CHAPTER THREE

AUDIT PRINCIPLES, PRACTICES AND TOOLS

3.1. Audit Objectives

A. Objective of Conducting and audit of Financial Statements
SAS 1 states that ‘the objective of the ordinary financial statements by independent
auditor is the expression of opinion on the fairness with which they present fairly, in all
material respects, financial position, result of operations, and its cash flows in
conformity with the generally accepted accounting principles.’ The only reason auditors
accumulate evidence is to enable them to reach conclusion about whether financial
statements are fairly stated in material respect, and to issue an appropriate audit report.

To achieve these objectives, both the management and the auditor have their respective
responsibility.
Management’s Responsibility
The responsibilities of the management of the client are:
Adopting sound accounting policies
Maintaining adequate internal control, and
Making representations in the financial statements

Although management has the responsibility for the preparation of the financial
statements and the accompanying footnotes, it is acceptable for an auditor to prepare a
draft for the client or to offer suggestions for clarification. If the management insists on
financial statement disclosure that an auditor find unacceptable, the auditor can issue an
adverse or qualified opinion or withdraw from the engagement.
Auditor’s Responsibility
The auditor has the responsibility to plan and perform the audit to obtain reasonable
assurance1 about whether the financial statements are free of material misstatements 2,
whether caused by error3 or fraud4. Generally, the auditor is responsible to:
Plan and perform the audit
Detect material error
Detect material fraud
Assess risk of fraud, and
Discover illegal acts – illegal act refers to a violation of laws or government
regulations.

1
The concept of reasonable assurance indicates that the auditor is not an insurer or guarantor of the
correctness of the financial statements. It refers to less than certainty or absolute assurance.
2
Misstatements are usually considered material if the combined uncorrected errors and fraud in the
financial statements would likely have changed or influenced the decisions of a reasonable person using the
statements.
3
An error is unintentional misstatements of the financial statements.
4
Fraud is an intentional misstatement of financial statements.
 B.Financial Statement Cycles
Audits are performed by dividing the financial statements into smaller segments or
components. This method makes the audit more manageable and aid in the assignment of
tasks to different members of the audit team.
There are different ways of segmenting an audit. A more common way to divide or
segment an audit is to keep closely related types (classes of transactions and account
balances in the same segment. This is called the cycle approach.
The cycles5 are:
 Sales and Collection(Revenue) cycle
 Acquisition and Payment(Expenditure) cycle
 Payroll and Personnel(Human Resource) Cycle
 Inventory and Warehousing(Production Cycle)
 Capital acquisition and Repayment (Financial) cycle, and
 General Ledger and Reporting Cycle.
Although care should be taken to interrelate different cycles at different times, the auditor
must treat the cycles somewhat independently in order to manage complex audits
effectively.
C.Management Assertions
Assertions are implied or expressed representations by management about classes of
transactions and the related accounts in the financial statements. Management assertions
are directly related to generally accepted accounting principles. These assertions are part
of the criteria that management uses to record and disclose accounting information in the
financial statements.
SAS 31 classifies management assertions into five broad categories:
1. Existence or Occurrence
2. Completeness
3. Valuation or allocation
4. Rights and obligations
5. Presentation and disclosure
A. Assertions about Existence or Occurrence: deal with whether assets,
obligations, and equities included in the balance sheet actually existed on the
balance sheet date. Assertions about occurrence concern whether recorded
transactions included in the financial statements actually occurred during the
accounting period. For example, management asserts that merchandise inventory
included in the balance sheet exists and available for sale at balance sheet date.
B. Assertions about Completeness: state that all transactions and accounts that
should be presented in the financial statements are included. For example,
management asserts that all sales of goods and services are recorded and included
in the financial statements.
The completeness assertions deal with matters opposite from those of existence or
occurrence assertion. The completeness assertion is concerned with the possibility
of omitting items from the financial statements that should have been included,
whereas the existence or occurrence assertion is concerned with inclusion of
amounts that should have not been included.
5
The audit of each cycle will be discussed in detail in Audit-II
 Thus, recording a sale that did not take place would be a violation of the
occurrence assertion, whereas the failure to record a sale that did occur would be
a violation of the completeness assertion.
C. Assertions about Valuation or Allocation: deal with whether asset, liability,
equity, revenue, and expense accounts have been included in the financial
statements at appropriate amount. For example, management asserts that property
is recorded at historical cost and that such cost is systematically allocated to
appropriate accounting periods through depreciation.
D. Assertions about Right and Obligation: deal with whether assets are the right of
the entity and liabilities are the obligation of the entity at a given date. For
example, management asserts that assets are owned by the company or that
amounts capitalized for leases in the balance sheet represent the cost of the
entity’s rights to leased property and that the corresponding lease liability
represents an obligation of the entity.
E. Assertions about Presentation and Disclosure: deal with whether components
of the financial statements are properly combined or separated, described, and
disclosed. For example, management asserts that obligations classified as long-
term liabilities in the balance sheet will not mature within one year.

General Transaction-Related Audit Objectives: they are intended to provide a

framework to help the auditor accumulate sufficient competent evidence required by the
third standard of field work of GAASs and decide the proper evidence to accumulate for
classes of transactions given the circumstances of the engagement. The objectives remain
the same from audit to audit, but the evidence varies depending upon the circumstances
There is a distinction between general transaction-related audit objectives and specific
transaction-related audit objectives for each class of transactions. The general
transaction-related audit objectives are applicable to every class of transactions but are
stated in broad terms. Specific transaction-related audit objectives are also applied to
each class of transactions but are stated in terms tailored to a class of transactions such as
sales transactions.
The six general transaction-related audit objectives are:
1. Existence – Recorded Transactions Exist: this objective deals with whether
recorded transactions have actually occurred. Inclusion of the sales in the sales
journal when no sales occurred violates this objective.
2. Completeness – Existing Transactions are recorded: this objective deals with
whether all transactions that should be included in the journals have actually been
included. Failure to include a sale in the sales journal and general ledger when a
sale occurred violates this objective.
The existence and completeness objectives emphasize on opposite audit concerns;
existence deals with potential overstatement and completeness with understatement.
3. Accuracy – Recorded Transactions are stated at the correct amount: this
objective deals with the accuracy of information for accounting transactions. For
example, for sales transactions, there would be a violation of accuracy objective if
the quantity of shipped was different from the quantity billed; the wrong selling
price was used for billing; errors occurred in billing or the wrong amount was
 included in the sales journal. Accuracy is one part of the valuation or allocation
assertions.
4. Classification – Transactions Included in the Client’s Journal are properly
Classified. Classification is also part of the valuation or allocation assertions.
5. Timing - Transactions are recorded on the Correct Dates: a timing error
occurs if transactions are not recorded on the dates transactions took place.
Timing is also part of the valuation or allocation assertions.
6. Posting and Summarization – Recorded Transactions are included in the
master files are Correctly Summarized: this objective deals with the accuracy
of the transfer of information from the journal to subsidiary ledger and general
ledger. Posting and summarization is also the part of the valuation or allocation
assertions.
Balance– Related Audit Objectives
Balance – Related audit objectives are similar to transaction – related audit objective in
that: 1) Both follow from management assertions and 2) they provide a frame work to
help the auditor accumulate sufficient competent evidence.
However, there are differences between the balance – related and transactions – related
audit objectives: 1) balance – related audit objectives are applied to account balances,
whereas transactions – related audit objectives are applied to classes of transaction, 2)
there are more audit objectives for account balances than for classes of transactions.
There are nine balance – related audit objectives
General Balance – Related Audit Objectives
1. Existence – amounts included Exist: this objective deals with whether the
amounts included in the financial statements actually be included.
2. Completeness – Existing amounts are included: this objective deals with
whether all amounts that should be included have actually been included.
3. Accuracy - Amounts included are stated at Correct Amount: this objective
refers to amounts being included at correct arithmetic amount. Accuracy is one
part of the valuation or allocation assertions.
4. Classification – Amounts included in the Client’s Listing are properly
classified: Classification involves determining whether items on clients listing are
included in the correct accounts. Classification is also a part of the valuation or
allocation assertions.
5. Cutoff – Transactions near the Balance sheet date are recorded in the proper
period: in testing for cut-off, the objective is to determine whether transactions
are recorded in the proper period. The transactions that most likely to be misstated
are those recorded near the end of the accounting period. Cutoff is also the part of
the valuation or allocation assertions.
6. Detail Tie-in – Details in the account balance agree with related Master File
amounts, Foot to the total in the account balance, and Agree with the total in
the General Ledger: this objective is concerned that the details on lists are
accurately prepared, correctly added, and agree with the general ledger.
7. Realizable Value – assets are included at the amounts estimated to be
realized: this objective concerns whether account balance has reduced for
declines from historical cost to net realizable value.
 8. Rights and Obligations: In addition to existing, most assets must be owned before
it is acceptable to include them in the financial statements. Similarly, liabilities
must belong to the entity. This objective is the auditor’s counterpart to the
management assertion of right and obligation.
9. Presentation and Disclosure – accounts balance and related disclosure
requirements are properly presented in the financial statements

Meeting Audit Objectives

The auditor plans appropriate combination of audit objectives and the evidence that must
be accumulated to meet them by following an audit process. An audit process is a well-
defined methodology for organizing an audit to ensure that the evidence gathered is both
sufficient and competent, and that all audit objectives are both specified and met. There
are four phases in audit process. These are:
Phase-I: Plan and Design an audit approach
Phase-II: Perform tests of controls and substantive tests of transactions
Phase-III: Perform analytical procedures tests and tests of details of balances
Phase-IV: Complete the audit and issue an Audit report

I. Plan and Design an audit approach (Phase 1)

For any given there are many ways in which an auditor can accumulate evidence to meet
the overall audit objective. Two overriding considerations affect the approach the auditor
selects: (1) sufficient competent evidence must be accumulated to meet the auditor’s
professional responsibility, and (2) the cost of accumulating evidence should be
minimized. Planning and designing an audit approach can be carried out by:
 Obtaining knowledge of the client’s Business
 Understanding internal control and assessing Control risk
II. Perform tests of controls and substantive tests of transactions (Phase 2)
Tests of controls refer to procedures involved to test the effectiveness the internal
controls. Substantive tests of transactions refer to the procedures involved to evaluate the
client’s recording of transactions by verifying the dollar amounts of transactions.
Frequently, auditors perform tests of controls and substantive tests of transactions at the
same time.
III. Perform analytical procedures tests and tests of details of balances (Phase 3)
There are two general categories of this phase: analytical procedures and tests of details
of balances. Analytical procedures tests are those that assess the overall reasonableness of
transactions and balances. Tests of details of balances are specific procedures intended to
test for monetary misstatements in the balances in the financial statements.
IV. Complete the audit and issue an Audit report (phase 4)
After the auditor has completed all the procedures for each audit objective and for each
financial statement account, it is necessary to combine the information obtained to reach
an overall conclusion as to whether the financial statements are fairly presented. When
the audit is completed, the CPA must issue an audit report to accompany the client’s
published financial statements.
 3.2. Audit Planning and Documentation
The first generally accepted auditing standards of fieldwork requires adequate planning to
be made before auditing is carried out.

The wok is to be adequately planned, and assistants, if any, are to be properly supervised.

3.2. Reasons for proper Audit Plan

The three main reasons why the auditor should properly plan engagements are:
 To enable the auditor to obtain sufficient competent evidence
 To help keep audit costs reasonable
 To avoid misunderstanding with the client

Obtaining sufficient competent evidence is essential if the CPA firm is to minimize

legal liability and maintain a good reputation in the business community. Keeping costs
reasonable helps the firm remains competitive and thereby retains or expands its client
base, assuming the firm has a reputation for doing high-quality work. Avoiding
misunderstanding with the client is important for good client relations and for
facilitating high-quality work at reasonable cost.
3.3. AUDIT PLANNING PROCEDURES
Parts of Audit Planning
Preplan

Obtain background
information

Obtain information about

client’s legal obligations

Perform preliminary
analytical procedures

Set materiality, and assess

acceptable audit risk &
inherent risk
Understand internal control
and assess control risk

Develop overall audit plan &

audit program
As shown on the diagram above, there is seven major parts of Audit planning. Each of the
first parts is intended to help the auditor develop the last part, an effective and efficient
overall audit plan and audit program.

To define some new terms on the parts:

Acceptable audit risk – is a measure of how willing the auditor is to accept that the
financial statements may be materially misstated after the audit is completed and an
unqualified opinion has been issued.
Types of Audit Risk
There are three types of audit risk: Inherent risk (IR), control risk (CR) and planned
detection risk (DR).
Inherent risk – is a measure of the auditor’s assessment of the likelihood that there are
material misstatements in an account balance before considering the effectiveness of
internal control.
Control risk – is a measure of the auditor’s assessment of the likelihood that
misstatement exceeding a tolerable amount in a segment will not be prevented or detected
by internal controls. Control risk represents (1) an assessment of whether client’s internal
controls are effective for preventing or detecting misstatements, and (2) the auditor’s
intention to make the assessment at the level below the maximum (100 percent) as part of
the audit plan
Planned Detection risk – is the measure of the risk that audit evidence for a segment
will fail to detect misstatements exceeding a tolerable amount, should such misstatements
exist.

I. Preplan the audit

Preplanning the audit involves four things, all of which should be done early in the audit.

 A decision whether to accept a new client or continue serving on existing one

 Identification of why the client wants or needs an audit
 Obtaining an understanding with the client about the terms of engagement to avoid
misunderstandings.
 Select staff for engagement.
Investigation of new client and reevaluation of existing ones is important to assess the
integrity of the client and to assess the acceptable financial risk it will assume. If the CPA
firm decides that acceptable risk is extremely low, it may choose not to accept the
engagement. If the CPA firm concludes that acceptable audit risk is low but the client is
still acceptable, it is likely to affect the fee proposed to the client. Audits with low
acceptable audit risk will normally result in higher audit costs, which should be reflected
in higher audit fees.

Identifying client’s reasons for audit will affect the auditor’s assessment of acceptable
audit risk. The two major factors affecting acceptable audit risk are the likely statement
users and their intended users of the statements. The auditor is likely to accumulate
more evidence when the statements are to be used extensively.
Obtain an understanding with the client is expressed by the use of engagement letter,
even though it is not required. Engagement letter is an agreement between the CPA firm
and the client for the conduct of the audit and related services. It should specify whether
the auditor will perform an audit, a review, or a compilation, plus any other services such
as tax returns or management consulting. It should also state any restrictions to be
imposed on the auditor’s work, deadlines for completing the audit, assistance to be
provided for the audit, an agreement on fees. The engagement letter is also a means of
informing the client that the auditor cannot guarantee that all acts of fraud will be
discovered.

Selection of staff for engagement involves the assignment of appropriate staff to the
engagement if the CPA firm decided to accept the client and conduct the audit. Selection
of audit staff is important to meet the first requirement of generally accepted auditing
standards and to promote audit efficiency. The first GAAS states that “The audit is be
performed by a person or persons having adequate technical training and proficiency
as an auditor”.

II. Obtain background information

An extensive understanding of the client’s business and industry and knowledge about
the company’s operations are essential for doing adequate audit.
There are three reasons for obtaining a good understanding of the client’s industry.
First, many industries have unique accounting requirements that the auditor must
understand to evaluate whether the client’s financial statements are in accordance with
GAAP.
Second, the auditor can often identify risks in that may affect the auditor’s assessment of
acceptable audit risk, or even whether auditing companies in the industry is advisable.
Finally, there are inherent risks that are typically common to all clients in certain
industries. Understanding those risks aids the auditor in identifying the client’s inherent
risk.
Knowledge of the client’s industry can be obtained in different ways. These include:
 Discussion with previous auditor
 Discussion with client’s personnel
 Tour the plant and office of the client
 Related parties. Related companies are an affiliated company, a principal owner
of the client company or those where the client influence the management or
operations of a company. Note that transactions made between the client company
and related companies be disclosed if they are material according to GAAP.
Discussion with outside specialists.

III. Obtain information about client’s legal liabilities

Early knowledge of the legal documents and records enables auditors to interpret related
evidence throughout the engagement and to make sure there is proper disclosure in the
financial statements.
Three closely related types of legal documents and records should be examined early in
the engagement:

a. The corporate charter And the bylaws

The corporate charter is granted by the state in which the company is

incorporated and is the legal document necessary for recognizing a
corporation as a separate entity. It includes the exact name of the corporation,
the date of incorporation, the kinds and amounts of capital stock the
corporation is authorized to issue and the types of business activities the
corporation is authorized to conduct. The bylaws include the rules and
procedures adopted by stockholders of the corporation. They specify such
things as the fiscal year of the corporation, the frequency of stockholder
meetings, and the method of voting for directors, and the duties and power of
the corporate officers.

b. The corporate minutes – are the official records of the meetings of the
board of directors and stockholders. They include summaries of the most
important decisions made by the directors and stockholders. The auditor
should read the minutes to obtain information that is relevant to
performing the audit including the authorizations and discussions by the
board of directors affecting inherent risk.

c. Contracts- clients involved in different types of contracts that are interest

to the auditor. These can include such diverse items as long-term notes
and bonds payable, stock options, pension plans, contracts of
manufactured products, contracts with vendors for future delivery of
supplies, government contracts and leases.

IV. Perform preliminary analytical procedure

As discussed in chapter 5, auditors are required to perform analytical procedures while

planning the audit to assist the audit in determining the nature, timing, and extent of
auditing procedures. Analytical procedures made during planning phase enhance the
auditor’s understanding of the client’s business and events occurring since the prior
year’s audit. Planning analytical procedures also help the auditor identify areas that may
represent specific risks of material misstatement warranting further attention.

3.3. Audit Working Paper

According to SAS41, working papers are the records kept by the auditor of the
procedures applied, the tests performed, information obtained, and the pertinent
conclusions reached in the engagement. Working papers should include all the
information the auditor considers necessary to conduct the audit adequately and to
provide support for the audit report.
Purposes of Working Papers
The overall objective of working paper is to aid the auditor in providing reasonable
assurance that an adequate audit was conducted in accordance with the generally
accepted auditing standards. More specifically, the working papers, as they pertain to the
current year’s audit, provide:
A basis for planning the audit
Record of the evidence accumulated and the results of the tests,
Data for determining the proper type of audit report, and
A basis for review by supervisors and partners.
Contents and Organization of working papers
Working papers contain virtually everything involved in the audit. Some of them are:
Permanent files
Audit program
General information
Internal control
Tests of controls and substantive tests of transactions
Analytical procedures
Assets,
Liabilities and equity
Operations
Legal letters/contingent liabilities
Adjusting journal entries
Working Trial Balances, and
Financial statements and Audit Report.
i.Permanent Files: are intended to contain data of a historical or continuing nature
pertinent to the current audit. The permanent files typically include the following:
Extracts or copies of such company documents of continuing importance as: the
articles of incorporation, bylaws, bond indentures, and contracts. The contracts
are pensions plan, leases, stock options, and so on.
Analyses, from previous years, of accounts that have continuing importance to the
auditor. These include accounts such as: long-term debt, stockholders’ equity
accounts, goodwill, and fixed assets.
Information related to the understanding of internal control and assessment of
control risk. This includes: organization charts, flowcharts, questionnaires, and so
forth
The results of analytical procedures from previous years’ audits. Among these data
are ratios and percentages computed by the auditor, and balanced selected by the
auditor.
ii.Current Files: include all working papers applicable to the year under audit. The
types of information included in the current files are:
 Audit program: is the detailed instruction for the entire collection of
evidence for an audit area or an entire audit. It includes: a list of audit
procedures, sample sizes, items to select, and the timing of the tests.
 General information: includes audit planning memos, abstracts or copies
of the board of directors’ meetings, abstracts of contracts or agreements
 not included in the permanent files, notes on discussions with the client
working paper review comments, general conclusions, and documentation
of the assessment of control risk.
 Working Trial Balances: is a list of the general ledger accounts and their
year-end balances.
Preparation of working papers
Working papers should possess the following characteristics:
Each working paper should be properly identified with such information as the
client’s name, the period covered, the description of the content, the initials of
preparer, the date of preparation, and index code
Working papers should be indexed and cross-referenced to aid in organizing and
filing.
Completed working papers must clearly indicate the audit work performed.
Each working paper should include sufficient information to fulfill the objectives for
it was designed.
The conclusions that were reached about the segment of the audit under
consideration should be plainly stated.

Ownership of Working Papers

The working papers prepared during the engagement, including those prepared by the
client for the auditor, are the property of the auditor. The only time anyone, including the
client, has the right to examine the working papers are when they are subpoenaed by the
court as legal evidence. At the completion of the engagement, working papers are
retained on the CPA’s premises for future reference.

Confidentiality of Working Papers

During the course of the audit, auditors obtain a considerable amount of information of a
confidential nature, including officer salaries, product pricing and advertising plans, and
product cost data. Auditors are forbidden from disclosing or divulging such information
to outsiders and/or to client employees who have been denied access.
Auditors should take due care to protect their working papers from unauthorized
alteration. Because having an access to the working papers would give employees an
opportunity to alter or change the information on the working papers.

Working papers and auditors liability

The auditors working paper are the principal record of the extent of procedures applies
and evidence gathered during the audit. If auditors are charged with negligence their
working papers will be a major factor on refuting or substantiating the charge.

Types of working papers

1. Audit Administrative working papers
Auditing is a sophisticated activity requiring planning, supervision, control and
coordination. Working papers are designed to aid auditors in the planning and
administrating engagement.
E.g. Audit plans and programs, internal control flowchart, engagement letter and time
budget.
 2. Working Trial Balance
Is a schedule listing the balances of accounts in the general ledger for the current and
previous year and providing columns for auditor’s adjustment.
3. Lead Schedules (Group Sheets or Summary Schedules)
are set up to combine similar general ledger accounts, the total of which appear on the
working trial balance.
4. Adjusting journal entries and reclassification entries.
Are suggested adjusting entries made by the auditor to correct material errors and
irregularities. Reclassification entries appear only in the auditors working paper for fair
presentation.
5. Supporting Schedules
Are listings of elements comprising the balance in an asset or liability account at specific
date.
6. Analysis of a ledger accounts
Shows on one paper all changes in an asset, liability, equity, revenue or expense account
during the audit period.
7. Reconciliations
To prove the relationship between amounts obtained from different sources.
8. Computations working papers: verify cent figures
Corroborating documents: e.g. minutes of BODs meetings