Far Eastern University

Institute of Accounts Business and Finance

ACT1207 – Auditing and Assurance Principles in Specialized Industries

Module 1
Review of the Audit Process

Rian Ceasar P. Soliman, CPA, MBA

Basic Auditing Concepts

1. Objectives of the Audit

The main objective of an audit is to provide an independent opinion on the fairness and accuracy of
the financial statements. This includes obtaining reasonable assurance whether the financial
statements are free from material misstatements and are in accordance with the applicable financial
reporting framework and reporting on those financial statements.

2. Responsibilities of the Auditor

The auditor's primary responsibility is to obtain reasonable assurance about whether the financial
statements as a whole are free from material misstatement, whether due to fraud or error. They
perform their work following the standards of the auditing profession, which includes planning and
performing the audit to obtain sufficient, appropriate evidence.

3. Responsibilities of Management

Management is responsible for the preparation and fair presentation of the financial statements in
accordance with the applicable financial reporting framework. This includes the design,
implementation, and maintenance of internal control relevant to the preparation and fair
presentation of financial statements that are free from material misstatement.

4. Reasonable Assurance and Audit Risk

Reasonable assurance is a high but not absolute level of assurance for the correctness of the financial
statements. Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the
financial statements are materially misstated. It is composed of inherent risk, control risk, and
detection risk. The auditor aims to reduce audit risk to an acceptably low level.

5. Materiality

Materiality is a key concept in auditing. An item is considered material if its omission or misstatement
could influence the economic decisions of users taken on the basis of the financial statements.
Materiality helps the auditor to determine the nature, timing, and extent of audit procedures.

Page 1 of 11
ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

6. Professional Judgment and Professional Skepticism

Professional judgment involves the application of relevant training, knowledge, and experience in
making informed decisions about the appropriate courses of action during the audit process.
Professional skepticism is an attitude that includes a questioning mind and a critical assessment of
audit evidence. Auditors should not accept or dismiss evidence or other information outright, but
should consider the sufficiency and appropriateness of the evidence obtained in light of the
circumstances.

Audit Evidence and Documentation

1. Audit Evidence

Audit evidence refers to all the information used by the auditor in arriving at the conclusions on which
the audit opinion is based. It includes both information contained in the accounting records
underlying the financial statements and other information.

The amount of audit evidence obtained in an engagement depends on assessed risk of material
misstatements, materiality and the quantity and quality of audit evidence.
quantity= materiality , quality of evidence
2. Types of Audit Evidence

Audit evidence can come from a variety of sources such as:

• Inquiries: This involves obtaining written or oral information from the client in response to
questions from the auditor.
• Inspection: Inspection of records or documents and physical examination of assets.
• Observation: Looking at a process while it is performed by others.
• Analytical procedures: Comparing financial and non-financial data to identify relationships or
trends that are consistent or inconsistent with expectations.
• Confirmation: This involves receiving a direct written response from a third party verifying an
assertion made by management.
• Recalculation: Checking the mathematical accuracy of the records, schedules, of journal entries
and ledgers.
• Reperformance: The auditor’s independent execution of a process that is originally performed by
client personnel.

3. Audit Documentation

Audit documentation, also known as working papers, is a record of the auditor's planning, nature,
timing, extent, and results of the audit procedures performed, evidence obtained, and conclusions
reached.

Audit documentation serves various purposes:

• Assisting the engagement team to plan, perform, and review the audit work.
• Enabling the accountability of the engagement team through the documentation of the work
performed and audit evidence obtained.

Module 1 – Review of the Audit Process Page 2 of 11

ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

• Retaining a record of matters of continuing significance to future audits.

• Enabling an experienced auditor to understand the work performed, the evidence obtained, and
significant decisions made.
• Proper audit documentation should be clear, complete, and detailed enough to provide an overall
understanding of the audit and the evidence supporting the auditor's significant conclusions and
findings.

Types of audit files:

a. Permanent files – files with continuing audit significance (e.g. corporate documents such as
articles of incorporation and by laws, schedules and analysis of balance sheet items,
documentation related to internal control structures)
b. Current files – record of audit procedures, evidence and conclusions related to the current
period under audit (e.g. working trial balance, summary of adjustments, lead schedules and
supporting working papers)

Client Acceptance and Continuance

1. Client Acceptance

Before accepting a new client, an audit firm performs a process known as client acceptance. This
involves evaluating the potential client's integrity and comparing it with the firm's risk management
capabilities. Factors taken into consideration may include the potential client's business reputation,
identity, nature, location, financial soundness, and legal and compliance status. The auditor also
considers their competence and availability of resources to conduct the engagement. Finally, the
auditor shall also consider their compliance with the ethical requirements, in particular,
independence.

Communication with predecessor auditor

The successor auditor shall initiate a communication with the predecessor auditor in the process of
evaluating a new client engagement. However, the successor auditor should first obtain permission
from the prospective client before contacting the predecessor auditor. The successor auditor obtains
information that bears with the integrity of the management that will aid the auditor in deciding
whether to accept or decline the new client engagement.

2. Client Continuance

Once an audit firm has accepted a client, it must reassess its relationship with the client on an annual
basis — this is known as client continuance. The purpose is to determine whether the firm should
continue the professional relationship or if circumstances have changed such that the relationship
should be terminated.

Establishing the Terms of an Audit Engagement

The terms of an audit engagement are established to set clear expectations and understanding between
the auditor and the client. These terms are generally agreed upon during the client acceptance or

Module 1 – Review of the Audit Process Page 3 of 11

ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

continuance process. They include the objectives of the engagement, management's responsibilities, the
scope of the engagement, and the extent of the auditor's responsibilities.

The objectives of the engagement define what the audit is expected to achieve. Management's
responsibilities typically include the preparation of the financial statements and the implementation and
maintenance of internal control. The scope of the engagement outlines what will be covered during the
audit, including the period under review and any specific items or areas of focus. The auditor's
responsibilities include conducting the audit in accordance with relevant auditing standards and providing
an opinion on the financial statements.

The Engagement Letter

The engagement letter is a formal document that serves as a contract between the auditor and the client.
It confirms the auditor's acceptance of the appointment, the scope of the audit, and the form of any
reports.

Key components of an engagement letter include:

• Objective and Scope: This details the objective of the audit, the financial reporting framework to be
followed, and the expected scope of the audit.

• Management's Responsibilities: This section includes management's responsibility for the preparation
and presentation of the financial statements, the selection and application of accounting policies, the
safeguarding of the company's assets, and internal control.

• Auditor's Responsibilities: This section outlines the auditor's responsibility to express an opinion on
the financial statements based on the audit, which will be conducted in accordance with relevant
auditing standards.

• Acknowledgement of Receipt: The client should acknowledge receipt of the engagement letter,
usually by returning a signed copy of the letter to the auditor, indicating that they agree with the
terms of the engagement.

The engagement letter helps to avoid misunderstandings regarding the role of the auditor and the
expectations of the client. It sets the professional relationship on a firm footing and serves as a point of
reference throughout the audit process.

Planning the Audit Engagement

Audit planning is a vital area of the audit process, where the auditor develops an overall audit strategy
that determines the scope, timing, and direction of the audit and the detailed audit plan for the expected
nature, timing, and extent of the audit procedures. The purpose of planning includes ensuring that
appropriate attention is devoted to important areas of the audit, potential problems are identified and
resolved on a timely basis, and the audit is properly organized and managed to be performed in an
effective and efficient manner.

Module 1 – Review of the Audit Process Page 4 of 11

ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

Key steps in the audit planning process include:

1. Understanding the Client's Business and Environment: This involves gaining knowledge about the
client's industry, regulatory environment, and business operations.

2. Assessing Risks: Based on the understanding of the client and its environment, the auditor assesses
the risks of material misstatement at the financial statement and assertion levels.

3. Establishing Materiality: The auditor determines materiality for the financial statements as a whole
and, if applicable, materiality for particular classes of transactions, account balances, or disclosures.

4. Developing Audit Strategy and Audit Plan: The audit strategy sets the direction and scope for the
audit, and the audit plan details the specific procedures to be performed.

5. Consideration of Internal Controls: The auditor reviews the client's system of internal controls to
determine the extent to which they can be relied upon.

Establishing Audit Materiality

Materiality is an essential concept in auditing. It refers to the magnitude of an omission or misstatement

that, individually or in the aggregate, could reasonably be expected to influence the economic decisions
of users made on the basis of the financial statements.

Establishing materiality involves setting a threshold above which misstatements or omissions are
considered to be material. This involves judgment and is based on the auditor's understanding of the
needs of the users of the financial statements. The auditor also considers factors such as the size and
nature of the entity, the entity's financial performance, and the economic environment in which the entity
operates.

It's important to note that materiality is established for the financial statements as a whole and, if
applicable, at the level of individual account balances, classes of transactions, or disclosures. The auditor
also sets the performance materiality, which is set a level less than the materiality for the financial
statements as a whole to reduce the risk that the aggregate of uncorrected and undetected
misstatements breaches the materiality for the financial statements as a whole. Tolerable misstatement
is the application of performance materiality in a particular sampling procedure. Materiality levels guide
the planning and performance of audit procedures and the evaluation of their results.

Throughout the audit, the auditor would review the materiality level based on actual results and adjust it
as necessary.

Components of Internal Control

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) has defined internal
control as a process designed to provide reasonable assurance regarding the achievement of objectives
in the following categories: effectiveness and efficiency of operations, reliability of financial reporting, and
compliance with applicable laws and regulations. According to COSO, internal control consists of the
following five interrelated components:

Module 1 – Review of the Audit Process Page 5 of 11

ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

1. Control Environment: This represents the tone set by an organization that influences the control
consciousness of its employees. It includes factors such as integrity, ethical values, management's
operating style, delegation of authority systems, and the processes for managing and developing
people in the organization.

2. Risk Assessment: This involves a dynamic and iterative process for identifying and assessing risks to
the achievement of objectives. Management should assess risks from both external and internal
sources.

3. Control Activities: These are the actions established by policies and procedures to help ensure that
management's directives to mitigate risks to the achievement of objectives are carried out. They may
include approvals, authorizations, verifications, reconciliations, reviews of operating performance,
security of assets, and segregation of duties.

4. Information and Communication: Pertinent information should be identified, captured, and

communicated in a form and timeframe that enables people to carry out their responsibilities.
Effective communication should also occur in a broader sense, flowing down, across, and up the
organization.

5. Monitoring Activities: The entire process should be monitored, and modifications made as necessary.
This is accomplished through ongoing management activities, separate evaluations, or a combination
of the two.

Auditor's Study and Evaluation of Internal Controls

As part of an audit, auditors need to understand and evaluate a company's internal controls. This
evaluation helps determine the nature, timing, and extent of further audit procedures.

In understanding the internal control system, auditors would typically:

• Identify key controls that relate to the objectives of the audit.
• Evaluate the design of the controls to determine if they have been implemented effectively.
• Test the operating effectiveness of these controls.

If auditors find that the control environment is strong, they might decide to perform fewer substantive
tests (tests of the details of transactions and balances). However, if the controls are weak, they would
perform more substantive tests to reduce the risk that the financial statements may be materially
misstated.

In evaluating the internal controls, auditors exercise professional skepticism, considering the potential for
management override of controls and the possibility of fraud. If significant deficiencies or material
weaknesses in the internal controls are identified, auditors are required to communicate these to
management and those charged with governance.

Module 1 – Review of the Audit Process Page 6 of 11

ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

Types of Audit Tests

1. Risk Assessment Procedures:

Risk assessment procedures are procedures performed by the auditor to obtain sufficient and
appropriate evidence as the basis for identifying and assessing the risk of material misstatement.
These procedures generally involve:
• Inquiries of management and others within the entity
• Analytical procedures, which involve reviews of financial and non-financial data to identify
patterns, relationships, or discrepancies.
• Observation and inspection, such as walkthroughs of the entity’s processes
• Discussion among the engagement team.
• Other risk assessment procedures.

Risk assessment procedures are always required to be performed in every audit. However, risk
assessment procedures alone are not sufficient as the basis of the auditor’s opinion. The auditor needs
to perform further audit procedures after performing risk assessment procedures. Further audit
procedures include test of controls and substantive audit procedures.

2. Test of Controls:

Test of controls are performed to evaluate the design and operating effectiveness of an entity's
controls in preventing or detecting and correcting material misstatements at the assertion level. They
involve:
• Inquiries about and observation of the controls in operation
• Inspections of documents and reports to provide evidence about the operation of controls
• Reperformance of the control activity in certain instances.

Test of controls are performed when:

a. The auditor intends to rely on client’s internal control to reduce the amount of substantive audit
procedures.
b. Substantive procedures alone do not provide sufficient and appropriate evidence.

3. Substantive Test of Transactions:

Substantive tests of transactions are performed to detect material misstatements at the assertion
level to satisfy transactions-related audit objectives. They may involve:
• Vouching, which is selecting a sample of recorded transactions and obtaining the original source
documents to confirm the validity and appropriateness of the recording of the transactions.
• Tracing, which is selecting a sample of original source documents and ensuring the transactions
are appropriately recorded in the books and accounts.
• Recalculation to ensure the accuracy of recorded transactions.

Substantive tests are always required to be performed every audit engagement. While test of controls
and substantive test of transactions are applied to the same set of population, which are the classes
of transactions and events such as sales transactions, they have different audit objectives. The
concern of test of controls is whether the control procedure is properly implemented and is operating

Module 1 – Review of the Audit Process Page 7 of 11

ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

effectively regardless of the transaction amount. On the other hand, substantive test of transactions
is concerned about the peso misstatements, and thus the materiality of the transaction is relevant.
Some procedures satisfy the audit objectives of both test of controls and substantive audit
procedures. These procedures are referred to as dual purpose test.

4. Substantive Analytical Procedures:

Substantive analytical procedures involve evaluations of financial information made by a study of

plausible relationships among both financial and non-financial data. They may involve:
• Trend analysis, which involves reviewing changes in an account over time to identify any unusual
trends or variations
• Ratio analysis, which involves comparing relationships between different financial and non-
financial data to identify any unexpected results or anomalies.
• Reasonableness tests, which involve assessing recorded amounts using independent expectations
of what the amounts should be.
Substantive analytical procedures involve high level analysis of data and are considered to be less
reliable compared to substantive test of details (test of details of transactions and balances). Thus,
the performance of analytical procedures as a substantive test is only warranted by circumstances.
Substantive analytical procedures are performed when the risk of material misstatement is lower.

5. Test of Details of Balances:

Tests of details of balances focus on the ending balances and figures in the financial statements to
verify that they are fairly presented to satisfy balance-related audit objectives. They are usually
performed as the last step in the audit process and their extent depend on the results of the previous
types of test. They may involve:
• Confirmation, which is obtaining evidence as to the validity of an account balance by
corresponding with a third party (e.g., confirming a receivable balance with the customer)
• Cut-off tests, which involve reviewing transactions around year-end to ensure they are recorded
in the correct accounting period
• Inspection of documents and assets, such as inspecting title deeds for property to confirm
ownership and valuation.

Completing the Audit

1. Litigations and Claims:

Auditors need to evaluate whether all legal matters which could impact the financial statements are
properly disclosed. Procedures may involve:
• Inquiries of management about the existence and progress of litigations and claims.
• Reviewing minutes of board meetings for indications of potential litigation or claims.
• Reviewing legal invoices, correspondence with attorneys, and other relevant documents.
• Obtaining legal confirmation letters from the company's attorneys confirming the status of current
litigations and claims.

Module 1 – Review of the Audit Process Page 8 of 11

ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

2. Subsequent Events:

The objectives of the auditor are to obtain sufficient appropriate audit evidence about whether events
occurring between the date of the financial statements and the date of the auditor’s report that require
adjustment of, or disclosure in, the financial statements are appropriately reflected in those financial
statements; and Respond appropriately to facts that become known to the auditor after the date of the
auditor’s report, that, had they been known to the auditor at that date, may have caused the auditor to
amend the auditor’s report. Auditors should:
• Inquire of management and review available records to identify any subsequent events.
• Extend procedures such as review of post-year-end bank statements, minutes of board meetings, and
legal correspondence.
• Consider whether any identified subsequent events require adjustment to, or disclosure in, the
financial statements.

3. Going Concern:

Auditors need to evaluate whether there is substantial doubt about the entity's ability to continue as a
going concern for a reasonable period (generally one year from the date of the financial statements). This
can involve:
• Evaluating management's plans to mitigate going concern risk, such as plans to reduce expenditures,
raise financing, or sell assets.
• Evaluating the feasibility of the plans and whether they will mitigate the going concern risk.
• Assessing whether any material uncertainties related to going concern are adequately disclosed.

4. Presentation and Disclosure, Including Fair Value Estimates:

Auditors review the presentation and disclosures in the financial statements to ensure they are in
accordance with the applicable financial reporting framework. For fair value estimates, auditors:
• Evaluate whether the methods used for making fair value measurements are appropriate and
consistently applied.
• Test the inputs and assess the assumptions used in the fair value measurements.
• Evaluate the adequacy of disclosure of fair value measurements in the financial statements.

5. Final Analytical Review:

As part of the overall review of the financial statements, auditors perform final analytical procedures to
confirm or dispel doubts about significant matters. This can include:
• Reviewing financial and non-financial information for inconsistencies with the auditor's
understanding of the entity.
• Investigating any unusual or unexpected relationships identified.

6. Management Representation Letter:

This is a letter provided by management confirming certain matters or supporting other audit evidence.
It can include confirmations regarding:
• Management's responsibility for the financial statements.

Module 1 – Review of the Audit Process Page 9 of 11

ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

• Completeness of information provided to the auditors.

• Occurrence of subsequent events.
• Absence of unrecorded liabilities.

Management representation letter is dated as of the same date of the auditor’s report and signed by the
appropriate officers of the client – one with overall responsibility for the entity (e.g. Chairman of the Board
and/or the President/CEO) and another responsible for its financial aspects (e.g. CFO/VP for
Finance/Treasurer).

Audit Reporting

Audit reporting is the final stage of the audit process, culminating in the auditor expressing an opinion on
the fairness of the entity's financial statements. The audit report communicates the outcome of the audit
and provides valuable information to stakeholders, such as investors, creditors, and regulators.

Forming an Opinion

The auditor forms an opinion on the financial statements based on an evaluation of the conclusions drawn
from the audit evidence obtained. The opinion reflects whether the financial statements present a true
and fair view (or are presented fairly, in all material respects) in accordance with the applicable financial
reporting framework.

Basic Sections of a Standard Unmodified Audit Report

• Title: Should indicate that it's an Independent Auditor's Report to clearly communicate the
independent role of the auditor.
• Addressee: Typically, the report is addressed to the shareholders of the entity being audited, as they
are the principal stakeholders.
• Opinion: States the auditor's conclusion regarding the fairness of the financial statements.
• Basis for Opinion: Provides a summary of the auditor's response to assessed risks and an overview of
the scope of the audit.
• Key Audit Matters: Describes the matters that were of most significance in the audit.
• Management Responsibilities: Highlights management's responsibility for the preparation of the
financial statements.
• Auditors Responsibilities: Explains the auditor's responsibilities and the scope of the audit.
• Other Reporting Responsibility: Discusses the auditor's responsibility to report on other legal and
regulatory requirements.
• Signature: The audit report should be signed by the audit firm or the auditor.
• Address: The location where the auditor is based.
• Date of Audit Report: The date when the auditor has obtained sufficient appropriate audit evidence
to support the audit opinion.

Types of Audit Opinion

1. Unmodified or Unqualified Opinion: The financial statements present fairly, in all material respects,
the financial position of the entity.

Module 1 – Review of the Audit Process Page 10 of 11

ACT1207 – Auditing and Assurance Principles: Audit in Specialized Industries

2. Qualified Opinion: Except for the effects of the matter(s) to which the qualification relates, the
financial statements present fairly, in all material respects, the financial position of the entity.
3. Adverse Opinion: The financial statements do not present fairly the financial position of the entity.
4. Disclaimer of Opinion: The auditor does not express an opinion on the financial statements due to
inability to obtain sufficient appropriate audit evidence.

Modification of Opinion

• A modification of opinion may be necessary if the auditor concludes that the financial statements are
materially misstated or if the auditor is unable to obtain sufficient appropriate audit evidence to form
an opinion.
• The auditor issues a qualified opinion when the financial statements contain material misstatements
or the auditor was unable to obtain sufficient and appropriate evidence and the effects (or possible
effects) are considered material but not pervasive.
• The auditor issues an adverse opinion when the financial statements contain material misstatements
and the effects are considered both material and pervasive.
• The auditor disclaims their opinion when the auditor is unable to obtain sufficient and appropriate
evidence and the possible effects are considered both material and pervasive.

Additional Paragraphs in Audit Report

a. Emphasis of Matter Paragraphs: These refer to a matter appropriately presented or disclosed in the
financial statements that is of such importance that it is fundamental to users' understanding of the
financial statements.
b. Other Matter Paragraphs: These refer to any matter other than those presented or disclosed in the
financial statements that, in the auditor's judgment, is relevant to users' understanding of the audit,
the auditor's responsibilities, or the auditor's report.

END

Module 1 – Review of the Audit Process Page 11 of 11