Basic Principles of Audit Theory

7/29/2019 Basic Principles of Audit Theory

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By: DAVE RITZ J. PERIA, CPA


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Auditing is a systematicprocess

by which a competent, independent

person objectively obtains and

evaluates evidence regardingassertions about economic actions

and events to ascertain the degree

of correspondence between the

assertions and established criteriaand communicating the results to

interested users.

Financial Statements

(including footnotes)

GAAP

Auditor's Report/

Other ReportsPersons who rely on

the financial reportsCreditors

Investors


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Financial Statement Audit

- conducted to determine whether the FS of anentity is presented in accordance with anidentified financial framework

Operational Audit

- is a study of an organizations unit to assessentitys performance, identify areas ofimprovement and make recommendations toimprove performance

Compliance Audit- involves a review of an organizationsprocedures to determine its compliance tospecific procedures, rules or regulations


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CPA Firms/External Auditors

-independent contractors

-are the ones who generally perform FS audit

Internal Auditors

- they usually perform operational audit

- Entitys own employees who investigate andappraise the effectiveness and efficiency ofoperations and internal controls

Government Auditors-conduct compliance audit like

COA Auditors

BIR Examiners


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to enable the auditor to express an opinion

whether the financial statements are prepared,

in all material respects, in accordance with anapplicable financial reporting framework.


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Financial Statement Assertions

Financial

Statements

EXISTENCE or

OCCURRENCE

RIGHTS andOBLIGATIONS

COMPLETENESS

VALAUATION and

ALLOCATION

PRESENTATION

and DISCLOSURE

AUDIT

EVIDENCE

AUDIT

PROCEDURE

S

AUDIT

OPINION


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Management is responsible in the fair

presentation of FS

In representing that the financial statements

are in accordance with applicable financialreporting framework, management

IMPLICITLY or EXPLICITLY makes assertions

regarding the recognition, measurement,

presentation and disclosure of the FSelements and related disclosures


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1. Assertions about CLASSES OF

TRANSACTIONS AND EVENTS for the period

under audit

2. Assertions about ACCOUNT BALANCES at theperiod end

3. Assertions about PRESENTATION AND

DISCLOSURE


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Completeness all transactions and events thatshould have been recorded have been recorded

Occurrence transactions and events that havebeen recorded have occurred ad pertain to the

entity Cut-off transactions and events have been

recorded in the correct accounting period

Accuracy amounts and other data relating to

recorded transactions and events have beenrecorded appropriately

Classification transactions and events have beenrecorded in the proper accounts


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Completeness all assets, liabilities and equityinterests that should have been recorded have beenrecorded

Existence assets, liabilities and equity interests

exist Rights and Obligations the entity holds or controls

the rights to assets, and liabilities are theobligations of the entity

Valuation and allocation assets, liabilities andequity interests are included in the financialstatements at appropriate amounts and anyresulting valuation or allocation adjustments areappropriately recorded


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Occurrence and rights and obligations disclosedevents, transactions, and other matters haveoccurred and pertain to the entity

Completeness all disclosures that should have

been included in the financial statements havebeen included

Classification and understandability financialinformation is appropriately presented and

described, and disclosures are clearly expressed Accuracy and Valuation financial and other

information are disclosed fairly and at appropriateamounts


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The auditor should select audit procedures

that enables the auditor to gather sufficient

appropriate evidence about a particular

assertion


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Inspection - involves examining records, documents ortangible assets

Observation consists of looking at a process orprocedure being performed by others

Inquiry consists of seeking information fromknowledgeable persons inside or outside the entity

Confirmation- consists of the response to an inquiry to

corroborate information contained in the accountingrecords

Computation consists of checking the arithmeticalaccuracy of source documents and accounting recordsor performing independent calculations

Analytical Procedures - consist of the analysis ofsignificant ratios and trends including the resultinginvestigation of fluctuations and relationships that areinconsistent with other relevant information or deviatefrom predicted amounts


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refers to the information obtained by the

auditor in arriving at the conclusions on

which the audit opinion is based.

comprises source documents andaccounting records underlying the FS andcorroborating information from othersources

it will either prove or disprove the validity ofmanagement assertions


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Management is responsible for preparation

and presentation of financial statements

With oversight from those charged with

governance. Audit does not relieve management or those

charged with governance of their

responsibilities


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The auditors responsibility is to form and

express an opinion on the financialstatements.


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The auditor should comply with the Code of

Professional Ethics

The auditor should conduct an audit in

accordance with Philippine Standards onAuditing

The auditor should adopt the attitude of

professional skepticism


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Professional skepticismis an auditors tendencynot to believe managements assertions without

sufficient corroboration.


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An audit conducted in accordance with PSA is

designed to provide only reasonable

assurance that the financial statement taken

as a whole are free from material

misstatements


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The use of testing.

The inherent limitations of internal control

(for example, the possibility of management

override or collusion). The fact that most audit evidence is

persuasive rather than conclusive.

Use of judgment


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ERROR refers to unintentional misstatement in financial

statements, including the omission of an amount or a

disclosure.

FRAUD refers an intentional act by one or more

individuals among management, those charged with

governance, employees, involving the use of deception to

obtain an unjust or illegal advantage.

NONCOMPLIANCE refers to acts of omission orcommission by the entity being audited, either intentional

or unintentional, which are contrary to the prevailing

laws or regulations.


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1. FRAUDULENT FINANCIAL REPORTING

or MANAGEMENT FRAUD

2. MISAPPROPRIATION OF ASSETS or

EMPLOYEE FRAUD


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FRAUDULENT FINANCIAL REPORTING or

MANAGEMENT FRAUD

- involves intentional misstatements oromissions of amounts or disclosures in thefinancial statements to deceive financialstatement users.

This may involve:

a. Manipulation, falsification or alteration ofrecords or documents

b. Misrepresentation in or intentional omissionof the effects of transactions from records ordocuments

c. Recording of transactions without substance

d. Intentional misapplication of accountingpolicies


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Involves MOTIVATION to commit it andPERCEIVED OPPORTUNITY to do so.


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When planning and performing audit procedures

and in evaluating and reporting the resultsthereof, the auditor should recognize that

fraud, error and noncompliance with laws andregulations may materially affect the financialstatements.


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MANAGEMENT- It is the responsibility of the

management to establish appropriate controls to

prevent and detect fraud, error and

noncompliance.

THOSE CHARGED WITH GOVERNANCE- It is the

responsibility of those charged with governance to

oversee management to ensure that appropriatecontrols are in place.


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The auditors responsibility is to designthe audit to obtain reasonable

assurance that the financial statementsare free from MATERIAL misstatements,whether caused by error, fraud or

noncompliance.


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Over reliance on client representations.

Lack of awareness or failure to recognize

that an observed condition may indicate a

material fraud. Lack of experience.

Personal relationships with clients.


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CONDUCTING

AN AUDIT OF

FINANCIALSTATEMENTS


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PRE-ENGAGEMENT

PROCEDURES

INTERNAL

CONTROL

CONSIDERATION

SUBSTANTIVE

PROCEDURES

COMPLETING

THE

AUDIT

AUDITPLANNING

ISSUE

REPORT


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1. Evaluate compliance with ethicalrequirements (PSA 220)

2. Evaluate continuance of relationship withexisting clients (PSA 220)

3. Establish the terms of the engagement (PSA210)


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Client selection and

retention

Communication

between predecessorand successor auditors

Engagement letters

Staff assignment

Time budget


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In making decisions whether to accept

or reject an audit engagement, thefirm should consider:

1. Its competence

2. Its independence3. Its ability to serve the client properly

4. The integrity of the prospective

clients management


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This serves as the written contractbetween the auditor and the client. Thissets forth:

a. Objective of the audit of FS

b. Management responsibility

c. Scope of the auditd. Forms or any reports or other

communication that the auditor expectsto issue

e. Limitations of the audit

f. Responsibility of the client to allow theauditor have unrestricted access towhatever information in connection withthe audit


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In addition, the auditor may alsoinclude the following items:

a. Billing arrangements

b. Expectations of receivingmanagement representation letter

c. Other arrangement like(involvement of an expert, internal

auditors and other client personnel?d. Request for the client to confirm

the terms of the engagment


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Helps ensure that appropriate attention is

devoted to important areas of the audit

Helps identify potential problems

Assists in proper assignment andcoordination of audit work

Helps ensure that the audit is conducted

effectively and efficiently


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Understand the entity and its environment

including the entitys internal control

Develop an overall audit strategy and

detailed approach (Risk, Materiality andAnalytical Procedures)

Audit Planning Documentation.


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1. Industry, regulatory and other external factors,including the applicable financial reportingframework

2. Nature of the entity, including the selection

and application of accounting policies3. Objectives and strategies and the related

business risks

4. Measurement and review of the entitysperformance

5. Internal control


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Phase 1: Understand and Document Understand the Clients Internal Control

Document the Internal Control understanding

Internal Control questionnaire

Narrative

Accounting and Control System Flowcharts

Phase 2: Assess Control Risk (Preliminary)

Phase 3: Testing and Reassessment Perform Test of Controls Audit Procedures

Re-Assess Control Risk


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Substantive Testing

Substantive Testing

Testing of Controls

More EffectiveMore Eff icient

Year-endInterim


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Audit risk (AR) is the risk (likelihood) that theauditor may unknowingly fail to modify the

opinion on financial statements that are

materially misstated (e.g., an unqualifiedopinion on misstated financial statements.)

The AUDIT RISK MODEL decomposes overall audit

risk into three components: inherent risk (IR),

control risk (CR), and detection risk (DR):AR = IR x CR x DR


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AUDIT RISK

The likelihood that

an error or fraud will occur,

and not get caught

by either the internal controls

or auditors procedures.

DETECTION RISK

The likelihood that

an error or fraud

will not be caught

by the auditors

procedures.

FinancialStatements

CONTROL RISK

The likelihood that an error

or fraud will not get caught by the

clients internal controls.

INHERENT RISK

The likelihood that,

in the absence of

internal controls,

an error or fraud

will enter the accounting

information system

AccountingInformationSystem

Internal Controls

Events,

TransactionsSubstantive

Procedures


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Using the information obtained in audit

planning and consideration of internal

control, the auditor performs test to

determine whether the entitys FS are fairly

presented in accordance with financial

reporting standards

These would involve EXAMINATION of

DOCUMENTS and EVIDENCE supporting the

amounts and disclosure in the FS


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Detection Risk and the Nature,

Timing, and Extent of AuditProcedures

Lower Detection Risk Higher Detection Risk

Nature More effective tests. Less effective tests.

Timing Testing performed at

year-end.

Testing can be performed at

Interim.

Extent More tests. Fewer tests.


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Auditevidence is all the information used by

the auditor in arriving at the conclusions on

which the audit opinion is based.


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1. Source documents and accounting records

underlying the financial statements.

2. Other corroborating information


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Sufficiency is the measure of the quantity ofaudit evidence.

Appropriateness is the measure of the

quality of audit evidence.


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The following factors should be considered

when evaluating the sufficiency of

evidence:

Competence of Audit Evidence Materiality of the amount involved

Risk of misstatement in the account


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Appropriate evidence

Must be relevant to a particularassertion; and

Must be reliable


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Relevance

Testing what you want to test (e.g., direction of

testing)

Reliability

Independence of source

Condition of internal control

How the evidence was obtained


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Review of subsequent events and

contingencies

Assessing going concern assumption

Performing overall analytical review

proceduresObtaining a written representations from the

management


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Forming a conclusions about the financial

statements.

This conclusion in the form of an opinion is

communicated to various interested users

through an AUDIT REPORT


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Auditors Report on Financial Statements

Unmodified ReportModifications to the

Opinion

Emphasis of Matter &Other MatterParagraphs


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The auditor must form judgment as to the ff.:

Consistency and appropriateness of selected and applied

accounting policies;

Reasonableness of accounting estimates;

Relevance, reliability, comparability and

understandability of information presented in the

financial statements including accounting policies; and

Provision of sufficient disclosures to enable users to

understand the effects of material transactions and

events conveyed in the financial statements.


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Materiality

Conclude whether:

Materiality remains appropriate

Uncorrected misstatements (individual or aggregate) could result

in a material misstatement

Audit Evidence Has sufficient appropriate audit evidence been obtained?

Are the accounting estimates reasonable

Did the analytical procedures performed corroborate

conclusions formed during the audit?


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4 Managements responsibility should describe the


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4. Management s responsibility should describe the

ff. managements responsibility: Preparation and fair presentation of the financial statements

in accordance with applicable financial reporting framework; Design, implementation and maintenance of internal control

5. Auditors responsibility should state the ff.: Responsibility of the auditor to express an opinion

The audit was conducted in accordance with PhilippineStandards on Auditing (PSAs)

General description of an audit

That the audit evidence obtained is sufficient and appropriate

6 Auditors opinion should state that the financial


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6. Auditor s opinion should state that the financial

statements are presented fairly in all material

respects in accordance with applicable financial

reporting framework7. Other reporting responsibilities

8. Auditors signature signed in the name of the

audit firm and/or the personal name of the auditor

9. Date of the report dated as of completion of all

essential audit procedures (last day of fieldwork)

10. Auditors address where the auditor maintains his

office


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Arises from either of the ff.:

Failure to conduct the audit in accordance

with PSA; and

Failure to prepare the financial statements inaccordance with the applicable financial

reporting framework


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S Li it ti


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Scope Limitation

May arise when:

The auditor is unable to perform necessary audit procedures; or

The auditor is unable to obtain sufficient appropriate evidenceabout an assertion

May be imposed by:

Client Circumstances beyond the control of the entity

Circumstances relating to the nature or timing of the auditors

work

Management


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CHAPTER CONTENT:

Guidance on how to express anappropriately modified opinion onfinancial statements when necessary.


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Pervasive effects on the financialstatements that in the auditors judgment:

i. Are not confined to specific

elements, accounts or items of the FSii. If so confined, represent or could

represent substantial proportion ofthe FS

iii. In relation to disclosures, arefundamental to users understanding

of the FS


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i. Misstatements that the auditor

has accumulated during the

audit and that have not been

corrected.


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i. A qualified opinion

ii. An adverse opinion

iii. A disclaimer of opinion


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FS are not free from material statement

The auditor is unable to obtain sufficient

appropriate evidence


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Obtained sufficient appropriate audit

evidence

Concludes that there is misstatements,individually or in aggregate

Misstatements are both material and

pervasive to FS


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unable to obtain sufficient appropriate

evidence on which to base the opinion

the possible effects on the FS of

undetected misstatements, if any, couldbe both material and pervasive


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MODIFICATION TO THE OPINION

Material Misstatements Scope Limitations

Materialbut not

Pervasive

Materialand

Pervasive

QualifiedOpinion

AdverseOpinion

Materialbut not

Pervasive

Materialand

Pervasive

QualifiedOpinion

DisclaimerOf Opinion


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In our opinion, because of thesignificance of the matter discussed

in the Basis for Adverse Opinion

Paragraph the FS do not presentfairly


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Basic Principles of Audit Theory

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