Auditing theory salosagcol chapter one

The need of various users for more reliable financial information has created a demand for an independent audit of financial statements. Primary function of an independent audit: o Lend credibility to the financial statements of an entity. Auditors opinion enhances the value and usefulness of the financial statements and by attaching a report to the financial statements, the auditor provides increased assurance to users that the financial statements are reliable.

PSA 200 defines auditing in the context of a financial statement audit: o To enable the auditor to express an opinion whether the financial statements are prepared in all material respects in accordance with the applicable financial reporting framework. A more comprehensive definition is given by the American Accounting Association which defines an audit as: o A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between these assertions and the established criteria and communicating the results to interested users. Auditing proceeds by means of an organized and structured series of steps. Assertions are representations made by the auditee regarding e conomic actions and events. The auditors objective is to determine whether these assertions are valid. To satisfy this objective, auditor must perform audit procedures and gather evidence that corroborates or refutes the assertions. Auditor should conduct the audit without bias. Impartial attitude must be maintained by the auditor in gathering evidence and in formulating his conclusion. Established criteria: o Are needed to judge the validity of the assertions. o Are important because they establish and inform the users of the basis against which the assertions have been evaluated and measured. For example, when auditing financial statements, the auditor judges the fair presentation of the financial statements (assertions) by comparing the financial statements with the applicable financial reporting framework. The communication of audit findings is the ultimate objective of any audit. For the audit to be useful, the results should be communicated to the interested users on a timely basis. The three (3) major types of audit are the financial statement audit, operational audit, and compliance audit Financial statement audit: o Financial statement audit is an audit that is conducted to determine whether the financial statements are fairly presented in accordance with applicable financial reporting framework. o Criteria used in a financial statement audit are usually defined. o Assertions made by the auditee in a financial statement audit - financial statements are fairly presented. o Established criteria in a financial statement audit Financial reporting standards or other financial reporting framework. o Content of the auditors report in a financial statement audit An opinion whether the financial statements are fairly presented in conformity with the applicable financial reporting framework. o External auditors generally perform financial statement audits. Operational audit: o Operational audit is the study of a specific unit of an organization for the purpose of measuring its performance. o The main objective of an operational audit is to assess the entitys performance, identify areas for improvements, and make recommendations to improve performance. o Operational audit is also known as performance audit or management audit and criteria used in an operational audit to assess the efficiency and effectiveness of operations are not usually clearly established o Assertions made by the auditee in an operational audit that the organizations activities are conducted effectively and efficiently. o Established criteria in an operational audit objectives set by the board of directors o Content of the auditors report in an operational audit Recommendations or suggestions on how to improve operations o Internal auditors generally perform operational audits. Compliance audit: o Compliance audit involves a review of an organizations procedures to determine whether the organization has adhered to specific procedures, rules, or regulations. o Performance of compliance audit is dependent upon the existence of verifiable data and recognized criteria established by an authoritative body. o Example of a compliance audit is the examination conducted by the BIR examiners to determine whether the entities comply with tax rules and regulations. o Assertions made by the auditee in a compliance audit that the organization has complied with laws, regulations, or contracts o Established criteria in a compliance audit laws, regulations, and contracts o Content of the auditors report in a compliance audit reports on the degree of compliance with applicable laws, regulations, and contracts o Government auditors generally perform compliance audits There are typically three (3) types of auditors external auditors, internal auditors, and government auditors.

External auditors are independent CPAs who offer their professional services to different clients on a contractual basis. Internal auditors are entitys own employees who investigate and appraise the effectiveness and efficiency of operations and internal controls. Main function of internal auditors: o To assist the members of the organization in the effective discharge of their responsibilities. Government auditors are government employees whose main concern is to determine whether persons or entities comply with government laws and regulations. It should be noted that although there are different types of audits, these audits also possess the same general characteristics: o Systematic examination and evaluation of evidence which are undertaken to ascertain whether assertions comply with established criteria o Communication of the results of the examination usually in a written report to the party by whom or on whose behalf the auditor was appointed The purpose of an independent financial statement audit: o To enhance the degree of confidence of intended users in the financial statements. This is achieved by the expression of an opinion by the auditor on the fair presentation of the financial statements. An audit conducted in accordance with the PSAs and relevant ethical requirements enables the auditor to form the opinion. Management and those charged with governance are responsible for: o The preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework o The design, implementation, and maintenance of internal control relevant to the preparation and presentation of the financial statements that are free from material misstatements whether due to fraud or error o Provide auditor with unrestricted access to all information, records, and documents relevant to the financial statements Auditors opinion on the financial statements is not a guarantee that the financial statements are dependable. An audit conducted in accordance with the PSAs is designed to provide only reasonable assurance (not absolute assurance) that the financial statements taken as a whole are free from material misstatements because of: o Inherent limitations of audit that affect the auditors ability to detect material misstatements: Use of testing / Sampling risk: Auditors do not examine all evidence available because of the cost-benefit constraint Whenever the sample is taken, there is always a possibility that the auditors conclus ion, based on the sample, may be different from the conclusion that would have been reached if the auditor examines the entire population Error in application of judgment / Non-sampling risk: Human weaknesses can cause the auditor to commit mistakes in the application of audit procedures and evaluation of evidence Reliance on managements representations: Some audit evidence must be obtained by obtaining oral or written representations from the management o Example: it is difficult for the auditor to determine the proper valuation of accounts receivable without managements honest assessment If the management lacks integrity, management may provide the auditor with false representations causing the auditor to rely on unreliable evidence. Inherent limitations of the clients accounting and internal control systems: Managements usual requirement that the cost of an internal control should not exceed the expected benefits to be derived Most internal controls tend to be directed at routine transactions rather than non-rountine transactions The potential for human error due to carelessness, distraction, mistakes in judgment, and misunderstanding of instructions The possibility of circumvention of internal controls through collusion among employees The possibility of management overriding the internal control The possibility that internal control procedures may become inadequate due to changes in conditions and compliance with procedures may deteriorate Nature of evidence: Evidence obtained by the auditor does not consist of hard facts (not conclusive) which prove or disprove the accuracy of the financial statements Evidence obtained by the auditor comprises pieces of information and impressions which are gradually accumulated during the course of an audit and which taken together, persuade the auditor about the fairness of the financial statements Audit evidence is generally persuasive rather than conclusive in nature

Because of the inherent limitations of an audit, there is an unavoidable risk that some material misstatements of the financial statements may not be detected even though the audit is properly planned and performed in accordance with the PSAs. o Accordingly, the subsequent discovery of a material misstatement of the financial statements does not in itself indicate a failure to conduct an audit in accordance with the PSAs. Management summarizes the financial information which will now become the unaudited financial statements. The auditor will be engaged to audit the financial statements transforming the unaudited to audited financial statements. Management will issue the audited financial statements to the interested users and the auditor will as well issue a written report on those financial statements to certify that those are audited. The procedures required to conduct an audit in accordance with the PSAs, relevant professional bodies, legislations, and where appropriate, the terms of the engagement and the reporting requirements, should be determined by the auditor. PSA 200 provides the following guidelines when auditing financial statements: o Auditor should comply with relevant ethical requirements, including those relating to independence, relating to financial statement audit engagements Auditors must adhere to standards of ethical conduct that embody and demonstrate integrity, objectivity, and concern for the public rather than self-interest in order to retain public confidence in the credibility of the auditors work. o Auditor should conduct an audit in accordance with the Philippine Standards on Auditing PSAs contain the basic principles and essential procedures which the auditor should follow. PSAs also include PAPS (Philippine Auditing Practice Statements) which are explanatory and other materials designed to assist the auditors in interpreting and applying the auditing standards o Auditor should exercise professional judgment in planning and performing an audit of financial statements Professional judgment: Hallmark of Auditing Exercised by an auditor whose training, knowledge, and experience have assisted in making competent and reasonable judgment. Essential because informed decisions required throughout the audit cannot be made without the application of auditors knowledge and experience to the facts and circumstances o Auditor should obtain sufficient appropriate audit evidence to reduce audit risk to an acceptably low level to enable the auditor to express an opinion on the financial statements Audit evidence: Necessary to support the auditors opinion and report Cumulative in nature Primarily obtained from audit procedures performed during the audit Must be both sufficient and appropriate to afford a reasonable basis for an opinion on the financial statements o Auditor should plan and perform the audit with an attitude of professional skepticism recognizing that circumstances may exist which may cause the financial statements to be materially misstated Professional skepticism Means the auditor makes a critical assessment, with a questioning mind, of the validity of audit evidence obtained and is alert to audit evidence that contradicts or bring into questions the reliability of documents or management representations Means that the auditor neither assumes that the management is honest nor dishonest Representations from management are not a substitute for obtaining sufficient and appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion The need for an independent audit of financial statements stems from the following interrelated sources: o Conflict of interest between management and users of financial statements Financial statements may be viewed as the report by the management as to how the entity performed under their direction and supervision Managers are frequently placed in positions where they can benefit by providing outside parties with overly optimistic or even false financial information Outside parties however, want unbiased, realistic financial statements Recognizing this conflict of interest, users of the financial statements have become skeptical of unaudited financial statements o Expertise The complexity of accounting and auditing requires expertise in verifying the quality of financial information A qualified person is hired by the users to verify the reliability of the financial statements on their behalf since most of the users of financial information are not equipped with the necessary skills and competence to determine whether the financial statements are reliable.

Remoteness Users of the financial information are usually excluded from directly assessing the reliability of the information Most of the users do not have access to the entitys records to personally verify the reliability of the financial statements An independent auditor is needed to assist them in verifying the reliability of the financial information o Financial consequences Misleading financial information could have substantial economic consequences for a decision maker. Important that the financial statements are audited before these are used for making important decisions Audit function operates within a theoretical framework. Below are the selected postulates, assumptions, or ideas that support many auditing concepts and standards: o Audit function operates on the assumption that all financial data are verifiable All balances reported in the financial statements must have supporting documents or evidence to prove their validity If no evidence exist on the financial statements, then there can be no audit to perform o The auditor should always maintain independence with respect to the financial statements under audit Independence is essential for ensuring the credibility of the auditors report. Auditors report will be of little or no value if readers are aware that the auditor is not independent with respect to the client. o There should be no long term conflict between the auditor and the client management Short-term conflicts may exist regarding the application of audit procedures and accounting policies but in the end, both the auditor and the management must be interested in the fair presentation of the financial statements o Effective internal control system reduces the possibility of errors and fraud affecting the financial statements The stronger the internal control is, the more assurance it provides about the reliability of the accounting data and financial statements o Consistent compliance with applicable financial reporting framework results in fair presentation of financial statements In the case of an independent audit of financial statements, the criteria are usually the PFRS or the PFRS for SMEs o What was held true in the past will continue to hold true in the future in the absence of known conditions to the contrary Experience and knowledge accumulated from auditing a client in prior years can be used to determine the appropriate audit procedures that need to be performed o An audit benefits the public Financial statements are ordinarily prepared and presented in order to meet the common information needs of a wide range of users (general purpose) These users who rely on the financial statements as their major source of information are o the primary beneficiary of the financial statement audit

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Broadly defined, the subject matter of any audit consists of assertions. The criteria for evaluating quantitative information vary. For example, in the case of an independent audit of financial statements by CPA firms, the criteria are usually the PFRS or the PFRS for SMEs. An audit of financial statements is conducted to determine if the overall financial statements are stated in accordance with the applicable financial reporting framework. Most of the independent auditors work in formulating an opinion on the financial statements consists of obtaining and examining evidential matter. In financial statement audits, the audit process should be conducted in accordance with the Philippine Standards on Auditing. Example of an operational audit: concentrates on seeking out aspects of operations in which waste would be reduced by the introduction of controls. A typical objective of an operational audit is to determine whether an entitys specific operating units are functioning efficiently and effectively. The auditor communicates the results of his or her work through the medium of the audit report. External auditing is performed most commonly by CPAs on a contractual basis. Independent auditing can best be described as a professional activity that attests to the fair presentation of financial statements. Internal auditing is an independent appraisal function established within an organization to examine and evaluate its activities. To that end, internal auditing provides assistance to management and the board of directors. Independent auditors represent third party users external to the auditee entity whereas internal auditors report directly to management Internal auditors are employees of the auditee whereas independent auditors are independent contractors. The internal auditors span of coverage goes beyond financial auditing to encompass operational and performance auditing. The auditors opinion is not an assurance as to the future viability of the entity as well as the effectiveness and efficiency with which management has conducted the affairs of the entity. The reason an independent auditor gathers evidence is to form an opinion on the financial statements. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. The level of assurance provided when an auditor issues an audit report is reasonable. The independent audit is important to readers of financial information because it involves the objective examination of and reporting on management prepared statements. The auditor should plan and perform the audit with an attitude of professional skepticism. The auditor should conduct the audit in accordance with the PSAs. The auditor should comply with the Philippine Code of Professional Ethics. Auditing is based on the assumption that financial data are verifiable. Data are verifiable when two or more qualified individuals working independently, each reach essentially similar conclusions. The auditors responsibility is confined to the expression of opinion on the financial statements audited. Audit of financial statements does not reduce managements responsibility. The term scope of the audit refers to audit procedures deemed necessary in the circumstances to achieve the objective of the audit. The phrase used to express the auditors opinion is present fairly in all material respects. Many financial statement assertions cannot be audited does not properly describe a limitation of an audit. The procedures deemed necessary in the circumstances to achieve the objective of the audit shall be determined by the independent auditor.