OVERVIEW OF THE AUDIT PROCESS

The audit process consists of a number of sequential steps, beginning with the decision to accept a client or continue
with an existing client, and ending with the issuance of an audit report. In between these decisions there are several
technical aspects of the audit, which involve gathering sufficient and appropriate evidence through the use of suitable
test of controls (compliance) and substantive tests. The following are the usual sequential steps undertaken in an
audit:
1. Client acceptance and continuance considerations
2. Audit planning (Risk-based audit planning)
a. Audit strategy development
b. Detailed audit planning
3. Sufficient and appropriate evidence consideration and wrap-up procedures
4. Audit report preparation

CLIENT ACCEPTANCE AND CONTINUANCE

The starting point of any audit is the acceptance of the new client or the decision to continue with an existing client.
PSA 220, Quality Control for an Audit of Financial Statements states that “The engagement partner should be satisfied
that appropriate procedures regarding the acceptance and continuance of client relationships and specific audit
engagements have been followed, and that conclusion reached in this regard are appropriate and have been
documented. PSQC 1, Philippine Standards of Quality Control further explained that the firm should establish policies
and procedures for the acceptance and continuance of client relationships and specific engagements, designed to
provide it with reasonable assurance that it will only undertake or continue relationships and engagements where it:
a. has considered the integrity of the client and does not have information that would lead it to conclude
that the client lacks integrity;
b. is competent to perform the engagement and has capabilities, time and resources to do so; and,
c. can comply with ethical requirements.

Therefore, procedures for evaluating prospective clients include considering integrity of those charged with
governance including directors and management, obtaining and reviewing financial information regarding prospective
client, information from third parties (e.g. legal advisers), and communication with predecessor auditor. The auditor
should also evaluate the audit firm’s independence and ability to service the client’s requirements. In larger
accounting firms the responsibility for evaluating all this information and making an acceptance decision should be
assigned to an individual group at appropriate management levels.

Similar conditions also apply to decision to continue with an existing client, except that there are additional
circumstances which, when they occur, may require the auditor to determine whether their relationships should be
continued. These events or circumstances include a major change in one or more matters relating to management,
directors, ownership, legal advisers, financial condition, litigation, nature of the client’s business and scope of
engagement.

In addition, the auditor may also take into account business risk when considering whether or not to accept the
engagement.

ENGAGEMENT LETTER OR OTHER FORM OR WRITTEN AGREEMENT

PSA 210, Agreeing the Terms of Audit Engagement, suggests that for the interest of both parties, an engagement
letter on any form of written material be prepared, agreed and signed by both parties once auditor has decided to
accept a client. The purpose of the engagement letter is to help avoid misunderstandings with respect to the
engagement.in general terms, the form and content of the engagement letter should include:
a) the objective and scope of the audit of the financial statements
b) the responsibilities of the auditor
c) the responsibilities of the management
d) identification of the applicable financial reporting framework for the preparation of the financial statements
e) reference to the expected form and content of any reports to be issued by the auditor; and
f) a statement that there may be circumstances in which a report may defer from its expected form and
content.

Where relevant, other matters such as fees, assistance form client’s staff and whatever else the auditor deems
relevant, may be included in the letter. In recurring the audits, the auditor may send a new letter when there are
any material changes, such as significant change in the nature and size if the client’s business.

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AUDIT PLANNING (RISK-BASED AUDIT PLANNING)
According to PSA 15, Identifying and Assessing the Risk of Material Misstatements through Understanding the Entity
and Its Environment, the auditor should obtain an understanding of the entity and its environment, including its
internal control, sufficient to identify and assess the risk of material misstatement of the financial statements whether
due to fraud or error, and sufficient to design and perform further audit procedures.

An understanding of the entity and its environment enables the auditor to identify and understand the events,
transactions and practices that, in the auditor’s judgment, may have a significant effect on the financial statements
or on the examination or audit report.

The objectives of the auditor in obtaining an understanding of the client’s internal control, on the other hand include:
a) the identification of the types of potential misstatements in the financial statements; b) the identification of factors
that affect the risk of significant misstatements in the financial statements, and; c) to design the nature, extent and
timing of further audit procedures.

Audit Risk (AR) is the risk the auditor that may unknowingly issue an erroneous opinion in an audit engagement.
Audit risk is the result of the interaction of two different risks: the risk of material misstatement and detection risk.
The risk of material misstatement in the financial statements is a result of inherent to the entity’s nature of the
business, nature of transactions, and other environmental factors that may have direct or indirect implication on the
company’s financial reporting system (inherent risk). The same is also affected by the company’s internal control
system in an attempt to minimize the possible effect of this internal and external inherent factors (control risk). The
risk of material misstatement is therefore further comprised of the inherent and control risk. Detection risk on the
other hand is the risk that the auditor’s own audit procedures may not be able to detect material misstatement in
the financial statements.

The following illustrates the mathematical representation of Audit Risk:

Audit Risk (AR) = Risk of misstatement in the FS x Detection Risk (DR)
Audit Risk (AR) = Inherent Risk (IR) x Control Risk (CR) x Detection Risk (DR)

Inherent Risk and control risk exist independently of the audit, thus is uncontrollable by the auditor. These risks are
simply assessed by the auditor. As a result of the assessed risk, the auditor then sets the acceptable level of detection
risk. Thus, among these risks, only the detection risk is controllable by the auditor, that is by setting the nature,
timing and extent of further audit procedures.

The auditor’s understanding of the entity and its environment is used directly to assess inherent risk while the
auditor’s understanding of the entity’s internal control is used to assess control risk. The understanding of the entity
and its environment including internal control is normally being done concurrently in an audit along with the
assessment of risk of material misstatement in the financial statements.

The relationship of the understanding of the nature of the business of the client along with its industry including
internal control and assessment of risk of potential misstatement to the financial statement to the other aspects of
the audit to the nature timing and extent of further audit procedures is best illustrated through the following diagram:

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FIG. 1-1: RISK-BASED AUDIT APPROACH/RISK ASSESSMENT PROCEDURE

AUDITOR’S PROCEDURES

•Potential mistatements due to:

Understanding of the business and the Nature of the business
nature of the industry to assess Nature of the industry
INHERENT RISK (IR)

Understanding of the internal's control •Prevention, detection and/or correction of

design and operation to determine its potential misstatement through a system
ability to prevent, dtect or correct the of Internal Control Financial
potential misstatements thus assessing Statements
CONTROL RISK (CR)

Based on the risk of material misstatement to the financial statements

(IRxCR), the auditor sets the acceptable level of DETECTION RISK (DR)

AUDIT RISK (AR) = IR X CR X DR

Based on the acceptable level of detection risk, the auditor plans the NATURE,
TIMING AND EXTENT OF FURTHER AUDIT PROCEDURES

AUDIT STRATEGY DEVELOPMENT

More and more audit firms are now adopting a business-like approach to audit planning as a result of the complexities
of modern business. This involves formulating an audit strategy for the client, in the same way as a company
formulates its own strategic plans. The audit strategy is formulated on the basis of an appraisal of both external and
internal factors. It then provides a framework within which detailed aspects of the audit are planned. PSA 300,
Planning of Audit of Financial Statements, identifies factors that auditors shall consider when designing the audit
strategy such as:
 Identifying the characteristics of engagement that define its scope
 Ascertaining reporting objectives of the engagement to plan the timing of the audit and the nature of the
communications required
 Considering the factors that, in the auditor’s professional judgment, are significant in directing the
engagement team’s effort
 Considering the results of preliminary engagement activities and, where applicable whether knowledge
gained on other engagements performed by the engagement partner for the entity is relevant; and
 Ascertaining the nature, timing and extent of resources necessary to perform the engagement.

In addition, PSA 300 also requires proper documentation to be made on overall audit strategy, the audit plan, and
any significant changes made during the audit engagement to the overall audit strategy or the audit plan, and the
reasons for such changes. In some firms, this is documented through the “Audit Planning Memo”.

An example of how audit strategy is being developed as practiced by one of big auditing firm follows:
Three steps in the development of audit strategy:
1. Knowledge and overall understanding of the client’s business
2. Planning of the audit of the business unit

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 3. Preliminary decision about the business unit components

KNOWLEDGE AND OVERALL UNDERSTANDING OF THE CLIENT’S BUSINESS

In developing an overall audit strategy or plan for the audit engagement the auditor should have an understanding
of the client’s business, including its internal control. PSA 315, identified that understanding of the entity and its
environment establishes a frame of reference within which the auditor plans the audit and exercises professional
judgment about assessing risk of material misstatement of the financial statements and responding to those risks
throughout the audit. PSA 315 provides guidelines on how the auditor gains knowledge of the client’s business and
how it is to be used in assessing the risk of material misstatements in the audit. The auditor should obtain information
about the following four broad areas:

 Industry conditions, regulatory environment and other external factors, including the applicable
financial reporting framework
 Nature of the entity, including business operations (e.g. products or services and geographic
dispersion) investments (e.g. acquisitions and mergers), financing (e.g. debt structure) and
financial reporting (e.g. accounting principles and revenue recognitions)
 Objectives and strategies and related business risks such as industry developments, new products
and services, expansion of the business and the use of IT, etc.
 Measurement and review of the entity’s financial performance (i.e. key ratios, key performance
indicators, employee performance measures, trends, use of forecasts, analyst reports and credit
rating reports, competitor analysis, period-on-period financial performance)

Knowledge and understanding of the client’s business are essential if the auditor is to form an opinion on the financial
report representation as a whole and assess their consistency with the auditor’s knowledge of the business.
Furthermore, it is the auditor’s knowledge and understanding of the business which will heavily influence the auditor’s
assessment of inherent risk. As defined by PSA 200, “Inherent risk is the susceptibility of an assertion to a
misstatement that could be material either individually or when aggregated with other misstatements, assuming that
there are no related controls. The risk of such misstatement is greater for some assertions and related classes of
transactions, account balances, and disclosures than for others”.

PLANNING THE AUDIT OF THE BUSINESS UNIT

Planning the audit of the business unit requires the auditor to take a close look at the business and to identify the
units that make up the firm. The units can be controlled entities, branches, divisions, or geographical locations. Once
these units have been identified the auditor collects evidence to assess risks, the control environment, the reliance
on internal control and client expectation for each sub-unit. One of the objectives of this step is to obtain an
understanding of the client’s expectations, which in turn determine the scope for each unit.

PRELIMINARY DECISION ABOUT BUSINESS UNIT COMPONENTS

The third step moves the auditor to a policy decision about the possible need to divide the business unit into
components, which are manageable part for planning and executing the actual audit. This component may be financial
reporting amounts, or a group of transactions. The auditor, after identifying these components, should consider
various risks attached to each of them, whether to rely on internal audit, what further information needs to be
gathered, and how, and an expected audit approach for each component.

DETAILED AUDIT PLANNING

The end product of the audit strategy is the expected audit approach for each component. On the basis of this
information the auditor then develops a detailed audit plan. The process involves two major steps: 1) gathering
further information; and, 2) selection of audit procedures. Information obtained in the strategic planning phase
regarding the component may not be adequate to determine the audit approach. The auditor may need further
information to be able to assess the risk and to identify key controls, including IT controls. Once sufficient information
on these matters has been obtained, the next step involves the selection of audit procedures. The selection should
concentrate on obtaining sufficient appropriate evidence about the assertions underlying the accounting records of
the various components. The approach adopted will involve:
 Analytical procedures

 Evaluation of internal control structure (tests if controls and assessing control risks)

 Substantive test of transactions and account balances

AUDIT PROGRAM
The procedures selected in the planning stage form the basis of the audit program. The program should state the
nature, timing and extent of planned audit procedures to be used at the assertion level for each material class of

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transactions, account balance and disclosure, and each program should be tailored to meet the circumstances of
each client. Other matters included in the program are the development of time budgets, assignment of audit staff
and scheduling of dates for the various phases of the audit process, culminating in the issue of the audit report. The
time budget sets out the number of hours expected to complete the audit and may include detailed time budgets for
each specific matter as 30 hours for work on cash, 50 hours for inventories, 24 hours for report presentation, 20
hours for partner’s review, and so on. There are quality control procedures, which should be followed in the
assignment of audit staff, and preliminary attention must be paid to the level of education and experience of audit
staff. PSA 300 provides useful guidelines on matters related to planning.

At the planning stage, the auditor may also include analytical procedures. These analytical procedures, such as
analysis of ratios, study of the relationship between financial and operating information of the client, and comparison
with similar companies in the industry, can provide the auditor with additional insights into matters related to the
audit engagement.

IDENTIFYING AND DOCUMENTING INTERNAL CONTROLS

The auditor has to consider and evaluate the clients internal control structure after the development of the audit
strategy phase. The auditor’s evaluation of internal controls will be affected by his assessment of control risk. PSA
200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Philippine
Standards on Auditing, defines control risk as: “the risk that a misstatement that could occur in an assertion about
a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated
with other misstatements, will not be prevented, or detected and corrected, on a timely basis by entity’s internal
control”.

UNDERSTANDING THE INTERNAL CONTROL STRUCTURE

If the internal control structure is effective, control risk will be below the maximum (less than high) and the amount
of audit evidence that the auditor plans to collect can be lower than when control risks are high. This obviously will
have an impact on the cost of the audit to the client. The presence or absence of an effective internal control
environment and the quality of information system are of fundamental importance to the audit. The control
environment includes the type of policies and procedures involved, materiality considerations, the size and complexity
of business, the nature of the client’s documentation of specific policies and procedures, and the auditor’s assessment
of inherent risk.

PSA 315 identified five components of internal control which include: a) the control environment; b) the entity’s risk
assessment process; c) the information system, including business processes, relevant to financial reporting, and
communication; d) control activities; and, e) monitoring controls. PSA 315, requires the auditor to document his
understanding of internal control structure and preliminary assessment of control risk as well as, where necessary,
the basis for conclusions reached.

PRELIMINARY ASSESSMENT OF CONTROL RISK

After obtaining an understanding of the client’s internal control structure, the auditor should make preliminary
assessment of control risk. This should be made in conjunction with an assessment of inherent risk, which is the
susceptibility of the financial report to material misstatements (in the absence of internal controls), in order to
determine the appropriate detection risk.

In most cases when control risk is assessed at the maximum level (high), the auditor should perform extended
substantive procedures. It should be noted that inherent risk should also be taken into taken into account in planning
the nature, timing and extent of substantive procedures. However, the assessed level of inherent risk and control
risk cannot be low enough to be conducted to obtain sufficient and appropriate audit evidence for the auditor to form
an opinion on the financial statements.

All the information regarding the control structure and information system and the evaluation of the relationship
between control risk, inherent risk and substantive procedures should be properly documented. Different techniques
may be used to document and record information relating to control structure and information system. Selection of
particular technique is a matter of auditor’s judgment. Common techniques used alone or in combination, are
narrative descriptions, questionnaires and flowcharts. The extent of the auditor’s record of control structure and
information system will vary depending on the reliance he intends to place on those controls.

Seven objectives must be met by an internal control structure that seeks to prevent errors in information produced
by the company’s accounting systems and records. These objectives may be categorized under broad headings of
occurrence, completeness, accuracy, cutoff, and classification. These objectives are consistent with the management
assertions on financial statements.

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OCCURRENCE
1. Recorded transactions are valid and the system protects against the inclusion of fictitious or non-existent
transactions in journals and other accounting records.

2. Transactions are properly authorized and if a transaction is not authorized, it could result in a fraudulent
transaction.

COMPLETENESS
3. All valid transactions should be recorded, and the client’s procedures must provide controls to prevent the omission
of transactions from the records.

ACCURACY
4. Transactions are properly valued and recorded, and the system protects against errors in calculation and recording
transactions.
5. Transactions are properly included in the subsidiary records and correctly summarized and posted to the general
ledger.

CUT-OFF
6. Transactions are recorded at the proper time and as near as possible to the time of transaction.

CLASSIFICATION
7. Transactions are properly classified according to the client’s chart of accounts.

These seven detailed internal control objectives should be applied to all major transactions in the audit. These
transactions typically include, sales, cash receipts, purchases, cash payments and payroll. If the auditor feels that
the internal control structure cannot be relied upon, the weakness in, or absence of, internal controls should be
identified and documented. These weaknesses may form the basis of the auditor’s report to management on
weaknesses in the internal control structure of the client. If the auditor is confident of the quality of the internal
control structure, the next phase is to identify the internal controls on which reliance is to be placed.

PERFORMING TEST OF CONTROLS

Test of controls include inquiry, observation, inspection and reperformance. The auditor conducts these tests to
obtain evidence about the effectiveness of the design and the operating effectiveness of the internal control structure.
The effectiveness of the internal control shall be determined, among others by the following factors: 1) the
consistency of the application of the control; 2) who performs the control (whether or not he is qualified to perform
the control); and, 3) how controls are being performed.

EVALUATING INTERNAL CONTROLS

Test of controls should be conducted by the auditor to obtain evidence that those internal controls internal control
internal control on which the auditor intends to rely operate generally as identified by him that they function
effectively throughout the period of intended reliance. The concept of effective operation recognizes that some
exceptions may have occurred.

If the auditor has doubts about relying on the internal controls at this stage, any other controls on which reliance
may be placed should be located. If there are controls that the auditor can identify, these are subjected to test of
controls and evaluated again. On the other hand, if no such control exists, the auditor will need to adopt more
extensive substantive testing procedures.

FIG 1-2 illustrates how the client’s internal control system factors in the entire risk-based audit approach:

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FIG 1-2: THE AUDITORS CONSIDERATION OF THE CLIENT'S INTERNAL CONTROL
SYSTEM
PERFORMING SUBSTANTIVE TESTING

Whether or not there are other controls that the auditor can rely on, the auditor still has to conduct substantive tests
of accounting system. Where internal controls are weak, substantive testing should be more extensive. The
substantive tests are designed to determine the completeness, accuracy and validity of the data produced by the
accounting system. In a sense, therefore, the test provide results to support the auditor’s understanding of the
internal control structure. If the results do not support the auditor’s understanding of the internal control structure,
substantive testing procedures should be modified (probably extended) and further tests undertaken until results of
the substantive procedures confirm the auditor’s understanding of internal control structure. Once this has been
done, the auditor will be able to form an opinion on the financial statement.

Substantive tests are test that are directed towards the assertions in the financial statements regarding transactions
and events, account balances and presentation and disclosure. The following summarizes the said financial statement
assertions:

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ASSERTION ABOUT TRANSACTION AND EVENTS
1. OCCURRENCE
Transactions and events that have been recorded have been occurred and pertain to the entity.
2. COMPLETENESS
All transactions and events that should have been recorded have been recorded.
3. ACCURACY
Amounts and other data relating to recorded transactions and events have been recorded appropriately.
4. CUT-OFF
Transactions and events have been recorded in the correct accounting period.
5. CLASSIFICATION
Transactions and events have been recorded in the proper accounts.

ASSERTION ABOUT ACCOUNT BALANCES

1. EXISTENCE
Assets, liabilities and equity interest exists.
2. RIGHTS AND OBLIGATION
The entity holds or controls the rights to assets, and liabilities are obligations of the entity.
3. COMPLETENESS
All assets, liabilities and equity interests that should have been recorded have been recorded.
4. VALUATION AND ALLOCATION
Assets, liabilities and equity interests are included in the financial statements at appropriate amounts and
any resulting valuation or allocation adjustments are appropriately recorded.

ASSERTION ABOUT PRESENTATION AND DISCLOSURE

1. OCCURRENCE AND RIGHTS AND OBLIGATIONS
Disclosed events, transactions and other matters have occurred and pertain to the entity.
2. COMPLETENESS
All disclosures that should have been included in the financial statements have been included.
3. CLASSIFICATION AND UNDERSTANDABILITY
Financial information is appropriately presented and described and disclosures are clearly expressed.
4. ACCURACY AND VALUATION
Financial and other information are disclosed fairly and at appropriate amounts.

Substantive tests are not designed as test of processing system: they are concerned primarily with the quality of the
output form the accounting system and with the detection of transaction or account balance errors. Thus, whereas
test of controls provide direct evidence of the level of control risk and perhaps information on the inherent risk
associated with the aspects of the client’s internal control structure, substantive testing addresses that are of risk,
detection risk, which is directly controllable by the auditor. PSA 330, Auditor’s Responses to Assessed Risk, prescribes
that “… the auditor has determined that an assessed level of material misstatement at the assertion level is a
significant risk, the auditor should perform substantive procedures that are specifically responsive to that risk…”

Audit techniques in substantive testing include inspection of records and documents, inspection of tangible assets,
observation, inquiry, confirmation, recalculation, reperformance and analytical procedures.

TYPES OF SUBSTANTIVE TESTS

1. Test of Detail
2. Analytical procedures

TEST OF DETAIL

Substantive tests relating to transactions and account balances referred to collectively as test of detail. These
substantive tests are performed to obtain audit evidence supporting or refuting the various assertions made by an
entity in the financial statements. Since specific audit objectives correspond with each of the assertions, substantive
procedures are designed directly to test of classes of transactions and account balances in order to detect material
misstatements in the financial statement assertions, i.e. to test the propriety and completeness of accounting
treatment of transactions and balances and to reveal existence of any monetary errors or other irregularities. The
nature, timing and extent of substantive testing performed to achieve the specific audit objectives for each class of
transactions and account balances may vary according to auditor’s consideration of materiality and risk assessments.

TEST OF DETAIL OF TRANSACTIONS

Substantive tests of transactions involve the application of auditing techniques such as observation, inspection,
vouching, recalculation, tracing and confirmation to test the details of a sample of selected transaction. Test of
controls is also referred to as compliance testing because testing the control procedures involves examining the
transactions. For example, by tracing from source document (e.g. shipping document, sales invoice) to the accounting
record (sales journal, accounts receivable ledger), the auditor is examining controls designed to detect unbilled
shipments or omitted transactions; thus, the test of controls requires the auditor to focus on the sales transactions.

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Any improper recording of individual transaction in the accounting record shown by testing control procedures will
have a direct effect on the fair presentation of financial statement balances. As a result, the auditor would also
perform substantive tests of transactions to ascertain that there are no monetary errors occurring in the accounts.
If there are, the auditor should assess their materiality. The quantity of errors and their materiality will determine
whether the auditor needs to perform additional substantive tests of transactions, substantive test of account
balances, or analytical procedures, in order to accumulate sufficient appropriate evidence to provide a reasonable
basis for the opinion.

The auditor’s objective (Audit Objective) in performing substantive tests of transactions is to obtain audit evidence
about the occurrence, completeness, accuracy, cut-off and classification assertions for a particular class of
transactions, more specifically:
 Test of Occurrence – Test of occurrence are designed to uncover situation where, for example,
sales are included in the journals when no shipment was made, or where shipments are recorded
as sales when they have been made to fictitious customers. To test for sales recorded in the sales
journal when there have been no actual shipments, the auditor can vouch entries in the sales
journal to check if the related copies of supporting documents, such as bill of lading, exist. Vouching
the physical amounts to the perpetual inventory records, which should show a corresponding
decrease in inventory, can also further verify the authenticity of these documents. The auditor
could examine the sales orders corresponding to the sales entries in the sales journal for existence
of shipping authorization and credit approval, to test the possibility of sales to non-existent
customers. Another approach that the auditor can use in checking the occurrence of sales
transactions is to vouch accounts receivable credit entries in the subsidiary ledger to their sources.
If the credit is for cash received or goods returned, a sale has actually occurred. Other reasons for
the credits, such this has been properly authorized and approved.

 Test of Completeness – Test of completeness are aimed as establishing whether all transactions
that should have been recorded are so recorded. Vouching recorded sales to supporting documents
only provides proof of occurrence; it cannot guarantee that the transactions were completely
recorded. To test the completeness assertion, the auditor should examine the underlying
documents and trace them through the accounting records. In another example, testing
completeness of purchase transactions, the primary source of evidence is by tracing a sample of
shipping reports to voucher register and cash payments journal. The auditing technique include
inspection of documents, vouching transactions, and analytical procedures.
 Test of Accuracy – Test of accuracy involve vouching and recalculation of transactions and the
information in the accounting records. The auditor can start with the relevant journal and compare
selected transactions with duplicate invoices and subsidiary ledgers. Prices on the duplicate
invoices are normally compared with an approved price list and extensions and totals are
recomputed. These substantive tests ensure that transactions are recorded at their proper
amounts.
 Test of Cut-off – Test of cut-off is to ascertain that transactions are recorded in the proper period.
Sales should be billed and recorded as soon as shipment takes place to avoid the possibilities of
omission from the records and of not recording sales in the proper accounting period.
 Test of Classification – Tests of classification is to ensure that appropriate accounts are used
specifically for a particular transaction. A proper coding system, for example should be maintained
for sales of goods and services rendered.

TEST OF DETAIL OF ACCOUNT BALANCES

While test of detail of transaction will provide some evidence of integrity of accounting records, it is imperative that
the auditor also perform direct tests of material account balances included in the financial statements before an
opinion ca be rendered. Unlike substantive test of transactions, direct tests of balances are concerned with individual
account balances such as accounts receivable, inventory, plant and equipment, and accounts payable. Since accuracy
of financial statement balances is essential to overall fair presentation, tests of details of balances are designed to
detect monetary errors in them. These substantive tests of account balances are normally applied to statement of
financial position accounts, but they are also used to verify income statement accounts. For example, in testing the
accounts receivable balance, the auditor also verifies the related sales, and sales returns and allowances.

The auditor’s objective (Audit Objective) in performing substantive tests of balances is to obtain audit evidence about
the existence, completeness, valuation and allocation, and rights and obligation assertions of the relevant account
balances. More specifically:
 Test of Existence – The existence assertion is concerned with whether an asset or liability exists
at the statement of financial position date. The auditor’s major interest in the existence assertion
is the possible overstatement of financial account balances, such as those of accounts receivable

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 and inventory. The primary audit procedures used to establish existence of tangible assets is
counting, observation and inspection. Thus, the auditor should count cash and marketable
securities on hand, observe inventory stocktaking and inspect tangible fixed assets. For other types
of assets such as cash in bank and accounts receivables, liabilities and owner’s equity accounts,
the primary audit procedures are third party confirmation and examination of supporting
documents.
 Test of Rights and Obligation – The rights and obligation assertion is concerned with whether an
asset or liability pertains to an entity at the statement of financial position date. The auditor is
required to ascertain that assets represent rights of entity and liabilities, the obligation of the entity
at a given date. Testing for this assertion is necessary because the existence of an asset does not
provide evidence of, for example, ownership rights to the asset. Moreover, some items, such as
capitalized lease equipment, will be recognized as assets, even though they are not owned.
Similarly, accrued employee entitlements are liabilities but not legal obligations. The audit
procedures used to obtain evidence concerning rights and obligations are confirmation, inquiry and
inspection of documents such as title deeds, rate notices and legal contracts.
 Test of Completeness – The completeness assertion is concerned with whether financial statement
account balances are properly recorded. Failure to record a financial statement item results in
understatement of that account, such as when some liabilities are omitted at year end. An auditor’s
substantive test for completeness should be directed at possible understatements, such as
unrecorded liabilities in the audit of accounts payable. Review of subsequent payments to creditors
is a primary audit procedure for testing the completeness of accounts payable at year-end.
Confirmation of accounts is another substantive audit procedure. In testing completeness of the
payroll liability account balances, the auditor reviews the payroll records, noting the date when
payroll was last paid, so the amount of wages accrued as of the statement of financial position
date can be established.
 Test of Valuation and Allocation – The valuation and allocation assertion is concerned with whether
financial statement balances are stated at their proper amount in conformity with Philippine
Financial Reporting Standards or other financial reporting framework. For example, the auditor
should ascertain the propriety of the inventory and depreciation methods employed, estimate the
collectability of accounts receivable, and verify liability amounts by examining the terms in legal
contracts and other documents. Recalculation is a primary audit procedure used in testing
valuation assertion, for example, multiplying each item listed on the inventory sheet by its unit
cost and then summing up to obtain the total cost of inventory. Another substantive test is to
perform analytical procedures to test for the overall reasonableness of inventory valuation (e.g.
inventory estimation through the gross profit method or retail method).

TEST OF DETAIL OF PRESENTATION AND DISCLOSURE

The presentation and disclosure assertion is concerned with whether an item is disclosed, classified and described
in accordance with Philippine Financial Reporting Standards so as to meet the objectives of occurrence and rights
and obligation, completeness, classification and understandability and accuracy and valuation. For example, an
asset item on the statement of financial position should be properly located within the particular asset
subcategory (i.e. current or fixed) and should be appropriately described. Additional disclosure in the
accompanying note to the financial statements should provide further relevant facts concerning the item, for
example, that inventories are valued at the lower of costs and net realizable value and, where appropriate, that
provision is made for possible obsolescence. The audit procedures to meet this objective include, inspection,
confirmation and inquiry. In particular, the auditor should ask about possible contingencies and restrictions that
would require specific disclosure in the financial statements.

ANALYTICAL PROCEDURES

Analytical procedures complement the substantive tests of transactions and account balances. They are
substantive tests involving the study of relationships and comparisons between data. As such, they are
reasonableness tests of account balances and classes of transactions. Analytical procedures range from simple
techniques such as ratio and trend analysis to complex techniques such as financial models and regression
analysis. The usefulness of analytical procedures in evidence gathering is that it enables the auditor to detect
out-of-line conditions and unusual fluctuations which require follow-up using other types of substantive tests.

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 FIG 1-3 illustrates, in summary the relationship of test of controls and substantive testing:

SUFFICIENT AND APPROPRIATE EVIDENCE CONSIDERATION AND WRAP-UP PROCEDURES

The final phase of the evidence gathering function of the audit engagement requires the auditor to form a judgment
about whether the evidence is sufficient and appropriate. Sufficiency of evidence relates to the quantity of evidence
gathered while appropriateness relates to the reliability and relevance of information. If the auditor has doubts about
the sufficiency and appropriateness of evidence collected to support an opinion, he needs to consider one of two
possible alternatives:
 Modify the audit plan and conduct more substantive procedures
 Issue a disclaimer of opinion

A disclaimer of opinion should be issued only in exceptional circumstances when, and only when, a significant
uncertainty exists and is caused by a limitation on the scope of the audit work or an inherent uncertainty.

SUBSEQUENT EVENTS REVIEW

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In gathering and evaluating sufficient and appropriate evidence, the auditor has to consider significant events that
have occurred between the statement of financial position date and the date the board of directors approves the
financial statements (Subsequent events period). This period may constitute the happening of any significant events
that may either have implication on the measurement/valuation of an account balance as of the statement of financial
position date (Type 1 subsequent event) or may have no implication on the measurement/valuation of an account
balance as of the statement of financial position date but is a significant information that needs to be disclosed in the
financial statements for the guidance of the potential user of the financial statements (Type 2 subsequent event).

REPRESENTATION LETTERS
The auditor should obtain a client’s representation letter which normally sets out matters related to the financial
statements and acknowledges the fact that the primarily responsibility for the financial statements rests with the
client. A legal representation letter on the other hand provides additional evidence to the auditor regarding any
uncertainties that may arise from possible lawsuits and other legal matters that may affect the client.

AUDIT REPORT PREPARATION

On the basis of the test of controls and substantive tests, review of subsequent events and representation letters the
auditor is in a position to form an opinion on the accounts and express it in the audit report. Under certain
circumstances, the working papers and other documentation should be reviewed by independent personnel in the
audit firm who are not involved in the audit. This should be done before the report issued.

PSA 700, Forming an Opinion and Reporting of Financial Statements deals with circumstances when auditor is able
to express an unqualified opinion and no modification to the auditor’s report is necessary. Understanding the content
of the standard unqualified report is essential because the report is the culmination of the auditor’s attest function
and is his formal means of communication with interested users. The Independent Auditor’s Report consist of a
number of basic elements as stated in the standard as follows:
PSA 700 REVISED PSA 700
Title Title
Addressee Addressee
Introductory paragraph Auditor’s opinion paragraph
Management responsibility paragraph Basis for opinion paragraph
Auditor’s responsibility paragraphs Going concern (where applicable)
Opinion paragraph Key audit matters
Other reporting responsibilities (where applicable) Management responsibility
Signature of the auditor paragraph
Date of auditor’s report Auditor’s responsibility paragraph
Auditors’ address Other reporting responsibilities
(where applicable)
Name of the engagement partner
Signature of the auditor
Date of auditor’s report
Auditor’s address

PSA 706, Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report, apply
when the auditor would want to highlight a concern about the validity of the use of going concern assumption or
about a significant uncertainty, which is dependent upon future events and may affect the financial statements. The
auditor shall include an “emphasis of a matter paragraph” after the opinion paragraph but before the section on any
other reporting responsibilities. The inclusion of this paragraph is to discuss the matter more extensively and refer
to the fact that the auditor’s opinion is not qualified in this respect.

PSA 705, Modifications to the Opinion in the Independent Auditor’s Report, deals with modifications in the auditors
report as a result of either scope limitation, that is the inability of the auditor to gather sufficient and appropriate
evidence (which shall result to qualified opinion or disclaimer of opinion) or from the client’s departure from the
reporting framework (which shall result to qualified opinion or adverse opinion).

The following is a summary of the types of opinion to be issued depending on the circumstances which resulted from
the audit process:

1. Unqualified Opinion
- issued if there is no material misstatement in the financial statement

2. Unqualified opinion with emphasis of a matter paragraph after the opinion

-issued if there are uncertainties which are adequately disclosed in the financial statements (e.g. uncertainty
about the appropriateness of the use of the going concern assumption)

3. Qualified opinion (with basis of qualified opinion paragraph before the opinion paragraph)

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 -issued if there
is a scope limitation
(unable to obtain
sufficient and
appropriate evidence)
that is material but not
pervasive to the
financial statements
taken as a whole
-issued if there
is a departure from the
financial reporting
framework that is
material but not
pervasive to the
financial statements
taken as a whole.

4. Adverse opinion
(with basis of adverse
opinion paragraph
before the opinion
paragraph)
-issued if there
is a departure from the
financial reporting
framework that is both
material and pervasive
to the financial taken as
a whole.

5. Disclaimer of opinion
(with basis of disclaimer
of opinion paragraph
before the opinion
paragraph)
-issued if there
is a scope limitation
(unable to obtain
sufficient and
appropriate evidence)
that is both material
and pervasive to the
financial statements
taken as a whole

MULTIPLE CHOICE

PROBLEM 1: CLIENT ACCEPTANCE AND CONTINUANCE

1. The following are considered by a CPA firm in deciding whether to accept a new client, except:
A. The client’s financial ability.
B. The client’s relations with its previous CPA firm.
C. The client’s standing in the business community.
D. The client’s probability of achieving an unqualified opinion.

2. To emphasize auditor independence from management, many corporations follow the practice of
A. Appointing a partner of the CPA firm conducting the audit to the corporation’s audit committee.
B. Establishing a policy of discouraging social contract between employees of the corporation and the staff
of the independent auditor.
C. Requesting that a representative of the independent auditor be on hand at the annual stockholder’s
meeting.

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 D. Having the independent auditor report to an audit committee of outside members of the board of
directors.

3. Where the client is changing auditors, PSA requires communication between the predecessor and successor
auditors. The burden of initiating the communication rests with:
A. The client. C. The Philippine SEC
B. The predecessor auditor. D. The successor auditor.

4. Before accepting an audit engagement, a successor auditor should make specific inquiries of the predecessor
auditor regarding:
A. Disagreements which the predecessor had with the client concerning auditing procedures and
accounting principles.
B. The predecessor’s evaluation of matters of continuing accounting significance.
C. The degree of cooperation the predecessor received concerning the inquiry of the client’s legal counsel.
D. The predecessor’s assessments of inherent risk and judgments about materiality.

5. If the prospective client refuses to permit the predecessor to respond or limits the predecessor’s response,
the successor should:
A. Continue to ask the predecessor auditor questions on facts that might bear on the integrity of
management.
B. Accept the engagement but only after an equitable increase in the professional fee.
C. Issue a disclaimer of opinion because the limited response of the predecessor auditor constitutes a
significant scope limitation.
D. Inquire as to the reasons and consider the implications in deciding whether to accept the engagement.

6. After client acceptance, the terms of the engagement are agreed by the auditor with the client. The objective
and the scope of the audit and the extent of the auditor’s responsibilities to the client are best documented
in:
A. Independent auditor’s report C. Client’s representation letter
B. Audit engagement letter D. Audit program.

7. The primary purpose of the engagement letter is to:

A. Remind management that the primary responsibility for the FS rests with management.
B. Provide a written record of the agreement with the client as to the services to be provided.
C. Provide a starting point for the auditor’s preparation of the preliminary audit program.
D. Satisfy the requirements of the CPA’s liability insurance policy.

8. Which of the following is least likely to be included in an audit engagement letter?

A. Identification of specific audit procedures that the auditor needs to undertake.
B. Description of any letters or reports that the auditor expects to submit to the client.
C. A reference to the inherent limitations of an audit that there is an unavoidable risk that some material
misstatements may remain undiscovered.
D. Basis on which fees are computed and any billing arrangements.

9. In which of the following situations will there be a need to send a new letter for recurring engagements?
A. Revisions or special terms of the engagement.
B. Significant change in nature or size if the client’s business.
C. Indications of misunderstanding of the objective and scope of the audit.
D. All the above are situations that may cause the auditor to send a new letter.

10. The following may lead the client to request for a change in engagement:
A. Restrictions on the scope of the engagement.
B. Misunderstanding as to the nature of an audit or related service originally requested.
C. Change in circumstances affecting the need for the service.
D. All the answers.

11. If a change in the type of the engagement from higher to lower level of assurance is reasonably justified,
the report based on the revised engagement:
A. Should qualify the opinion due to a scope limitation.

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 B. Omits reference to the original engagement.
C. Should always refer to any procedures that may have been performed in the original engagement.
D. Should refer to the original engagement in a separate paragraph preceding the opinion paragraph.

12. If a change in the type of engagement from higher to lower level of assurance is not justified, the auditor
should:
A. Qualify the report on the original engagement.
B. Continue with the revised engagement but make explicit reference about the original engagement.
C. Refuse to agree the management’s request on the change of engagement and continue with the original
engagement.
D. Withdraw from the engagement.

PROBLEM 2: UNDERSTANDING THE BUSINESS AND INDUSTRY

1. One of the considerations in audit planning is obtaining a knowledge of the client’s business. An auditor
obtains knowledge about a new client’s business and its industry to
A. Make constructive suggestions concerning improvements to the client’s internal control.
B. Develop an attitude of professional skepticism concerning management’s financial statement assertion.
C. Evaluate whether the aggregation of known misstatements causes the financial statements taken as a
whole to be materially misstated.
D. Understand the events and transactions that may have an effect on the client’s financial statement

2. Which of the following is not a reason for utilizing analytical review procedures?
A. To assess the entity’s ability to continue as a going concern.
B. To identify areas with no usual fluctuations so that fewer detailed tests may be performed on those
accounts.
C. To highlight changes from the prior year to the current year so that trends can be identified which will
influence audit planning.
D. To determine the magnitude of errors in the financial statements.

3. When the continuing auditor intends to use information about the entity and its environment obtained in
prior periods, the auditor should:
A. Seek permission with the client in using the prior period information obtained by the auditor.
B. Determine whether to equitably reduce the audit fee due to lower audit effort expended during the
engagement.
C. Determine whether changes have occurred that may affect the relevance of such information in the
current audit.
D. Assess control risk as “high” for the assertions affected by the prior-period information.

4. Relevant industry conditions include the following, except:

A. The market and competition, including demand, capacity and price competition.
B. Cyclical or seasonal activity.
C. Product technology relating to the entity’s products.
D. Regulatory framework for a regulated industry.

5. Which of the following matters is not included under “regulatory environment”?

A. Accounting principles and industry specific practices.
B. Legislation and regulation that significantly affect the entity’s operations.
C. Government policies currently affecting the conduct of the entity’s business.
D. General level of economic activity (for example, recession, growth).

6. The nature of the entity refers to the following, except:

A. The entity’s operations, its ownership, and governance.
B. The types of investments that it is making and plans to make.
C. The way that the entity is structured and how it is financed.
D. Other external factors, such as general economic conditions.

7. These are the operational approaches by which management intends to achieve its objectives.
A. Strategies. C. Business risk approaches.
B. Planning methods. D. Operational plans.

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8. These result from significant conditions, events, circumstances, actions or inactions that could adversely
affect the entity’s ability to achieve its objectives and execute its strategies.
A. Business failure. C. Business obstacles.
B. Information risk. D. Business risk.

9. S1. Business risk is broader in scope than the risk of material misstatement.
S2. Most business risks have financial consequences and they may have an effect on the financial statements
of an entity.
A. True, False B. False, True C. True, True D. False, False

10. In obtaining an understanding of a client’s objectives, strategies and related business risks, the auditor
would most likely consider the following as business risks, except:
A. The entity does not have the personnel or expertise to deal with the changes in the industry.
B. There is increased product liability.
C. Demand has not been accurately estimated.
D. The entity relies more on debt financing rather than equity financing
E. All of the above are considered.

11. The auditor’s understanding of the entity’s selection and application of accounting policies encompasses the
following:
A. B. C. D.
 The methods the entity uses to account for Yes Yes Yes Yes
significant and unusual transactions.
 The effect of significant accounting policies No Yes Yes No
in controversial or emerging areas for which there is
lack of authoritative guidance or consensus.
 The changes in the entity’s accounting policies. Yes No Yes No

12. S1. Performance measures and their review indicate to the auditor aspects of the entity’s performance that
management and others consider to be not of importance.
S2. The sources of information used in measuring and reviewing financial performance consist of externally
and internally-generated information.
A. True, False B. False, True C. True, True D.False, False

13. Examples of matters an auditor may consider under measurement and review of the entity’s financial
performance include of the following (select the exception):
A. Key ratios and operating statistics.
B. Use of information technology.
C. Competitor analysis.
D. Employee performance measures and incentive compensation policies.

14. According to PSA 315, the auditor should document:

A. The discussion among the engagement team.
B. Key elements of the understanding obtained regarding each of the aspects of the entity and its
environment, including each of the internal control components.
C. The identified and assessed risks of material misstatements at the financial statement level and at the
assertion level, the risks identified, and related controls evaluated.
D. All of the choices.

15. The form and extent of documentation is influenced by the following:

A. Nature, size and complexity of the entity and its internal control.
B. Availability of information from the entity.
C. Specific audit methodology and technology used in the course of the audit.
D. All of these factors affect the form and extent of documentation.

16. A reason to establish control is to:

A. Have a basis for planning the audit.
B. Provide reasonable assurance that the objectives of the organization are achieved.
C. Encourage compliance with organizational objectives.
D. Ensure the accuracy, reliability and timeliness of the information.

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PROBLEM 3: INTERNAL CONTROL

1. This is the process designed and effected by those charged with governance, management and other
personnel to provide reasonable assurance about the achievement of the entity’s objectives on the financial
reporting, operations and compliance.
A. Strategies C. Internal Controls
B. Operating plans D. Risk Assessments

2. According to PSA 315, the auditor uses the understanding of internal control to:
A. Identify types of potential misstatements
B. Considers factors that affect the risk of material misstatements
C. Design the nature, timing and extent of further audit procedures (i. e., tests of controls and substantive
tests)
D. All of these.

3. The primary purpose of the auditor’s consideration of internal control is to provide a basis for
A. Determining whether the procedures and records that are concerned with the safeguarding of assets
are reliable.
B. Constructive suggestions to clients concerning deficiencies in internal control.
C. Determining the nature, timing and extent of audit tests to be applied.
D. The expression of an opinion.

4. In an audit of financial statements, an auditors’ primary consideration regarding a control is whether it:
A. Enhances management’s decision-making processes.
B. Reflect management’s philosophy and operating style.
C. Affects management’s financial statement assertions.
D. Provides adequate safeguards over access to assets.

5. What is the relationship between an entity’s objectives and the controls it implements to provide reasonable
assurance about their achievement?
A. Direct C. Adverse
B. Inverse D. Cannot be determined.

6. An auditor would most likely be concerned with internal control policies and procedures that provide
reasonable assurance about:
A. The efficiency of management’s decision-making process.
B. Appropriate prices the entity should charge for its products.
C. Methods of assigning production tasks to employees.
D. The entity’s ability to process and summarize financial data.

7. These controls may also be relevant to the audit if the external auditor intends to make use of company-
produced information in designing and performing further audit procedures (test of controls and substantive
tests):
A. Controls over completeness and consistency.
B. Controls over existence and occurrence.
C. Controls over completeness and accuracy.
D. Controls over presentation and disclosure.

8. The following are components of internal control:

A. Organizational structure, management philosophy, and planning.
B. Legal environment of the firm, management philosophy, and organizational structure.
C. Risk assessment process, backup facilities, responsibility accounting and natural laws.
D. Control environment, risk assessment process, control activities, information system and
communication, and monitoring of controls.

9. Which of the following statements best describes “control environment”?

A. The entity’s process for identifying business risks relevant to financial reporting objectives and deciding
about actions to address those risks, and the results thereof.
B. The system for transferring information from transaction processing systems to the general ledger or
the financial reporting system.
C. Policies and procedures that help ensure that management directives are carried out.

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 D. This includes the governance and management functions and the attitudes, awareness and actions of
those charged with governance and management concerning the entity’s internal control and its
importance to the entity.

10. Management’s attitude towards aggressive financial reporting and its emphasis on meeting projected profit
goals most likely would significantly influence an entity’s control environment when:
A. Management is denominated by one individual who is also a shareholder.
B. External policies established by parties outside the entity affects its accounting practices.
C. The audit committee is active in overseeing the entity’s financial reporting policies.
D. Internal auditors have direct access to the board of directors and entity management.

11. An entity’s risk assessment process includes how management:

A. Identifies business risks relevant to financial reporting objectives.
B. Estimates the significance of the risks.
C. Assesses the likelihood of the occurrence of risks.
D. Decides on actions to address the risks.
E. All of the choices.

12. Risks can arise or change due to circumstances such as the following, except:
A. There is a change in the regulatory or operating environment.
B. No new employees have been hired by the company.
C. The company switched from natural information systems to a computerized system.
D. The accounting and financial reporting framework has experienced significant revisions.

13. The information system consists of the following:

A. Infrastructure (physical and hardware components) and software
B. People
C. Procedures and data
D. All of these.

14. The objective of the recording function of transactions (in the context of internal accounting control) is to
A. Limit access to assets and to permit preparation of financial statements in accordance with GAAP.
B. Assure compliance with the rules of all regulatory bodies having jurisdiction over the reporting entity.
C. Permit preparation of financial statements in accordance with GAAP and to maintain accountability of
assets.
D. Encourage operational efficiency and adherence to prescribed managerial policies.

15. Which of the following statements describe reporting?

A. Identifying and capturing the relevant information for transactions or events.
B. Editing and validation, calculating, measuring, valuing, summarizing, and reconciling functions.
C. The preparation of financial reports as well as other information, in electronic or printed format, that
the entity uses in measuring and reviewing the entity’s financial performance.
D. All of these statements describe the recording function.

16. Which of the following descriptions pertain to physical controls?

A. Control activities that include reviews and analyses of actual performance versus budgets, forecasts,
and prior period performance.
B. Controls performed to check accuracy, completeness, and authorization of transactions.
C. Physical security of assets, including adequate safeguards such as secured facilities over access to
assets and records.
D. The assignment of incompatible functions to different people.
E. Control activities involving the specific or general authorization of a transaction.

17. Which of the following would be preventive controls?

A. The use of batch totals.
B. Reconciling the accounts receivable subsidiary file with the control account.
C. Requirement that two persons open mail.
D. Preparation of bank reconciliation.

18. An example of specific transaction authorization is the:

A. Setting of automatic reorder points.
B. Establishment of sales prices.

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 C. Establishment of a customer’s credit limits.
D. Approval of a construction budget for a new warehouse.

19. A proper segregation of duties requires:

A. That an individual authorizing a transaction should record it also.
B. That an individual authorizing a transaction maintain custody of the asset that resulted from the
transaction.
C. That an individual maintaining custody of an asset be entitled to access the accounting records for the
asset.
D. The different individuals should handle the custody, authorization and record-keeping.

20. A process implemented by management to assess the effectiveness of internal control performance over
time.
A. Monitoring of controls C. Test of controls
B. Quality control system D. Risk assessment procedures

21. An entity’s ongoing monitoring activities often include:

A. Periodic audits by the audit committee.
B. Reviewing the purchasing function.
C. The audit of the annual financial statements.
D. Control risk assessment in conjunction with quarterly reviews.

22. An effective internal control structure

A. Reduces the need for management to review exception reports on a day-to-day basis.
B. Eliminates risk and potential loss to the organization.
C. Cannot be circumvented by management.
D. Is unaffected by changing circumstances and conditions encountered by the organization.

23. Internal control can only provide reasonable, not absolute, assurance of achieving entity control objectives.
One of the factors limiting the likelihood of achieving those objectives is that:
A. The auditor’s primary responsibility is the detection of fraud.
B. The board of directors is active and independent.
C. The cost of internal control should not exceed its benefits.
D. Management monitors internal control.

24. When an organization has a strong internal control structure, management can expect various benefits. The
benefit least likely to occur is
A. Reduces cost of an external audit.
B. Elimination of an employee fraud.
C. Availability of reliable data for decision-making purposes and protection of important documents and
records.
D. Some assurance of compliance with SEC regulations.

25. Which of the following is an example of an inherent limitation in a client’s internal control system?
A. The effectiveness of procedures depends on the segregation of employee duties.
B. Procedures are designed to assure the execution and recording of transactions in accordance with
management’s authorization.
C. In the performance of most control procedures, there are possibilities of errors arising from mistakes
in judgment.
D. Procedures for handling large numbers of transactions are processed by information technology (IT)
equipment.

26. Which of the following conditions supports strong internal control?

A. Strict monitoring by the Bureau of Internal Revenue.
B. The existence of related parties and related party transactions.
C. Pressure by the financial community to improve earnings performance.
D. An economic downturn.

PROBLEM 4: RISK BASED AUDIT PLANNING

1. Which of the following regarding audit is a concept statement?

A. The auditor should use professional judgment to assess audit risk and to design audit procedures to
ensure it is reduced to an acceptably high level.

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 B. Audit risk is the risk that the auditor gives an appropriate audit opinion when the financial statements
are materially misstated.
C. The subsequent discovery that a material misstatement exists in the financial statements is evidence
of inadequate planning, performance, or judgment.
D. The auditor should obtain an understanding of the accounting and internal control systems sufficient to
plan the audit and develop an effective audit approach.

2. Inherent risk and control risk differ from detection risk in that they
A. Arise from the misapplication of auditing procedures.
B. May be assessed in either quantitative or nonquantitative terms.
C. Exist independently of the financial statement audit.
D. Can be changed at the auditor’s discretion.

3. Which of the following is an incorrect statement?

A. Detection risk is a function of the effectiveness of an auditing procedure and its application.
B. Detection risk arises partly from uncertainties that exist when the auditor does not examine 100 percent
of the population.
C. Detection risk arises partly because of other uncertainties that exist even if the auditor were to examine
100 percent of the population.
D. Detection risk exists independently of the audit of the financial statements and cannot be changed at
the auditor’s discretion.

4. The relationship between acceptable level of detection risk and the combined level of inherent control risk
is
A. Direct
B. Inverse
C. Parallel
D. Independent

5. Which of the following statements is true?

A. If control risk is assessed at the maximum, the nature of related substantive tests should be changed
from more to less effective.
B. If control risk is assessed at the maximum, the nature of related substantive tests should be changed
from less to more effective.
C. If control risk is assessed at the maximum, the timing of related substantive tests should be changed
from year-end to an interim date.
D. If control risk is assessed at the maximum, the extend of related substantive tests should be changed
from a larger to a smaller sample.

6. Which of the following procedures would an auditor most likely perform in planning a financial statement
audit?
A. Inquiring of the client’s legal counsel concerning pending litigation.
B. Comparing the financial statements to anticipated results.
C. Examining computer generated exceptions reports to verify the effectiveness of internal controls.
D. Searching for unauthorized transactions that may aid in detecting unrecorded liabilities.

7. Analytical procedures used in planning an audit should focus on

A. Reducing the scope of tests of controls and substantive tests.
B. Providing assurance that potential material misstatements will be identified.
C. Enhancing the auditor’s understanding of the client’s business.
D. Assessing the adequacy of the available evidential matter.

8. Which of the following shall not be undertaken during the audit planning?
A. Inquiry of the client legal counsel regarding their assessment of the possible outcome of a pending
litigation test.
B. Analytic procedures in the form of financial analysis to enhance understanding about the client’s
financial condition.
C. Walk-through procedures to confirm understanding of the client’s policies and procedures in customer
order processing.
D. Observation of the performance of policies and procedures in receiving and inspecting merchandise
deliveries from suppliers.

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 9. In rendering a preliminary financial ratio analysis on Atom Inc.’s financials you have observed that the
client’s accounts receivable turn-over ratio decreased from 10 times last year (based on audited financial
statement) to 6 times this year (based on unaudited figures). Which of the following is correct regarding
the implication in your audit plan?
A. Accounts receivables may be materially misstated thus the auditor should issue a qualified opinion due
to departure from PFRS.
B. Account receivables are materially misstated thus the auditor should issue an adverse opinion due to
material and pervasive departure from PFRS.
C. The auditor increases his assessment of inherent risk in the financial statement thus shall plan to do
extensive substantive analytical procedures.
D. The auditor increases his assessment of risk of misstatement in the financial statement thus shall plan
to render test of details at year-end.

10. To obtain an understanding of the client’s internal control over its revenue/ receipt transactions, an audit
staff was assigned to do inquiries with the department’s involved ( Sales Department, for order processing;
Credit Department, for credit authorization; Warehouse for determining the availability of
goods, Shipping, for the preparation and the actual shipment of goods, and; Billing Department, for the
invoice preparation). Which of the following shall be rendered next?
A. Assessment of control risk at below the maximum level if the staff is satisfied that the design, operation
and effectiveness of internal control can reasonably detect/prevent potential misstatement in the
financial statements.
B. Assessment of control risk at the maximum level if the design and operations of the internal controls
are inappropriate to detect or prevent potential misstatement in the financial statements.
C. Confirm his understanding of the internal control through inspection of documents and/or observation
of the performance of policies and procedures.
D. Test the effectiveness of the controls as to consistency of their application.

11. After obtaining and understanding of the Atom Inc.’s internal control policies and procedure over its
purchasing and disbursements transactions, the auditor was satisfied regarding the internal control’s
potential reliability. Which of the following shall be rendered next?
A. Test the effectiveness of the internal control in terms of their consistent application by extending the
analytical procedures done during audit planning.
B. Sending confirmation letters to suppliers to confirm their agreements with Atom Inc.’s reported balance.
C. Examine the consistency of the application of the control by inspecting documents where control
performance are documented.
D. Render purchases cut-off to ascertain whether purchases where recorded in the correct period.

12. After the audit planning procedures, your audit team decided to place the preliminary audit risk at a high
level. Which of the following is correct?
A. The risk the planned further audit procedures will not be able to detect misstatement should be
increased.
B. The audit materially levels should be decreased.
C. The auditors should plan extensive substantive testing through analytical procedures.
D. The auditors should plan set the timing of its extensive compliance testing at year-end.

PROBLEM 5: SUBSTANTIVE TESTING

1. Tests to determine whether the accounting transactions have been properly authorized, correctly recorded
and summarized in the journals, and correctly posted to subsidiary ledgers and the general ledger are:
A. Test of control C. Substantive test of balances
B. Substantive tests of transactions D. Analytical procedures.

2. The primary emphasis in most test of details of balances is on the:

A. Balance sheet accounts C. Cash flow statement accounts
B. Income statements accounts D. All of these

3. As required by PSA 500, the auditor’s substantive procedures should include the following:
A. Agreeing the financial statements to the underlying accounting records.
B. Examining material journal entries and other adjustments made during the course of preparing the
financial statements.
C. Both a and b

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 D. Neither a nor b

4. Ultimately, what is sufficient appropriate audit evidence depends on:

A. The users of the financial statements under audit.
B. The professional judgment of the client’s management and those charged with governance.
C. The professional judgment of the auditor.
D. A combination of the professional judgments of the auditor and the client’s management.

5. S1 A given set of audit procedures may provide audit evidence that is relevant to certain assertions, but
not to others.
S2The auditor often obtains audit evidence from different sources or of a different nature that is relevant
to the same assertion.
S3 Obtaining audit evidence relating to a particular assertion (for example, existence) is a substitute for
obtaining audit evidence regarding another assertion (such as ownership rights)
A. False, true, true C. True, true, false
B. True, false, true D. False, False, False

6. Which of the following statements on reliability is incorrect? Audit evidence is…

A. More reliable when it exists in documentary form as compared evidence consisting of oral
representations from the client.
B. More reliable when obtained directly by the auditor as compared to audit evidence obtained indirectly
(second-hand knowledge) or by inference.
C. More reliable when it is obtained from independent sources outside the
entity as compared to audit evidence obtained from within the entity.
D. Internally under conditions of good internal control does not meet the required appropriateness of
evidence mentioned in PSA 500.

7. Which of the following audit procedures is used extensively throughout the audit but does not, by itself,
provide sufficient appropriate evidence?
A. Inspection of records or documents C. Inquiry
B. Observation D. Inspection of tangible assets.

8. Physical examination of tangible assets is not a sufficient form of evidence when the auditor wants to
determine the:
A. Existence of the asset C. Condition or quality of the asset
B. Quantity & description of the asset D. Ownership of the asset.

9. Confirmation is the process of obtaining a representation of information or of an existing condition directly

from a third party. Traditionally, confirmations are used to verify:
A. Usual transactions between organizations, such as sales transactions
B. Asset additions
C. balances and accounts receivable.
D. None of the above.

10. Confirmation is most likely to be the relevant form of evidence with regard to assertions about accounts
receivable when the auditor has concerns about the receivables’
A. Valuation B. Classification C. Existence D. Completeness

11. Who signs the confirmation request letter prior to sending the same to the recipient?
A. The appropriate level of management
B. The audit partner
C. The CEO/CFO of the client
D. Both management and the auditor

12. A confirmation request letter should always be sent under the control of:
A. The client B. the auditor C. the recipient D. both a and b

13. Negative confirmation requests may be used when:

A. The assessed level of inherent and control risks are HIGH
B. A large number of small balances is involved
C. A substantial number of errors is expected.

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 D. The auditor has reason to believe that respondents will disregard negative confirmation request.

14. When the recipient has accomplished the confirmation request, replies should be:
A. Sent directly to the auditor
B. Sent directly to the client, after which the client gives the replies to the auditor.
C. Sent directly to the auditor, with another copy of the reply going to the client.
D. Not sent back since the confirmation request does not necessitate replies.

15. Where no response is received to a positive confirmation request, the auditor should
A. Contact the recipient to elicit a response; and perform alternative procedures as necessary.
B. Issue a qualified opinion or an adverse opinion, depending on the materiality involved.
C. Issue a qualified opinion or a disclaimer of opinion on grounds of a scope limitation.
D. Contact the recipient/respondent in order to force a response from such recipient.

16. Which of the following types of procedures will aid the auditor in obtaining evidence regarding the
mathematical accuracy of accounting records and other information?
A. Observation C. Hearsay
B. Recalculation D. Query

17. It means an approximation of the amount of an item in the absence of a precise means of measurement.
A. Accounting estimate
B. Accounting policy
C. Accounting error
D. Accounting change

18. The auditor should adopt one or a combination of the following approaches in the audit of an accounting
estimate:
I. Review and test the process used by management to develop the estimate.
II. Use an independent estimate for comparison with that prepared by management.
III. Review subsequent events which confirm the estimate made.
A. Any of the above
B. None of the above
C. Either I or II
D. I only

19. In evaluating the assumptions on which the estimate is based, the auditor would need to pay particular
attention to assumptions which are:
A. Reasonable in light of actual results in prior periods.
B. Consistent with those used for other accounting estimates.
C. Consistent with management’s plans which appears appropriate.
D. Subjective or susceptible to material misstatement.

20. It means the analysis of significant ratios and trends including the resulting investigation of fluctuations
and relationships that are inconsistent with other relevant information or which deviate from predicted
amounts.
A. Analytical procedures
B. Substantive procedures
C. Tests of controls
D. Audit sampling

21. Analytical procedures are used for the following purposes, except:
A. To assist the auditor in planning the nature, timing and extent of other audit procedures.
B. As a test performed to obtain audit evidence about the suitability of design and effective operation of
the accounting and internal control systems.
C. As substantive procedures when their use can be more effective or efficient than test of details in
reducing detection risk for specific financial statement assertions.
D. As an overall review of the financial statements in the final review stage of the audit.

22. Analytical procedures enable the auditor to predict the balance or quantity of an item under audit.
Information to develop this estimate can be obtained from all of the following, except
A. Comparison of financial data for data for comparable prior periods, anticipated results (e. g., budgets
and forecasts), and similar data for the industry in which the entity operates.

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 B. Study of the relationships of elements of financial data that would be expected to conform to a
predictable pattern based upon the entity’s experience.
C. Study of the relationships of financial data with relevant nonfinancial data.
D. Tracing transactions through the system to determine whether procedures are being applied as
prescribed.

23. Analytical procedures used as a substantive procedure focus on

A. Understanding the business and in identifying areas of potential risk.
B. Detecting material misstatements in the financial statements.
C. Obtaining audit evidence about the suitability of design and effective operation on the accounting and
internal control systems.
D. whether the financial statements as a whole are consistent with the auditor’s knowledge of the business.

24. Which of the following statements concerning analytical procedures is true?

A. Analytical procedures may be omitted entirely for some financial statement audits.
B. Analytical procedures used in planning the audit should not use nonfinancial information.
C. Analytical procedures usually are effective and efficient for tests of controls.
D. Analytical procedures alone may provide the appropriate level of assurance for some assertions.

25. The application of analytical procedures is based on the expectation that relationships among data exist and
continue in the absence of known conditions to the contrary. Which of the following items tend to be the
most predictable for the purposes of analytical procedures applied as substantive tests?
A. Relationships involving balance sheet accounts.
B. Transactions subject to management discretion.
C. Relationships involving income statement accounts.
D. Data subject to audit testing in the prior year.

26. Analytical procedures performed in the overall review stage of an audit suggest that several accounts have
unexpected relationships. The results of these procedures most likely indicate that
A. Irregularities exist among the relevant account balances.
B. Internal control activities are not operating effectively.
C. Additional tests of details are required.
D. The communication with the audit committee should be revised.

27. As a result of analytical procedures, the independent auditor determines that the gross profit percentage
has declined from 30% in the preceding year to 20% in the current year. The auditor should
A. Document’s management intentions with respect to plans for reversing this trend.
B. Evaluate management’s performance in causing this decline.
C. Require footnote disclosure.
D. Consider the possibility of a misstatement in the financial statements.

28. An auditor’s decision either to apply analytical procedures as substantive tests or to perform tests of
transactions ad account balances usually is determined by the
A. Availability of data aggregated at a high level.
B. Relative effectiveness and efficiency of the tests.
C. Timing of tests performed after the balance sheet data.
D. Auditor’s familiarity with industry trends.

29. An auditor’s preliminary analysis of accounts receivable turnover revealed the following rates:
2015_________________2014_____________2013
4.3 6.2 7.3

Which of the following is the most likely cause if the decrease in the accounts receivable turnover?
A. Increase in the cash discount offered
B. Liberalization of credit policy
C. Shortening of due date terms
D. Increased cash sales

30. Auditor’s sometimes use comparison of ratios as audit evidence. For example, an unexplained decrease in
the ratio of gross profit to sales suggests which of the following possibilities?
A. Unrecorded purchases
B. Unrecorded sales
C. Merchandise purchases being charged to selling and general expenses

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 D. Fictitious sales

31. If accounts receivable turnover is 7.1 times in 2003 as compared to only 5.6 times in 2004. It is possible
that there were
A. Unrecorded credit sales in 2004.
B. Unrecorded cash receipts in 2003.
C. More thorough credit investigations made by the company late in 2003.
D. Fictitious sales in 2004.

32. Analytical procedures used in the overall review stage of an audit generally include
A. Considering unusual or unexpected account balances that were not previously identified.
B. Performing tests of transactions to corroborate management’s financial statement assertion.
C. Gathering evidence concerning account balances that have not changed from the prior year.
D. Retesting controls that appeared to be ineffective during the assessment of control risk.

33. The investigation of unusual fluctuations and relationships ordinarily begins with
A. Identification significant fluctuations or relationships that are inconsistent with other relevant
information or that deviate from predictive amounts.
B. Inquiries of management.
C. Comparing management’s responses with the auditor’s knowledge of the business and other evidence
obtained during the course of the audit.
D. Consideration of the need to apply other audit procedures.

PROBLEM 6: AUDIT REPORT

1. The following circumstances result in a modified but unqualified report, except:

A. Inconsistent application of accounting principles.
B. Emphasis of a related party transaction that is disclosed in a footnote.
C. Lack of disclosure of a restriction on payment of dividends.
D. Other auditors perform work for which the principal auditor does not assume responsibility.

2. When there is an assessed substantial doubt about the ability of the entity to continue as a going concern
and such an information is adequately disclosed in the notes to financial statements, the auditor should
express a(an):
A. Standard unqualified opinion
B. Unqualified opinion with explanatory paragraph
C. Qualified opinion
D. Disclaimer of opinion

3. The auditor’s report contains a paragraph explaining that the entity changed from the straight line to the
declining balance method of depreciation. The auditor expressed an:
A. Adverse opinion
B. Unqualified opinion
C. Qualified opinion
D. Disclaimer of opinion

4. An auditor is confronted with an exception sufficiently material to warrant departing from the standard
wording of an unqualified report. If the exception relates to a departure from the generally accepted
accounting principles, the auditor must decide between a(an):
A. Adverse opinion and an unqualified opinion
B. Adverse opinion and a qualified opinion
C. Adverse opinion and a disclaimer of opinion
D. Disclaimer of opinion and a qualified opinion

5. If the auditor concludes that the fraud or error has a material effect on the financial statements and has not
been properly corrected in the financial statements, the auditor should issue a:
A. Unqualified opinion with explanatory paragraph.
B. Qualified or adverse opinion.
C. Qualified or disclaimer of opinion.
D. Adverse or disclaimer of opinion

6. If the auditor is precluded by the entity from obtaining evidence to evaluate whether fraud or error that
may be material to the financial statement has, or is likely to have, occurred, the auditor should issue a(an):
A. Unqualified opinion with explanatory paragraph
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 B. Qualified or adverse opinion
C. Qualified or disclaimer of opinion.
D. Adverse or disclaimer of opinion

7. Because of inadequate records the auditor is uncertain as to whether property and equipment is stated at
cost. The auditor should issue a(an):
A. Qualified opinion
B. Unqualified opinion
C. Adverse opinion
D. Standard opinion

8. In your audit of the financial statements of VIVAR CORP you were able to observe the counting of the
physical inventories as of the statement of financial position date under audit since the count was conducted
prior to the time you were initially engaged as auditors for the Company. Owing to the nature of the
company’s records, you were unable to satisfy yourself as to inventory quantities by other audit procedures.
What type of opinion is deemed appropriate in the circumstance?
A. Unqualified C. Qualified or adverse
B. Qualified or disclaimer D. Disclaimer or adverse

9. In your audit of the financial statements of LINDSAY COMPANY you failed to convince the management to
provide the proper depreciation expense. The provision for the year under audit should be at a certain
amount on the straight-line method of depreciation using annual rates of 5% for the building and 20% for
the equipment. Accordingly, fixed assets should be reduced by accumulated depreciation adjusted for the
supposed depreciation and loss for the year and accumulated deficit should have been increased by the
same amount. What type of opinion is deemed appropriate in the circumstance?
A. Unqualified C. Qualified or adverse
B. Qualified or disclaimer D. Disclaimer or adverse

10. In your audit of the financial statements of LARANANG CORP. you ascertained that the company issued
debentures of material amounts for the purpose of financing its planned plant expansion. The debenture
agreement restricts the payment of future cash dividends to earnings after December 31, 2015. This
information which you deemed necessarily be disclosed in the financial statements were failed to be
disclosed by the company in its financial statements.

A. Unqualified C. Qualified or adverse

B. Qualified or disclaimer D. Disclaimer or adverse

11. If adequate disclosure has been made by the entity regarding substantial doubt about its ability to continue
as a going concern and the auditor opted to make specific reference about the matter in his report as to the
company’s ability to continue as a going concern, the auditor should express:
A. Unqualified C. Qualified or adverse
B. Qualified or disclaimer D. Disclaimer or adverse

12. In case where an auditor observed that the accounting for a certain material item is not in conformity with
the applicable PAS and/or PFRS, and that this fact is prominently disclosed in a footnote to the financial
statements, the auditor should:
A. Unqualified C. Qualified or adverse
B. Qualified or disclaimer D. Disclaimer or adverse

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