Chapter 2 — Introduction to Audit Services and Financial Statement Audit CHAPTER 2 INTRODUCTION TO AUDIT SERVICES AND FINANCIAL STATEMENT AUDIT OO Chapter Overview and Objectives: This chapter discusses the fundamental principles of audit services. At the end of this chapter, readers should be able to discuss 1, The fundamental principles of auditing services 2. The different types of audit a. As to nature of assertions b. Asto types of auditors 3, The financial statements audit The definition and key concepts The objective of FS audit The general principles of an FS audit The theoretical framework of FS audit The elements of FS audit The assurance provided by FS audit The demand for FS audit The value of FS audit FR *Paooo Relevant references: PSA 120 - Framework of Philippine Standards on Auditing PSA 200 - Overall Objectives of the Independent Auditor and the Conduct of an Audit in accordance with Philippine Standards on Auditing —_——— ee Page 37Chapter 2 - Introduction to Audit Services and Financial Statement Audit Nea ee reiattes radiohead as the flagship service rendereg b In ee sr accountants not only inthe Philippines but across the globe. This , ety to public’s perception of the auditors’ responsibility in ensurin, frarket integty. Credible and reliable reporting together with an effective audit function fortifies confidence in the entire financial system. ‘As mentioned in the previous chapter, in business, reliable information becomes ‘an essential aspect of decision-making. However, in most instances, this information is prepared and provided by other persons or organizations, Whose. interests contradict with those of the users of the information. This situation hag created the need for an objective evaluation of the information by an independent professional accountant. Such service is widely known as audit, The primary objective of an audit function is to improve the quality of or lend credibility to the information prepared by a particular entity. This objective is met through expression of an opinion that provides users with reasonable assurance that the subject matter of the audit service is free from material misstatements, Such opinion is then communicated to the users through the audit report, Attachment of the audit report to the subject matter of an audit engagement means that the information can be relied upon by the users. AUDITING Definition As defined by the American Accounting Association, an audit is 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 an id established criteria and communicating the results thereof. The following are key concepts obtained from the a. Assystematic process An audit is composed of logical, ordered and structured series of steps and procedures. In order to meet the objectives of an audit engagement, ‘one must follow a sequence of procedures, b. It involves objectively obtaining and evaluating evidence about assertions. definition of an audit: Audit evidence is the information obtained by the auditor in arriving at the conclusions on which the audit opinion is based. On the other hand, assertions are representations made by an audit client, explicit of otherwise, about economic actions and events. a Page 38 .. Believe... ClalChapter 2 — Introduction to Audit Services and Financial Statement Audit Furthermore, in obtaining and evaluating evidence about assertions, auditors shall observe the principle of objectivity. It imposes an obligation on all CPAs not to compromise their professional or business judgment because of bias, conflict of interest or the undue influence of others. c. It ascertains the degree of correspondence between assertions and established criteria In order to meet the objective of an audit engagement, an auditor must be able to express an opinion. To do that, auditor uses criteria (standard or benchmark) to verify the validity of the assertions prepared and presented by the audit client. d._ Itincludes communication of the results to interested users After obtaining sufficient appropriate evidence, the auditor prepares @ report which contains an overall opinion. Such report is then communicated to interested users. This is considered to be the most important characteristics of an audit. Failure to communicate the results will render the audit engagement useless. Types of audit ‘Audit may be classified in number of ways such as legislative controls, risks involved, subject matter, and affiliation of the auditor performing the engagement with the audit client. However, in compliance with the syllabus in ‘Auditing of the Philippine CPA Licensure Examination, we will be limiting the discussion to types of audit as to (1) nature of assertion or data and (2) types of auditor. objectives, 1. Nature of assertion or data a. Financial statement (FS) audit > a type of audit pertaining to the gathering of evidence on the assertions embodied in the financial statements of an entity to determine whether the financial statements are fairly presented in accordance with generally accepted accounting principles or another comprehensive and authoritative financial reporting framework > the results of this type of audit is for the use of external users b. Operational audit > a type of audit involving a systematic review of the organization's activities in relation to specified objectives for the purpose of assessing the performance, identifying opportunities for improvement, and developing recommendations for improvement or further action > also known as management audit or performance audit Aim... Believe... Claim.. Page 39Ny Chapter 2 — Introduction to Audit Services and Financial Statement 4, ¢. Compliance audit uci > type of audit involving the review of organizations pro, determine whether the organization has adhered 4." | Procedures and rules set down by some higher authority. "ty 2. Types of auditor a, External audit > a type of audit engagement performed by independent or CPAs on a contractual basis (rendered by CPAs engaged practice) Pubji > it emphasizes that the auditor must not be a member of being audited > can provide financial statements, operational and compliance aug © to private entities is the en b. Internal audit > an independent appraisal function established with an organiza to examine and evaluate its activities as a service to Organizations > its primary objective is to assist all members of the Organization in the effective discharge of their responsibilities > can perform operational and compliance: audits. (for internal use) but not financial statements audit because of independence requirements To establish the independence of internal auditors, they are requiredto be independent of the different operating units to be audited. in addition, to emphasize their independence, they shall report to theaucit committee, any equivalent supervisory board, or board of directors, Below is a sample organizational chart considered as one of the best practices adopted by different entities to emphasize the independence of internal auditors. Operating Departments Aim... Believe... Claim. Page 40Chapter 2 — Introduction to Audit Services and Financial Statement Audit c. Government audit > the primary objective of this type of audit is to determine whether government funds are being handled properly and in compliance with existing laws and whether programs are being conducted efficiently and effectively > can provide financial statements, operational and compliance audits to public. entities including government owned and controlled corporations (GOCCs) Comparison of the different types of audit Financial Statements Audit | 2Perational Audit | Compliance Audit Assertions | Financial Operations are __| Activities complied statements are conducted with applicable fairly presented efficiently and laws, rules, effectively regulations, contracts or management policy Suitable GAAP or any other | Objective set by _] Applicable Criteria identified financial | the management | contracts, rules, reporting regulations, laws framework or management policy Report ‘An opinion whether | Report on Degree of the financial efficiency and compliance with statements are effectiveness. applicable laws, fairly presented in | This will also rules, regulations, conformity with an | include or management identified financial | recommendations | policy. reporting to improve framework Operations. Generally —xternal auditors Internal auditors Government performed auditors by IMPORTANT NOTES: 1. Both financial statements and compliance audits use established criteria, whereas, internal audit uses specifically developed criteria. 2. Both financial statements and compliance audits generally cater external users, whereas, internal audit assists the members of the organization in the effective discharge of their responsibilities. — Page 41Chapter 2 — Introduction to Audit Services and Financial Statement Audit 3, Internal auditors are generally part of the organization, thus, creating a, employer-employee relationship. With this, they do not render financia) statements audit. FINANCIAL STATEMENTS AUDIT Financial statements audit remains to be the most common type of audit rendered by CPAs. It involves the examination of the financial statements of a particular entity to determine whether or not they are presented in accordance with a specified criterion. Financial statements are ordinarily prepared and presented annually and are directed toward the common information needs of a wide range of users. Many of those users rely on the financial statements as their major source of information because they do not have the power to obtain additional information to meet their specific information needs. Thus, financial statements need to be prepared in accordance with one, or a combination of: a. Accounting standards generally accepted in the Philippines (Philippine Financial Reporting Standards — PFRSs); b. Internationally accepted accounting standards (International Financial Reporting Standards — IFRSs); and c. Another authoritative and comprehensive financial reporting framework which has been designed for use in financial reporting and is identified in the financial statements. — GABP Objective of financial statement audit PSA 120 dictates that 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 generally accepted accounting principles or other identified financial reporting framework. PSA 200 (Revised and Redrafted) further supported the above objective by stating that “in conducting an audit of financial statements, the overall objectives of the auditor are: a. 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 b. To report on the financial statements, and communicate as required by the PSAs, in accordance with the auditor's findings. Aim... Believe... Claim... Page 42Chapter 2 - Introduction to Audit Services and Financial Statement Audit From these statements, the following key phrases were emphasized: > Expression of an opinion. The ultimate objective of a financial statements audit is for the auditor to express an opinion regarding the fairness of preparation and presentation of the financial statements. In forming the audit opinion, the auditor obtains sufficient appropriate audit evidence to be able to draw conclusions on which to base that opinion. xpressed by the > Financial statements are taken as a whole. The opinion e n s prepared and auditor applies to the complete set of financial statement: presented by the entity. Reasonable assurance. Though the auditor’s opinion enhances the credibility of the financial statements, user cannot assume that the opinion is a guarantee or an assurance that the presented information is free from any misstatements. > In all material respects. In rendering financial statement audit, auditor is requiréd to adhere to the requirements of Philippine Standards on Auditing. This set of standards applies only to material matters. Presence of criteria. The financial statements shall be prepared in accordance with an applicable financial reporting framework. > Communication of the results. Again, the ultimate objective of an audit engagement is the communication of the results to various interested users. General Principles of an FS Audit ‘Whenever FS audit are conducted, the following principles must be observed 1. The auditor should comply with relevant ethical requirements (Code of Ethics). The auditor should conduct an audit in accordance with Philippine Standards ‘on Auditing. The auditor should plan and perform the audit with an attitude of Professional skepticism. 4, All throughout the audit engagement, the auditor should exercise Professional Judgment. 5. The auditor should obtain Sufficient Appropriate audit Evidence. Aim... Believe... Claim... Page 43Chapter 2 — Introduction to Audit Services and Financial Statement Audit Theoretical Framework of FS Audit Efforts had been made to formally create a conceptual structure for auditing financial statements. The conceptual structure would include conditions that should exist whenever FS Audit is conducted to have a favorable result. The following are some of the assumptions, postulates or concepts included jn, this conceptual structure (VIC BPI): 1, All financial data are Verifiable through existence of supporting documents andrecords SSS An audit involves the obtaining and evaluating evidence about assertions, which should be capable of being verified. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. 2. Auditor should always maintain Independence with respect to the financial statements under audit The value and credibility of the auditor’s report lies in the auditors independence. If the auditor is not independent from both of the client and users, the report is of little or no value. 3. No long-term Conflict between the auditor and the client’s management Management may be motivated to present financial information in a manner favorable to them even if it would mean violation of the criterion used. This scenario may create disagreements or conflicts between the auditor and client’s management since auditors are expected to attest to data that is fairly presented. Such conflicts may exist temporarily or on a short-term basis but should be resolved prior to the completion of the audit. The auditor shall be satisfied on the resolution of the said conflicts; otherwise, it could lead to the modification of auditor's report. 4. Audit Benefits the Public Financial statement audit shall have the objective of increasing the quality of the information or lending credibility to the items presented in the financial statements which will assist its different users in making economic decisions. This can be done by providing assurance that the financial statements audited are free from material misstatements. 5. Effective intro! educes the possibility of errors and fraud Information presented on the financial statements is more reliable when the internal controls designed and implemented by the entity are effective.Chapter 2 ~ Introduction to Audi i jnvtewofalenone ee Ade Services and Financial Statement Audit aricsic 7 ay a : ae {St @ Composition of a much wider assurance services. The 5 2.25 discussed in chapter 1, apply to that of the former, To recall, the following are the ; v elements of an a: i aa applied inan audit of financial steternect ” BEsurance Service and how iti Management and Those Charged with Governance ‘Audit Report a Other Reporting Responsibilties Assertions TFRS/GAAP/ / Materiality Others ‘Audit Risk in FSs Gultable Cost-Benefit Constraint Criteria) Evidence Professional Skepticism A. Athree-party relationship The table below summarizes the parties, with their respective responsibilities, involved in a financial statement audit. Parties Responsibilities Auditor (represents the | “formation and expression of an practitioner) opinion on the financial statements Y compliance with ethical requirements (e.g. independence and competence) Y determining the scope of audit in accordance with PSAs and other applicable regulations of professional bodies Management and those | v preparation and presentation of the charged with governance financial statements in accordance (represents the responsible with the applicable _ financial party) reporting framework Y prevention and detection of fraud and error Yadoption and implementation of adequate accounting and internal control systems Users of FS (represent the | Y use the audit report which contains intended users) the opinion expressed by the auditor a Aim... Believe... Claim... Page 45Chapter 2 Introduction to Audit Services and Financial Statement aug IMPORTANT NOTES: 1. The audit-of financial statements does not. reli and/or those charged with gove a of their res Nsibil ie 2. “The auditor is not, and cannot, be held responsibletor fa. error. However, because of the expertise of the auditor mt procedures he/she performs, an audit may be carried out th ‘Which, act as a deterrent. my B. An appropriate subject matter In financial statement audit, the assertions embodied in ¢ statements represent the subject matter of the engagement. et financial statements to be an appropriate subject matter of an wt engagement, adequate supporting records and documents shoud available. This concept is popularly known as “auaitabiity”, be Suitable criteria Criteria used in audit of financial statements generally include the PERS/IFRS, GAAP and other applicable financial reporting framework he finan: ¢. D. Sufficient appropriate evidence Concepts discussed in assurance engagements apply to audit engagements. Terms are revised to specifically relate to audit engagements (e.g. assurance engagement risk is changed to audit tisk) E. Awritten assurance report or conclusion. The auditor provides a written report called “audit report” which contains the conclusion or opinion conveying the assurance obtained about the financial statements. In addition, the auditor considers other Feporting responsibilities, including communicating with those charged with governance. The opinion to be expressed by the auditor depending on the evidence obtained may include either of the following: Type Common phrase used Unmodified or | ¥’Presents fairly, in all material respect unqualified Qualified ¥ Except for Adverse ¥ Do not present fairly, in all material respect Disclaimer of | ¥We do not express a conclusion opinion Aim... Believe... Claim... PageChapter 2 — Introduction to Audit Services and Financial Statement Audit To warrant the issuance of ifi tor st an unmodi it it al ‘ ified opinion, the auditor shall a. Material limitation on the Disclaimer of Opinion). Ther the auditor is unable to gat b. Material disagreement wit! of the accounting policies s the adequacy of financial st Opinion). ‘Scope of the auditor’s work (Qualified or eis a limitation on the scope of audit when ther sufficient appropriate evidence. th management regarding the acceptability elected, the method of their application or tatement disclosures (Qualified or Adverse The table below illustrates how the auditor's judgment about the nature of the matter giving rise to the modification, and the pervasiveness of its effects or possible effects on the financial statements, affects the type of opinion to be expressed, Nature of Matter Auditor’s Judgment about the Giving Rise to the Pervasiveness of the Effects or Possible Modification Effects on the Financial Statements Material but Not Material and Pervasive Pervasive Financial statements | Qualified opinion | Adverse opinion are materially misstated Inability to obtain Qualified opinion Disclaimer of sufficient appropriate opinion audit evidence Refer to Chapters 12 and 13 for a more detailed discussion of audit reporting. Assurance provided by the auditor In audit, assurance refers to the auditor's satisfaction as to the reliability of the financial statements prepared and presented by a particular entity to address the common needs of wide range of users. To provide such assurance, the auditor assesses the evidence collected as a result of procedures conducted and expresses an opinion. The auditor's opinion is intended to enhance the credibility of financial statements by providing a high, but not absolute, level of assurance. Reasonable assurance and the inherent limitations of an audit ‘An auditor conducting an audit in accordance with PSAs obtains reasonable assurance that the financial statements, taken as a whole, are free from material misstatement, whether due to fraud or error. Aim... Believe... Claim... Page 47Chapter 2 - Introduction to Audit Services and Financial Statement Audit An auditor cannot obtain absolute assurance because of the following inher limitations of an audit that affect the auditor's ability to detect mater: misstatements. These limitations result from factors-such as the following. ia 1. Use of selective testing (exposure to sampling risk) Auditing standards do not require auditors to examine all availaby, information supporting a particular assertion for practical reasons (time an, cost constraints), as long as the auditor has sufficient appropriate eVidency that can serve as a basis in expressing his/her opinion. 2. Inherent limitations of internal control (exposure to control risk) Effectiveness of internal control influences the conduct of an audit, However such controls cannot fully guarantee the validity and accuracy of items generated from it because of some inherent limitations (e.g. cost-benefj consideration, management overriding the controls, circumvention through collusion among employees, and human errors). 3. Fact that most of audit evidence is persuasive rather than conclusive While performing evidence-gathering procedures, auditors are exposeq to persuasive (items that leaves some doubts) rather than conclusive (very convincing) evidence. 4. Work undertaken by the auditor to form opinion is permeated by judgment (exposure to non-sampling risk) Through the course of the audit, the auditor exercises his/her judgment. Itis inherent that whenever he/she exercises judgment, there is a great possibility that he/she might be commit mistakes due to carelessness, fatigue, misinterpretation of facts, and other human weaknesses. 5. Nature/characteristics of assertions (exposure to inherent risk) In some instances, it may be necessary to rely heavily on representation made by entity's management. If the management lacks integrity, they may provide materially misleading information causing the auditor to rely to unreliable information. Due to the above limitations, all financial statement audit engagements are exposed to risk termed as audit risk (for assurance engagement, this is termed as assurance engagement risk), which is the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated.Chapter 2 — Introduction to Au THE DEMAND FOR FS AUDIT Investors, creditors, and other Users of financial information demand high- quality, relevant, and reliable informati Nn. Such information will enable them to come up with educated financial decisions that will assist them in managing business and information risks, idit Services and Financial Statement Audit Business risk Countless number of decisions is made each and every day by businesses in order to appropriately manage business tisk, which is any event or activity that will prevent the entity in ‘Meeting its business objectives such as wealth and profit maximization. If an entity is exposed to a very significant business risk, such risk may ultimately lead the entity to fail. This is the primary reason why decisions to be made must be carefully evaluated and should be founded on suitable basis. Information risk A further complication in decision making is the presence of information risk or the risk that the information Prepared and presented by the entity contains misstatement... Information risk is the mathematical complement of reliability level. This means that as information risk increases (from 5% to 10%), reliability level decreases (from 95% to 90%). The following are some of the factors contributing to information risk. > -Voluminous data. As the number of transactions entered into by the entity Brows, the risk that errors might occur during processing also increases, > Complexity of transactions, The more complicated the transactions entered into by the entity, the greater the possibility that transactions will not be recorded properly. > Remoteness of information. Decision makers normally rely on information Prepared by another party. They do not have direct access to records and documents which can assist them in verifying the validity of the information presented, > Conflicts of interest between the provider and users of information. Users of financial statements rely heavily on the quality of information prepared by the management, who is in the position to present their business appear to be better than it actually may be. Because of information risk, users had been more skeptical with the information Presented by management. They even find ways on how to reduce the said risk. To reduce information risk, users do the following: > Information is verified. Under this approach, users directly verify the validity of the information by examining supporting records and documents held by the entity. However, major problems are commonly encountered by users relying from this approach. These are Page 49Chapter 2 — Introduction to Audit Services and Financial Statement Audit a. users are separated from entity's records by distan, 7 b. users do not possess the necessary skill and co; appropriately verify the information; and ¢. most often than not, users cannot directly acc q RSS C records (see remoteness above). ompany' 1 And time mpetence t, > Financial statements are audited. The users rely on the evaluation by an independent auditor. This approach addresses the ret encountered by users in “verify the information” approach pti auditor f a. monitors the financial information reported by Management and would include direct examination of records and documents; and b. is equipped with skills and competence in objectively obtaining and evaluating evidence. > Information risk is shared with the management. This approach dictates that in the event users fail or incur a loss because of incorrect decisions based on inaccurate data, users may seek reimbursements (fully or partially) from the entity. Additional conditions creating the need for FS Audit Below isa list of circumstances which contribute to the need for FS Audit (CERF). > Conflict of interest between the responsible party and the intended users of the financial statements > Expertise. Complexity of accounting and auditing requires expertise > Remoteness of users. Users of information frequently are prevented from directly assessing the quality of information > Financial consequence. Misleading financial information could have substantial economic consequences for a decision maker. Alm... Believe... Claim... Page 50Chapter 2 - Introduction to Audit Beare . REGULATORS’ REQUIREMENTS lit Services and Financial Statement Audit naddition to the above circumstance: for FS audit is some regulator: are the following: 4. General Financial Reporting Re . : . quirements (as stated ed Securities Regulation Code [SRC] Rule 68) (as stated in the Revis The following shall submit financial statements audited by an independent es, one of major reasons why there is a need S require the submission of audited FS. Examples Certified Public Accountant to the Securities and Exchange Commission: : Entity Threshold Stock corporation Assets or Total jes > P600,0007 Nonstock corporation Assets or Total Liabilities > P600,000* Branch offices/representative offices of | Assigned capital 2 stock foreign corporations 1,000,000 Branch offices/representative offices of | Total assets 2 P1,000,000 non-stock foreign corporations Regional operating headquarters of foreign | Total. revenues > corporations 1,000,000 Note: Corporations that do not meet the threshold above may submit their Annual Financial Statements accompanied by a duly notarized Treasurer's Certification only (rather than an Auditor’s Report). 2. Tax Compliance Requirements The National Internal Revenue Code, as amended, states the requirement for audited books of accounts under Section 232 (A) as follows: Entity Threshold Corporations, Companies, | Gross annual sales, earnings, receipts Partnerships or Persons or output > P3,000,000 For entities that meet the above threshold, they are required to Y Have their books of accounts audited and examined yearly by independent Certified Public Accountants, and Y Their income tax returns accompanied with a duly accomplished Account Information Form (AIF) which shall contain, among others, information lifted from certified balance sheets, profit and loss statements, schedules listing income-producing properties and the corresponding income therefrom and other relevant statements. Further details of tax compliance requirements are discussed in your respective taxation courses. > As prescribed by Republic Act No. 11232, or the Revised Corporation Code of the Philippines (RCC) and any of its subsequent revisions or such amount as may be subsequently prescribed Aim... Believe... Claim... Page 51Chapter 2 ~ introduction to Audit Services and Financial Statement Audit VALUE OF FS AUDIT Based from the discussions of the demand for FS audit, the following may be construed as the value of a FS audit * Audit reduces information risk that may lead to lower cost of capital, One of FS Audit’s focuses is to enhance the quality of the information, thus, reducing information risk. With high-quality, '' elevant 2 ng reliable information, users may come up with educated financial decisions which minimizes the possibility of incurring losses on resources invested. © Audit may be used to deter inefficiency and fraud. Audit involves objective obtaining and evaluating of evidence which could lead to identification of material misstatements presented in the financial statements. e Audit may be used to enhance systems of internal controls. Audit includes an understanding of the entity and its environment which incorporates the internal controls of the entity. During the course of this evaluation, deficiencies may be identified which may help management in formulating actions to improve its controls that help them achieve their objectives.