

to these capital markets and many private companies would be denied access to

loans.

2. Lower Cost of Capital – companies often engage auditor to have their financial

statement audited in order to obtain bank loans with more favorable terms. Because

of the reduced information risk associated with audited financial statements, creditors

may offer loans with lower interest rates.

3. Deterrent to Inefficiency and Fraud – research has demonstrated that when

employees know that an independent audit is to be made, they take care to make

fewer errors in performing accounting functions and are less likely to misappropriate

company assets. Thus, the data in company records will be more reliable, and losses

from embezzlements and the like will be reduced. In addition, the fact that financial

statement assertions are to be verified reduces the likelihood that management will

engage in fraudulent financial reporting.

4. Control and Operational Improvements – the independent auditor often makes

suggestions to improve internal control, to evaluate management’s assessments of

business risks, to recommend improved performance measures and to make

recommendations to achieve greater operational efficiencies within the client’s

organization.

LIMITATIONS OF A FINANCIAL STATEMENT AUDIT

A financial statement audit is subject to a number of inherent limitations. One constraint is

that the auditor works within fairly restrictive economic limits. Following are two important

economic limitations.

1. Reasonable Cost – A limitation on the cost of an audit results in selective testing,

or sampling, of the accounting records and supporting data. In addition, the auditor

may choose to test internal controls and may obtain assurance from a well-functioning

system of internal controls.

2. Reasonable Length of Time – time constraint may affect the amount of evidence

that can be obtained concerning events and transactions after the balance sheet date

that may have an effect on the financial statements. Moreover, there is a relatively

short time period available for resolving uncertainties existing at the statement date.

Another significant limitation is the established accounting framework for preparing

financial statements. Following are two important limitations associated with the

established accounting framework.

3. Alternative Accounting Principles – Alternative accounting principles are permitted

under GAAP. Financial statement users must be knowledgeable about a company’s

accounting choices and their effect on financial statements.

4. Accounting Estimates – Estimates are an inherent part of the accounting process,

and no one, including auditors, can foresee the outcome of uncertainties. Estimates

range from the allowance for doubtful accounts and an inventory obsolescence

reserve to impairment tests for fixed assets and goodwill. An audit cannot add
exactness and certainty to financial statements even if these factors do not exist.

TYPES OF AUDITORS

Individuals who are engaged to audit economic actions and events can be classified into

three groups as follows: (1) external or independent auditors, (2) internal auditors, and (3)

government auditors.

1. External or independent auditors – are certified public accountants (CPA) who

have their own independent accounting practices that provide independent auditing

services of client financial statements. Independent auditors mostly perform financial

statement audits, but they may also perform compliance and operational audits. They

are also referred to as external auditors.

2. Internal auditors – are employees of the entities they audit and are primarily

concerned in determining whether organizational policies and procedures have been

followed in safeguarding the entity’s assets. They are involved in an independent

appraisal activity called internal auditing, which is designed to assist the management

of the organization in the effective discharge of its responsibilities. Internal auditors

generally perform compliance and operational audits.

The internal auditing staff often reports to the president and also to the audit

committee of the board of directors. This is to ensure that the internal auditors will

have ready access to all units of the organization, and their recommendations will be

given prompt attention by department heads. It is also necessary that the internal

auditors be independent of the department heads and other line executives whose

work they review.

3. Government auditors – are engaged to provide assurance that all local and
national governmental agencies, including government owned and controlled

corporations, have complied with laws, rules, regulations, policies, and procedures.

Government auditors generally conduct comprehensive audits which combine

elements of financial, compliance and operational auditing.

Government auditors perform audits to determine that spending programs follow the intent

of Congress and operational audits to evaluate the effectiveness and efficiency of selected

government programs Government auditors also conduct examinations of government owned

and controlled corporations’ financial statements.

TYPES OF AUDITS

Audits are generally classified into different types of activities as follows: (1) financial or

independent audits, (2) compliance audits, and (3) operational audits.

1. Financial or independent audits – is an audit of the financial statements of an entity.

It involves obtaining and evaluating evidence about an entity’s presentation of its

financial position, results of operations, and cash flows for the purpose of expressing

an opinion as to whether they are presented fairly in accordance with a specified

financial reporting framework or criteria most often the Philippine Financial Reporting

Standards (PFRS).

2. Compliance audits – involves obtaining and evaluating evidence to determine

whether certain financial or operating activities of an entity conform to established

policies and procedures, conditions, laws, rules, or regulations set by some higher

authority that may have a material effect on the financial statements.

For example, auditors may perform an audit to provide assurance that the client is in

compliance with loan covenants established by the client’s lender (e.g., banks and

other financial institutions) in financing agreements such as whether the client

maintained or exceeded the specified minimum debt to equity ratio level.

3. Operational audits – is a study of a specific unit of an organization for the purpose

of measuring its performance. It involves obtaining and evaluating evidence about the

efficiency, economy and effectiveness of an entity’s operating activities, policies and

procedures in relation to specified objectives. At the completion of an operational

audit, management normally expects recommendations for improving operations.

This type of audit is sometimes referred to as a performance audit or a management

audit.

For example, auditors may perform an audit of a client’s employee cash advance

liquidation policy to determine that approved business expenses are liquidated by the employees

(effectiveness), the expenses incurred are ordinary and reasonable, and the process of liquidating

the expenses is fair and timely (efficient).