ADAMSON UNIVERSITY

COLLEGE OF BUSINESS ADMINISTRATION

ACCOUNTANCY DEPARTMENT

AUDITING & ASSURANCE CONCEPTS and APPLICATIONS 1

LECTURE GUIDE

MODULE 1 : INTRODUCTION

1. AUDITING defined
a. The on-site verification activity, such as inspection or examination, of a
process or quality system, to ensure compliance to requirements.
b. The audit is an intelligent and critical examination of the books of
accounts of the business.
c. Audit is performed to ascertain the validity and reliability of information.
d. Is a systematic process by which a competent, independent person objectively obtains and
evaluates evidence regarding assertions about economic actions and events to ascertain the
degree of correspondence between those assertions and established criteria and
communicating the results to interested users.

2. OVERALL OBJECTIVE OF THE INDEPENDENT AUDITOR

 The objective of an audit of financial statements is to enable the auditor to express an opinion
whether the financial statements are prepared, in all material respects, in accordance with an
applicable financial reporting framework.
o To obtain reasonable assurance about whether the financial
statements as a whole are free from material misstatement.
o To report on the financial statements and communicate as required by the PSAs, in
accordance with the auditor’s findings.

3. PREPARATION OF FINANCIAL STATEMENTS

 The financial statement subject to audit are those of the entity, prepared and presented by
management of the entity with oversight from those charged with governance with the auditor
engaged for purposes of forming and expressing an opinion on them.

4. BASIC CONCEPTS UNDERLYING A FINANCIAL STATEMENT AUDIT

 The following concepts underlie a financial statement audit:
 Auditor’s independence
o The auditor shall comply with relevant ethical requirements –the auditor’s ability to
form an audit opinion without being affected by influences that might compromise
that opinion.

 Professional skepticism

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 o The auditor should have the attitude that includes a questioning mind and a critical
assessment of audit evidence (audit evidence that contradicts other audit evidence
obtained.

 Conduct and scope of an audit in accordance with PSAs.

o The auditor shall comply with all PSAs relevant to the audit.
o If an objective cannot be achieved, the auditor shall evaluate whether this prevents
the auditor from achieving the overall objectives of the auditor and thereby requires
the auditor to modify the auditor’s opinion or withdraw from the engagement.
o The term “scope of the audit” refers to the audit procedures deemed necessary in
the circumstances to achieve the objective of the audit.

 Audit evidence and financial statement assertions

o Audit evidence is all the information used by the auditor in arriving at the
conclusions on which the audit opinion is based and includes the information
contained in the accounting records underlying the financial statements.
o Management assertions – Auditors gather audit evidence regarding the assertions
(representations) of management.
o Management implicity or explicitly makes assertions regarding the recognition,
measurement, presentation and disclosure of the elements of financial statements
and related disclosures.

 Audit materiality
o Materiality is defined as – information is material if its omission or misstatement
could influence the economic decisions of users taken on the basis of the financial
statements.

 Professional skepticism
o It means that auditors makes a critical assessment with a questioning mind, of the
validity of audit evidence obtained and alert to audit evidence that contradicts the
reliability of documents and responses.

 Reasonable assurance
o Reasonable assurance that the financial statements taken as a whole are free from
material misstatement, whether due to fraud or error.

 Audit risk and materiality

o The auditor should plan and perform the audit to reduce audit risk to an acceptable
low level that is consistent with the objective of an audit.
o In order to reduce audit risk, the auditor should design and perform audit
procedures to obtain sufficient appropriate audit evidence to be able to draw
reasonable conclusions on which to base an audit opinion.

 Responsibility for the Financial Statement

o The auditor is responsible for forming and expressing an opinion on the financial
statements in accordance with applicable

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 financial reporting framework.
o The responsibility for the preparation and presentation of the financial statements is
that of the management of the entity, with oversight from those charged with
governance.

MODULE 2 : AUDIT PROCESS

THE RISK-BASED AUDIT PROCESS

 Is an audit approach that begins with an assessment of the types and
likelihood of misstatements in account balance and then
 Adjusts the amount and type of audit work to the likelihood of material
misstatements occurring in account balances.
 The audit team views all activities in the organization first in terms of risks to strategies and
objectives and then in terms of management’s plans and processes to mitigate the risk.

THE ACCOUNT-BASED AUDIT

 Is an approach wherein the auditor obtains an understanding of control and assesses control
risk for particular types of errors and frauds in specific accounts and cycle.

STAGES OF THE RISK-BASED AUDIT PROCESS

 Phase I : Risk Assessment – this phase involves the following activities:
 Performance of preliminary engagement activities to decide whether
to accept/continue an audit engagement
 Planning the audit to develop overall audit strategy and audit plan
 Performance of risk assessment procedures to identify/assess risk of material
misstatement through understanding the entity.

 Phase II : Risk response – this phase covers the following activities

 Designing overall responses and further audit procedures to develop appropriate
responses to the assessed risk of material misstatement.
 Implementing responses to assessed risk of material misstatement to reduce audit risk
to an acceptably low level.

 Phase III Reporting – this phase involves the following activities:

 Evaluating the audit evidence obtained to determine what additional
audit work, if any , is required.
 Forming an opinion based on audit findings and preparing the auditor’s report.

UNDERSTANDING THE AUDIT RISK MODEL

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  Risk is a concept used to express uncertainty about events and/or their
outcomes that could have a material effect on the organization.
 The four critical components of risk relevant in conducting the audit are:
 Audit risk
o the risk that an auditor may give an unqualified opinion on financial statements
that are materially misstated.

 Engagement risk
o the economic risk that a CPA firm is exposed to
o inability of the client to pay the auditor
o management is not honest and inhibits the audit process

 Financial reporting risk

o risks that relate directly to the recording of transactions and the presentation of
financial data in an organization’s financial statements.

 Business risk
o those risks that affect the operations and potential outcomes of organizational
activities.

COMPONENTS OF AUDIT RISK MODEL

The general premises have been incorporated into an audit-risk model with three components as
follows:

Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR)

 Inherent risk
 is the initial susceptibility of a transaction or accounting adjustment
to be recorded in error.
 Control risk
 is the risk that the client’s internal control system will fail to prevent
or detect a misstatement.
 Detection risk
 is the risk that the audit procedures will fail to detect a material misstatement.

CASE ILLUSTRATION #1: HIGH RISK OF MATERIAL MISSTATEMENT

A client company of BBM, CPAs has many complex transactions and weak internal control. The auditors
assess both IR and CR at their maximum. This implies that the client does not have effective control (CR)
and there is high risk
that the transactions would be recorded incorrectly (IR).
The auditors believe that engagement risk is high and have set audit risk at the 0.01 level. This means
that the auditors do not want to take much of a risk that

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the misstatement goes undetected in the financial statement.
REQUIRED:
1. Determine the rate of detection risk.
2. How does the result affects the auditor’s work ?

CASE ILLUSTRATION #2: LOW RISK OF MATERIAL MISSTATEMENT

K-POP Corporation is an audit client of LENI and BONG, CPAs. The client has simple transactions, well-
trained accounting personnel, have effective control and
no incentive to misstate the financial statement.
The auditor’s previous audit experience with the client, understanding of the client’s internal control
and the results of preliminary testing this year indicate a low risk of material misstatement existing in
the accounting records. The auditor assesse inherent risk as low as 50% and control risk of 20%. Audit
risk is consistent with its low engagement risk of 0.05.

REQUIRED:
1. What is the rate of the detection rate for this engagement ?
2. What action/s would the auditor take based on the findings ?

AUDIT PLANNING
 The objective of the auditor is to plan the audit so that it will be performed in an effective
manner

MAJOR AUDIT PLANNING ACTIVITIES

1. Obtaining an understanding of the client and its environment.

2. Assessing the possibility of non-compliance
3. Establishing materiality and assessing risk.
4. Identifying related parties
5. Performing preliminary analytical procedures
6. Determining the need for experts
7. Development of the overall audit strategy and detailed audit plan
8. Preparation of preliminary audit programs.

DISCUSSION

1. Obtaining an understanding of the client and its environment

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  The auditor should obtain an understanding of the entity and its
environment, including its internal control.
 With this understanding, it enables the auditor to identify and understand the events,
transactions and practices that, in the auditor’s judgment, may have significant effect on the
financial statements, the engagement or the
audit report.
 Sources of Understanding (EXAMPLE)
o Previous experience with the entity
o Discussion with people with the entity
o Discussion with internal audit personnel and the internal audit reports
o Discussion with other auditors and legal advisors
o Visits to the entity’s premises and plant facilities

2. Assessing the possibility of non-compliance

 non-compliance refers to acts of omission or commission by the entity being audited, either
intentional or unintentional, which are contrary
to the prevailing laws or regulations.
 The auditor should obtain a general understanding of the legal and regulatory framework
applicable to the entity and the industry and how the entity is complying with that framework.

3. Establishing materiality and assessing risk

 The auditor shall determine performance materiality for purposes of assessing the risks of
material misstatement and determining the nature, timing and extent of further audit
procedures.
 The materiality criteria often used by practicing auditors are:
o percentage effect on net income before taxes ( MOST COMMONLY USED BY PRACTICING
AUDITORS)
o percentage effect on total revenues
o percentage effect on total assets.
 Tolerable misstatement is the amount of planning materiality that is allocated to an account
balance or class of transaction.
 Most auditors agreed that combined error of less than 5% of net income is normally immaterial
and combined error of more than 10% is normally material.

4. Identifying related parties

 The auditor needs to have sufficient understanding of the entity and its environment to enable
identification of the events, transactions and practices that may result in a risk of material
misstatement regarding related parties. such as:
 Directly or indirectly in control or controlled by
 An associate of the entity
 A joint venture
 A close member of the family
 etc

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5. Performing preliminary analytical procedures
 Refers to evaluations of financial information, study of relationships among both financial and
non-financial data such as:
 Study of the changes in a given account balance.
 Comparison of financial information with anticipated results: budgets
and forecast.
 Study of the relationships between account balances or among firms in the same
industry.
 Study of the relationship of financial information with non-financial information.

6. Determining the need for experts

 The auditor is not expected to have the expertise of a person trained or qualified to engage in
the practice of another profession such as:
 Valuation of certain type of assets – work of art, precious stone, etc
 Legal opinions on interpretations of agreements, statutes and regulations.
 Determination of amounts using specialized techniques or methods, for example, an
actuarial valuation.

7. Development of the overall audit strategy and detailed audit plan

 The overall audit strategy sets the scope, timing and direction of the audit and guides the
development of the more detailed audit plan and involves the following:
 Determining the characteristics of the engagement that define its scope
 Ascertaining the reporting objectives of the engagement to plan the timing of the audit
and the nature of the communications required
 Considering the important factors that will determine the focus or direction of the
engagement team’s effort

8. Preparation of preliminary audit programs

 The most important control mechanism in an audit is the audit program.
 The program is a list of procedures (tests of controls or substantive tests) used to gather
sufficient and appropriate audit evidence.
 There are two types of audit program:
 Test of Controls Audit Program
 Also known as compliance test audit program, which is prepared when the
auditor has identified controls, which he plans to rely on.

 Substantive Test Audit Program

 Prepared regardless of the approach taken by the auditor.

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LEVELS OF AUDIT PLANNING
A. Establishment of overall audit strategy
B. Development of detailed audit plan

A. The Process of Establishing the Audit Strategy

PSA requires that the auditor establishes the overall strategy for the audit which sets:
 the scope of the audit
 the timing of the audit
 direction of the audit

The process of establishing the audit strategy involves :

 Identifying the characteristics of the engagement that define its scope, examples are:
 The financial reporting framework
 Industry specific reporting requirements
 The locations of the components of the entity

 Ascertaining the reporting objectives of the engagement to plan the timing of the audit and the
communication required such as:
 Deadlines for interim and final reporting
 Key dates and organization of meetings with management and those
charged with governance to discuss the nature and extent of audit work.
 Discussion with management regarding the expected communication on the status of
audit work throughout the engagement.

 Considering the significant factors and experience that will determine the focus and direction of
the engagement team efforts, such as
 Determination of appropriate materiality levels
 Preliminary identification of areas where there may be higher risks of
material misstatement
 Preliminary identification of material components and account balances.
 Evaluation whether the auditor may plan to obtain evidence regarding the
effectiveness of internal control
 Identification of recent significant entity specific, industry, financial reporting or other
relevant developments.

 Determine whether there are significant business developments affecting the entity, such as
 Significant industry development (change in industry regulations and new
reporting requirements)
 Significant changes in information technology and business processes, key
management, acquisition, mergers
 Significant changes in the financial reporting framework such as changes in
accounting standards

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  Significant changes in the legal environment

 Determination of the nature, timing and extent of resources required, such as :

 The resources to deploy for specific audit areas
 The amount of resources to allocate to specific audit areas
 How much resources are managed, directed and supervised
 Engagement budgeting including time allocation.

B. The Detailed Audit Plan

Once the audit strategy has been established, the auditor is able to start the development of a more
detailed audit plan to address the various matters identified in the audit strategy. The audit plan is
more detailed than the audit strategy and includes the nature, timing and extent of audit
procedures to be performed by engagement team members.

Scope of the Engagement

The auditor may consider the following matters when establishing the scope of the audit
engagement as follows:
 The financial reporting framework on which the financial information to be
audited has been prepared
 Industry-specific reporting requirements
 Expected audit coverage included
 The nature of the business segments to be audited
 The reporting currency to be used
 The need for a statutory audit of stand alone financial statements
 The availability of the work of internal auditors
 The entity’s use of service organization and how the auditor may obtain
evidence.
 The expected use of audit evidence obtained in prior audit
 The effect of information technology on the audit procedures and tests of
controls.
 The coordination of the expected coverage and timing of the audit work
 The discussion of matters that may affect the audit
 The availability of client personnel and data.

OTHER CRITICAL MATTERS IN ENGAGEMENT PLANNING

1. Application of analytical procedures in planning the audit
 Analytical procedures assist the auditor in planning the nature, timing and
extent of audit procedure.
 PSA 520 requires the auditors to perform analytical procedures as part of the planning
process for every audit.

2. Establishment of an engagement or audit team.

 The audit team consists of people with different levels of expertise and

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 experience.
 The team is composed of an engagement partner, a manager, at least one senior and
one or more staff auditors.

3. Consideration of work performed by other auditors/parties.

 Predecessor auditor
 Other CPAs
 Specialists
 Internal auditors
 Use of client’s staff

4. Assessment of going concern assumption

 PSA 570 requires auditors to evaluate whether substantial doubt exists about an entity’s
ability to continue as a going concern, based on procedures planned and performed to
obtain evidence about management assertions embodied in the financial statements.

5. Identification of related parties

 Related party is defined as an affiliated company, a principal owner of the client
company that can influence the management or operating policies of the other.
 Transactions with related parties are important to auditors because they will be
disclosed in the financial statements if they are material.

6. Client’s legal obligations

 The auditor should review:
o Minutes of director’s and stockholders’ meetings
o Changes to articles of incorporation or by-laws
o Any significant contracts executed during the year
 The auditor should be alert to the following:
o Major contracts or agreements, debt agreements, compensation
agreements
o Information on future business plans
o Authorization of dividends

7. Completion of the initial audit program

 The program which includes both substantive tests and tests of controls will enable the
auditor to express an opinion on the financial statements taken as a whole.

8. Preparation of a time budget

 Time budget is an estimate of the total hours an audit is expected to take.
 Based on the information obtained in the first major step in the audit, that is, obtaining
an understanding of the client as to:
o The client’s size (gross assets, sales, number of employees
o Location of client facilities
o The anticipated accounting and auditing problems
o The competence and experience of staff available

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 9. Assignment of personnel to the engagement
 On larger engagements, there are likely to be one or more partners and
staff at several experience levels.
 On smaller audits, they may be only one or two staff members.

10. Scheduling of work

 Audit work that can always be performed during the interim period includes:
o Deadline for submitting final audit report and filing of ITRs
o Ability of the client’s staff to submit required schedules
o Other audit clients

MODULE 3 : AUDIT PROCEDURES

Audit Procedures
 This are procedures/methods or acts that auditors use to gather evidence to determine the
validity of financial statement assertions.
 In developing the detailed audit plan, the auditor would use his professional judgment to select
the appropriate types of possible audit procedures
 The auditor applies the audit procedures that is based on the PSA’s are deemed appropriate in
the circumstances.

TYPES OF AUDIT PROCEDURES

1. Test of Controls or Compliance Test
 These are audit procedures designed to evaluate the operating effectiveness of controls
in preventing or detecting and correcting material misstatements at the assertion level.

Types of Compliance Test are:

 No trail – this type does not leave a visible trail in the supporting documents
of the performance of control procedure. The auditor makes inquiries and
observation of personnel and routines to determine how control procedures
are performed and who
performs them.
 Documentary trail – this type leaves a visible trail in the supporting
documents. The auditor inspects the documents to see whether a control
procedure, such as signatories was performed.

2. Substantive procedures
 These audit procedures designed to detect material misstatements at the assertion level
and comprises the following:
 Test of details (class of transaction, account balances and
disclosures)
 Substantive analytical procedures – used to obtain evidential matter about
particular assertions related to account balances. Example are:

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 o Bank confirmation
o Accounts receivable confirmation
o Inquiry on collectability of customer’s accounts
o Match customer orders to invoice billed
o Observe a physical inventory count
o Confirm inventories not on site.

 Types of Substantive Tests

 Test of details of transactions or balances
o This type involves obtaining evidential matter on the items involved in
an account balance or class of transactions.

 Analytical review procedures

 The types of test involve study and comparison of relationships among accounting data
and related information. Common analytical procedures that involve comparison are as
follows:

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