Chapter 2: Fundamentals of Auditing

Introduction: Economic Decisions and the Need for Reliable Information

- Reliable information is essential to existence and survival of society (makes economic decisions)
- Wrong information (input) = less effective decisions.
- Independent audits is required (thru report, CPA can tell decision-makers the information)

Nature, Philosophy, and Objectives of Auditing

Auditing Definition:
- A systematic process of objectively obtaining and evaluating evidence regarding assertions
about economic actions and events to ascertain the degree of correspondence between
assertions and established criteria and communicating the results to interested users.
(American Accounting Association (AAA) )

Processes
1. Investigative Process
- Involves systematic gathering and evaluation of evidence as a basis for determining
whether assertions or representations made by responsible persons in a company’s FS,
correspond with established financial reporting criteria (GAAP)

2. Reporting Process
- Involves communicating an evaluation or opinion in an audit report to interested users.

Primary Objective of Audit Function:

- Improve quality of or lend credibility to the information prepared by an entity.

Key Concepts/Objectives of Audit:

1. A systematic process - follows a logical sequence of procedures.
2. Objectively obtaining and evaluating evidence
- Objectivity = combination of impartiality, intellectual honesty, and a freedom from conflicts
of interest while Gathering/Evaluation = come in the form of oral representations, written
documents, e-media.
- CPA can’t express opinion w/o supporting evidence to back up.
3. Assertions about economic actions and events
- Assertions = representations of MGMT (explicit or implied e.g. embodied in FS).
- The CPA’s job is obtain & evaluate evidence (support or contradict assertions)
4. Degree of correspondence between assertions and established criteria - auditors use
standards/benchmarks or criteria for expressing opinion on the assertions of MGMT.
 5. Communicating the results to interested users - after audit > written report w/ opinion >
constitutes fairness.

Auditing & Accounting Distinguished:

Auditing Accounting

- Not a branch of accounting. - The process of recording, classifying, and

- Concerned with determination of whether summarizing economic events in logical manner
the recorded accounting information for the for the purpose of providing financial info.
entity properly reflects the economic events - A service activity > purpose is to provide fin info
that occurred during the accounting period. which is quantitative in nature to help mgmt in
- Auditors must have expertise in the decision-making.
accumulation and interpretation of audit - Accountants must have a thorough
characteristics. understanding of principles & rules to ensure
- “Auditing begins where Acctg ends” economic events are properly recorded on a
timely basis.

Audit Services Assurance Services

- Under attestation engagements (under - Encompass assertion-based engagements

assurance engagements) - Practitioners evaluate the subject matter from
- The narrowest concept (arisen first, the responsible party against suitable criteria,
followed by assertion-based engagements, and express opinion which provides users with a
then assurance engagements. level of assurance.
- Both assurance and assertion-based
engagements encompass audit.
- The broadest concept.
-

Types of Audits According to Nature of Assertion

A. As to Nature of Assertion or Data
1. Financial Statement Audits
- Refers to gathering of evidence on the assertions embodied in the FS of the entity and
using evidence to determine whether assertions adhere to GAAP and other
comprehensive/authoritative financial reporting frameworks.
- This type of audit requires CPA, reports on fairness of FS.
- Interested Users: Investor, Creditors.
2. Operational Audit
- A systematic review of an organization's activities in relation to specified objectives
for the purposes of (1) assessing performance (efficiency, effectiveness, economy of
operations)
- (2) identifying opportunities for improvement, and (3) developing recommendations for
improvement or further action.
- Is future-oriented, systematic, and independent evaluation of org’s activities.
 -Primary sources of evidence are operational policies and achievements related to the org's
objectives but financial data may be used.
- Example: Audit of company’s computerized accounting system.
3. Compliance Audit
- Used to determine whether a person/entity has adhered to laws and regulations.
- Results are reported to a specific user with organization.
- Example: Audit regarding violation of labor law and degree of compliance.

Types of Audits According to Types of Auditors

B. As to Types of Auditor
1. External Audits
- Performed by CPA (independent of the organizations whose assertions are being audited)
- CPAs = Independent or External Auditors.
- Audits performed are mainly FS audits, but operational & compliance may be performed.
2. Internal Audits
- An independent appraisal (estimate/judging) function within an organization to
examine & evaluate its activities as a service to the organization.
- Internal Auditing Staff > Audit Committee of BoD & President (or other executives).
- Not independent because they are employees.
- Audit performed mainly operational and compliance audits.
3. Government Audits
- Involves determination of whether gov’t funds are being handled properly and in
compliance with existing laws and whether govt programs of agencies are conducted
efficiently & economically.
- Three Main Divisions of COA:
a. Compliance Audit - examination, audit, settlement according to laws/regulations.
b. Financial Audit - audit of accounting & financial system and controls (to ensure
reliability of recorded financial data)
c. Performance Audit - objective examination of financial & operational performance
of an org, program, activity. Must be oriented towards opportunities for greater
economy, efficiency, & effectiveness.
i. Economy & Efficiency Audit - “Management Audit” and is the appraisal
of MGMT performance from a least cost POV and analysis of cost-benefit.
ii. Effectiveness Audit - “Program Results Audit” and the evaluation of
programs, projects, activities, to determine the extent of achievement of
objectives set.

Objectives and Scope of Financial Statement Audit

Objective of Audit of FS:
- The expression of an opinion on the fairness of such FS, the auditor's report is the medium thru
which he expresses opinion, disclaims.
 - He states whether his examination is in accordance with PH Standards on Auditing (PSA)

Scope:
- The auditor normally determines the scope of an audit in accordance with requirements of
legislation, regulations, or relevant professional bodies.
- PSA > auditor must exercise judgment 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 ENTITY.

Information Risk
Information Risk Definition:
- The risk that information is misstated or misleading.

Factors contributing to existence of Info Risk:

1. Remoteness of information from information provider (MGMT)
- Decision-makers (info users) don’t get first hand knowledge about business since owners
are different from management (info provider)
2. Potential bias and motives of information providers
- Conflict of interest may be existing between MGMT (info provider) and decision-makers
(info users) regarding FS. Information may be in favor of provider.
3. Voluminous data
- Larger number of exchange transactions are processed daily = increased likelihood of
errors in recording & reporting.
4. Complex exchange transactions
- New and complicated business RS and transactions > lead to innovative acctg and
reporting problems. Some transactions are complex and difficult to record.

Reducing Information Risk: Approaches

1. Allow user to verify information:
- Users may go to the establishment to examine records and obtain info about the reliability
of statements. Problem: Not all are competent to verify due to time & distance constraints.
2. User shares information risk with management
- A lawsuit may be brought against MGMT to recover part of such loss (if MGMT gave
inaccurate FS)
3. Have FS audited
- The users can have an independent audit performed (used in decision-making process)
- I.A.’s opinion provides users with input to making logical decisions about company’s
earnings performance, FS, liquidity.
- Helps to minimize biases by acting as a monitor of Fin. Info.
 - Also act as deterrent (discouragement) to inefficiency and fraud.

Audit Reports
Audit Report Definition:
- The means thru which the auditor provides reasonable assurance that the FS are fairly stated.
- Report is uniform in format and suitably titled to avoid confusion regarding the level of assurance
provided and differentiate from other reports.

Limitations of an Audit
Note:
- Audit = not a guarantee of the exactness of accuracy of assertions in the FS.
- To enhance only the degree of confidence of intended users in the FS.
- The audit can’t provide guarantee or absolute assurance (certainty) that FS is free from material
misstatement due to fraud/error.

Inherent Limitations of Audit Arising From:

1. Nature of Financial Reporting - preparation of FS involves judgment by MGMT in applying
applicable FR Framework, and subjective decisions (estimates) involving a range of interpretations.
2. Nature of Audit Procedures - audit procedures (even well-designed) will not detect every
misstatement.
3. Nature of Audit Evidence Available - tends to be persuasive (strong and convincing but not
absolutely foolproof) rather than conclusive
4. Timeliness of Financial Reporting - users expects auditor within reasonable time at reasonable
cost but impracticable to address all information or pursue every matter.

History and Evolution of Auditing

1. Mesopotamian Civilizations (Egypt and Babylonia)
- utilized elaborate internal control systems, including the preparation of transaction
summaries by scribes who did not provide the original lists of receipts and payments
(this is a crude form of segregation of duties)
- Documents from this period have indications of the audit function (such as checkmarks,
ticks, dots and other symbols) being performed on them.
- Audit (from Latin term) = hearing or listening (hence the "auditory nerve", auditorium, etc.)
- Auditors note any error or inconsistencies based on what they hear (or did not hear).
2. Ancient Greece and Rome
- The concept of the audit of public expenditure and financial management by an
independent body.
- Greek philosophers from Plato (gov’t should be closely linked with the duty to report to the
people who elected them re: power)
 - Audit Body = best way to safeguard the smooth operation of Athenian Democracy and
avoid corruption and irregularities.
- Roman officials submit accounts to auditors.
3. Medieval and Renaissance Periods
- Manorialism = was a system where a lord owned a large estate and peasants worked the
land. In exchange, peasants got protection and a place to live.
- Manors (large estate or house) = have some most sophisticated and advanced
record-keeping and auditing techniques.
- Segregation of duties is enforced and auditor listens to the “reading of accounts” together
with the Lord of the manor.
- Earlier Surviving Mention of Public Official (charged with gov exp) = Auditor of the
Exchequer in England in 1314.
- The Auditors of the Imprest = established under Queen Elizabeth I in 1559 for auditing
Exchequer payments.
4. The 17th and 19th (1900) Centuries
- 1780: Commissioners for Auditing the Public accounts were appointed by statute.
- 1834: Commissioners worked with Comptroller of the Exchequer (eks-tse-ker) who is
charged with controlling issue of funds to gov’t.
- 1852-1882: William Ewart Gladstone initiated major reforms of public finance.
- 1866: Exchequer and Audit Departments Act required all departments to produce annual
accounts (appropriation accounts)
5. Industrial Revolution
- English corporations registered with the State, and management functions passed from
owners to professional business managers.
- "Shareholder audits" were performed by auditors who possessed little or no independence
(at least by today's standards).
- Auditors were required to own stock in the audited company (in great contrast to today's
independence requirements).
- Auditors began to report on the work they had performed to the owners of the entity. The
concept of the independent auditor's report was born.
- Audit sampling also developed during this period. Auditors select a "few haphazard cases"
whenever it was not economically feasible to examine all transactions of the enterprise.
6. Early 20th Century
- American audits and British audits began to differ in terms of audit objective.
- American Audit = focused on reporting on the 'actual' financial condition of an entity
- British Audit = continued to focus on the detection of fraud and error.
7. World War II up to the 80's
- Audit sampling became the rule and detailed checking the exception.
- From 1940 onwards, the primary objective of an audit became providing an opinion on the
financial statements.
- Around 1972, audit risk was recognized in auditing literature.
8. Auditing Today
- Audit firms adopted a 'risk-based approach,' determining the nature, timing, and extent of
audit procedures. Risk-based audits are standard today.
- Treadway Commission was formed to study and reduce fraudulent financial reporting. The
1987 report led to the Internal Control - Integrated Framework.
9. Enron and its Aftermath
- Auditing standards changed significantly after failures like Enron's, which hid off-book
liabilities and filed for bankruptcy. Arthur Andersen, Enron’s auditor, had its licenses
revoked.
- Post-Enron, there is a renewed focus on internal controls to ensure account accuracy and
restricted financial system access. This is now mandatory for SEC-listed companies under
PCAOB standards set by the Sarbanes-Oxley Act of 2002.
- Enron was an American energy, commodities, and services company based in Houston,
Texas. It became infamous for its massive accounting scandal in the early 2000s, where it
used complex financial practices to hide debt and inflate profits. The scandal led to Enron’s
bankruptcy in 2001 and the dissolution of its accounting firm, Arthur Andersen. The Enron
case prompted major reforms in financial reporting and auditing standards.