Audits of Financial

Statements: An
Introduction
CHAPTER 2
Economics decisions and the need for
reliable information
1. An investor is deciding whether to buy, hold, or sell shares of stock
2. A bank loan officer is faced with several outstanding loan applications, and is
trying to determine which loan to approve
3. Employees are checking whether they should stay with the company or try to
find another job
4. Government agencies are testing enterprises for compliance with legal,
regulatory and reporting requirements
Auditing defined

 Auditing is “a systematic process of objectively obtaining and evaluating

evidence regarding assertions about economic actins and events to ascertain the
degree of correspondence between these assertions and established criteria and
communicating the results to interested users”.
Auditing defined

 Auditing encompasses two processes:

1. Investigative process - involves the systematic gathering and evaluation of evidence
as a basis for determining whether assertions or representations made by a
responsible person in company’s financial statements, correspond with the established
financial reporting criteria such as generally accepted accounting principles (GAAP).
2. Reporting process – involves communicating an evaluation or opinion in an audit
report to interested users.
Key phrases in the definition of audits

 A systematic process - an audit follows a logical sequence of procedures

 Objectively obtaining and evaluating evidence – it means a combination of

impartiality, intellectual honesty and a freedom from conflicts of interest.
 An audit requires the gathering and evaluation of evidence, which may come in the
form of oral representations, written document, electronic media, etc.
 A CPA cannot express an opinion without supporting evidence to back up the opinion.
Key phrases in the definition of audits

 Assertions about economic actions and events – assertions are representations of

management, explicit or otherwise, that are embodied in financial statement
components, records, or systems. The CPA’s job is to obtain and evaluate
evidence, which may support, or contradict, the assertions of management.

 Degree of correspondence between these assertions and established criteria –

auditors use standards or benchmarks (criteria) for purposes of expressing an
opinion on the assertions of management. In the case of audits of financial
statements the established criteria are generally accepted accounting principles.
Key phrases in the definition of audits

 Communicating the results to interested – after the audit has been completed, a
CPA prepares a report which contains, in writing , the opinion (or disclaimer of
opinion)of the CPA. In financial statement of audits, the opinion is on the fairness
of the presentation of financial statements for the period under audit.
Auditing and Accounting Distinguished

 Accounting is to provide financial information which is quantitative in nature to help management

in decision making. To be able to provide relevant quantitative and financial information,
accountants must have a thorough understanding of the principles and rules to make sure that the
entity’s economic events are properly recorded on a timely basis and at a reasonable cost.
 Auditing is concerned with the determination of whether the recorded accounting information for
the entity properly reflects the economic events that occurred during the accounting period. An
auditor must possess, not only an understanding of the accounting rules, but also an expertise in the
accumulation and interpretation of audit evidence. The skill is the major characteristic that
distinguished auditors from accountants.
Audit services and Assurance services
Distinguished
 Accounting is to provide financial information which is quantitative in nature to help management
in decision making. To be able to provide relevant quantitative and financial information,
accountants must have a thorough understanding of the principles and rules to make sure that the
entity’s economic events are properly recorded on a timely basis and at a reasonable cost.
 Auditing is concerned with the determination of whether the recorded accounting information for
the entity properly reflects the economic events that occurred during the accounting period. An
auditor must possess, not only an understanding of the accounting rules, but also an expertise in the
accumulation and interpretation of audit evidence. The skill is the major characteristic that
distinguished auditors from accountants.
Audit services and Assurance services
Distinguished
 Assurance services encompass assertion-based engagements.
 Assurance services is one where a professional accountant will evaluate a subject matter that is the
responsibility of another party against suitable criteria, and expresses an opinion which provides the
intended users with a level of assurance about that particular subject matter.
 In other words, it is an engagement to express an opinion giving assurance to users of such reports
on information which is the responsibility of others.
 Both assurance and assertion-based engagements encompass audits.
 Reliability, Credibility
Relevance, Timeliness

ASSURANCE ENGAGEMENTS
Realibility, credibility Broadest concept

ATTESTATION
ENGAGEMENTS DIRECT
ENGAGEMENTS
FS
AUDITS

Narrowest
concept
Types of Audit

 Financial Statement Audits – this refers to the gathering of evidence on the

assertions embodied in the financial statements of an entity and using the
evidence to determine whether the assertions adhere to generally accepted
accounting principles (GAAP) or another comprehensive and authoritative
financial reporting framework
 This type of audit requires a Certified Public Accountant.
Types of Audit

 Operational audit – involve a systematic review of an organization’s activities in

relation to specified objectives for the purposes of assessing performance (the
efficiency, effectiveness and economy of operations), identifying opportunities for
improvement, and developing recommendations for improvement or further
action.
 Operation audit is a future-oriented systematic, and independent evaluation of
organizational activities.
 In operational audit financial data may be used, but the primary sources of
evidence are the operational policies and achievements related to organizational
objectives.
Types of Audit

 Compliance audits – is used to determine whether a person or entity has adhered

to laws and regulations.
 Results of compliance audits are generally reported to a specific user within the
organization.
 Examples include audits conducted to determine whether violations of labor laws
have occurred and audits performed by government auditors to determine
adherence to rules and regulations currently in force.
Types of Audit

 External Audits – performed by CPAs who are independent of the organizations

whose assertions are being audited.
 These CPAs are also known as independent auditors or external auditors.
 The audits performed by external auditors comprise mainly of financial statement
audits, though compliance audits and operation audits may also by performed by
them.
Types of Audit

 Internal Audits – is an independent appraisal function established within an

organization to examine and evaluate its activities as a service to the organization.
 The internal auditing staff often reports to the audit committee of the board of
directors, and also to the president or other high executive.
 Internal auditors are not independent as external auditors since the former are
employees of the organization.
 Internal audits comprise mainly of operational audits and compliance audits.
Types of Audit

 Government audits involves the determination of whether government funds are being
handled properly and in compliance with existing laws and whether the government
programs of a particular agency are being conducted efficiently and economically.
 The Commission on Audit is recognized as the Supreme Audit Institution in the
Republic of the Philippines.
Types of Audit
 Government audit (or State Audit) has been classified into three main divisions:
1. Compliance audit – the examination, audit and settlement in accordance with laws and regulations.
2. Financial audit – audit of the accounting and financial system and controls to ensure reliability of recorded
financial audit.
3. Performance audit – an objective examination of the financial and operational performance of an
organization, program, activity or function and is oriented towards opportunities for greater economy,
efficiency and effectiveness.
a. Economy and efficiency audit - also known as management audit. This is the appraisal of
management performance from a least cost point of view and the analysis of the cost-benefit
relationship.
b. Effectiveness audit - also known as program results audit. This is the evaluation of programs, projects
and activities to determine the extent of achievement of previously set goals and objectives.
The objective and scope of a financial
statement audit
 Objectives
The objective of an audit of financial statements is the expression of an opinion on the fairness of
such financial statements.
The auditor’s report is the medium through which he expresses his opinion or, if circumstances
require, disclaims an opinion.
In either case, he states his examination has been made in accordance with Philippine Standards on
Auditing or PSAs.
PSAs require the auditor to state whether in his/her opinion, the financial statements are presented
in conformity with generally accepted accounting principles.
The objective and scope of a financial
statement audit
 Scope
The auditor normally determines the scope of an audit in accordance with the requirements of
legislation, regulations or relevant professional bodies.
In the observance of PSAs, the auditor must exercise his judgement in determining which auditing
procedures are necessary in the circumstances to afford a reasonable basis for his opinion.
His judgment is required to be the informed judgment of a qualified professional person.
The audit should be organized to cover adequately all aspects of the entity as far as they are
relevant to the financial statements being audited.
Information Risk

 The risk that information is misstated or misleading is known as information risk.

Several factors contribute to the existence of information risk, including the
following:
1. Remoteness of information users from information provider. Decision makers in
most cases, do not get first hand knowledge about the business enterprise with
which they do business because in many cases owners are different from
management , and they are not involved in day-to-day operations or decisions.
Information Risk

 The risk that information is misstated or misleading is known as information risk.

Several factors contribute to the existence of information risk, including the
following:
2. Potential bias and motives of information provider. A conflict of interest may be
assumed to exist between management (the information provider) and
information users (decision makers) regarding the financial statements.
Information may be biased in favor of the provider when his goals are
inconsistent with the decision maker.
Information Risk
 The risk that information is misstated or misleading is known as information risk. Several factors
contribute to the existence of information risk, including the following:
3. Voluminous data. As business grow, a large number of exchange transactions are processed
daily. This increases the likelihood that errors may occur in recording and reporting these
transactions.

4. Complex exchange transactions. New and complicated business relationships and transactions
may lead to innovative accounting and reporting problems. Certain transactions are so complex
and therefore more difficult to record properly.
Reducing Information Risk
 To reduce risk, management of businesses and the users of their financial statements may adopt
any or all of the following approaches:
1. Allow users to verify information. The user may go to the business establishment to examine
records and obtain information about the reliability of the statement.
A major problem with this option is that not all users of financial statements are professionally
competent to verify the information presented in the financial statements.
in addition, most financial statement users cannot directly assess the quality of information
due to time and distance constraint.
Reducing Information Risk
 To reduce risk, management of businesses and the users of their financial statements may adopt
any or all of the following approaches:
2. User shares information risk with management. Management has the primary responsibility of
providing reliable information to users.
If users rely on inaccurate financial statements and as a consequence incurs a financial loss,
a lawsuit may be brought against management to recover part of such loss.
Reducing Information Risk
 To reduce risk, management of businesses and the users of their financial statements may adopt
any or all of the following approaches:
3. Have the financial statements audited. To obtain reliable information, the user can have an
independent audit performed.
An independent auditor’s opinion provides both internal and external users with input to
making a reasoned, logical, and informed decisions about a variety of financial matters, including
a company’s earnings performance, financial position, liquidity position, managerial
performance, and economic vulnerability.
Financial statement audits act as deterrent to inefficiency and fraud.
The Audit Report
 Provides reasonable assurance that the financial statements are fairly stated.
 Uniform in format
 Suitably titled to avoid confusion regarding the level of assurance being provided

Assignment: Submit a company’s audited financial report for the year 2018-2019.
Limitations of an audit

 An audit is not a guarantee of the exactness of accuracy of assertions in the

financial statements.
 An audit is undertaken to enhance the degree of confidence of intended users in
the financial statements.
 Based on the conclusion drawn from the audit evidence obtained, the auditor
expresses an opinion on the financial statements.
 An audit is not intended to and cannot, provide a guarantee or absolute assurance
that the financial statements are free from material misstatement due to fraud or
error.
Limitations of an audit

 This is because there are inherent limitations of an audit arising from:

 The nature of financial reporting
 The nature of audit procedures
 The need for the audit to be conducted within a reasonable period of time and at a reasonable cost.
 Limited scope and objective which deal with the expression of an opinion on the FS
 The auditor does not express an opinion on such matters as
 the future viability of the entity
 the efficiency or effectiveness with which management has conducted the affairs of the entity
 The extent of compliance with all laws and regulation that may be applicable to the entity
Responsibilities of management and those charged
with governance for the FS
 Management is responsible for the preparation and fair presentation of the FS in
accordance with PFRSs
 Internal control as management determines is necessary to enable the preparation
of FS that are free from material misstatement, whether due to fraud or error
 In preparing the financial statements, management is responsible for assessing the
company’s ability to continue as a going concern,
 Those charged with governance are responsible for overseeing the company’s
financial reporting process
Auditor’s responsibilities for the audit of the FS

 To obtain reasonable assurance that the FS are free from material misstatement
(fraud and error)
 Material misstatement are material if they could reasonably expected to influence
the economic decisions of users taken on the basis of these FS
 Issue an auditor’s report that include their opinion
 Exercise professional judgment and maintain professional skepticism throughout
the audit
Auditor’s responsibilities for the audit of the FS

 Identify and assess the risks of material misstatement of the FS whether due to
fraud or error
 Design and perform audit procedures responsive to those risks
 Obtain audit evidence sufficient and appropriate to provide a basis and to provide
a basis for their opinion
 Obtain an understanding of internal control relevant to the audit in order to design
audit procedure for the purpose of expressing an opinion but not for the purpose
of opinion on the effectiveness of the company’s internal control.
Auditor’s responsibilities for the audit of the FS

 Evaluate the appropriateness of accounting policies used and the reasonableness of accounting
estimates and related disclosures made by management.
 Conclude on the appropriateness of management’s use of the going concern basis of
accounting, based on the audit evidence obtained, whether a material uncertainty exists related
to events or conditions that may cast significant doubt on the Company’s ability to continue as
a going concern.
 Evaluate the overall presentation, structure and content of the financial statements, including
the disclosures, and whether the financial statements represent the underlying transactions and
events in a manner that achieves fair presentation.
Auditing Today

 Audit firms adopted what is generally called a “risk-based approach”.

 This approach involves a particular way of determining the nature, timing and
extent of audit procedures.
 Risk based audits are the standard audit engagements performed today.
Assignment

1.US companies involved in major corporate, auditing and accounting scandals.

 Example.
 Enron succeeded in hiding some important facts, such as off-book liabilities, from
banks and shareholders.
2. Off-book liabilities?