MODULE 5: AUDIT PROCESS: ACCEPTING AN ENGAGEMENT

I. Description
This module discusses on the process flow of the audit engagement, as well as the
management assertions concerning the financial statements.

II. Objectives
After completing the module, the students are expected to:

 Enumerate and describe the different steps in audit process

 Describe the different management assertions concerning the financial statements

III. Duration
Start: Week 8
End: Week 8

IV. Learning Contents

A. MANAGEMENT ASSERTIONS

An audit of financial statements generally begins with the financial statements prepared by
the entity’s management. Without these financial statements, there would be no audit to
perform. A general approach to auditing financial statements would require consideration of
financial statement assertions, audit procedures, and audit evidence.

Financial Statements Assertions

Management is responsible for the fair presentation of financial statements that reflect the
nature and operations of the entity. In representing that the financial statements in
accordance with the applicable financial reporting framework, management implicitly or

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 1

Desiree D. Cemefrania, CPA
explicitly makes assertions regarding the recognition, measurement, presentation and
disclosure of the various elements of financial statements and related disclosures. The
auditor uses these assertions to consider the different types of potential
misstatements that may occur in the financial statements.

ASSERTIONS DEFINITION
Rights and obligations The entity holds or controls Examination of documents
the rights to assets, and that proves ownership. E.g.
liabilities are the obligations TCT of real properties.
of the entity
Valuation and allocation Assets and liabilities are Recalculation of financial
properly valued and statements values such as
revenues and expenses are accrued interest,
properly measured. depreciation and amortized
costs of assets and liabilities.
Presentation and Assets and liabilities are Application of the relevant
disclosure properly classified and accounting and financial
disclosures are adequate. reporting standards.

Review of major contracts

entered into by the entity e.g.
loan agreements to identify
information that needs to be
disclosed.
Existence or occurrence Assets and liabilities exist as Physical examination or
of financial statement date ocular of the assets.
and revenue and expenses
occurred during the reporting External confirmation.
period.
Completeness All items that should be Procedures that start with the
reported in the financial source documents e.g. sales
statements are so included. invoice and determine if
recorded in the Sales
Journal.

Examination of A.P. Voucher

to determine if included or
recorded in the Purchase
Journal.

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 2

Desiree D. Cemefrania, CPA
ASSERTION CATEGORIES

AUDIT PROCEDURES

The objective of the audit is to determine the validity of the financial statements assertions.
To accomplish the objective, auditors develop specific audit objectives for each relevant
assertion. These objectives serve as guide to the auditors in assessing the risk of material
misstatement and in designing appropriate audit procedures to be performed.

Selection of the appropriate procedures to satisfy a particular assertion is affected by a

number of factors including the auditor’s assessment of materiality and risk. Regardless of
the procedures selected, there is only one basic criterion. The procedures selected should
enable the auditor to gather sufficient appropriate evidence about a particular assertion.

1. Inspection - involves examining of records, documents or tangible assets.

2. Observation - consists of looking at a process or procedure being performed by

others.

3. Inquiry - consists of seeking information from knowledgeable persons inside or

outside the entity.

4. Confirmation - consists of the response to an inquiry to corroborate information

contained in the accounting records.

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 3

Desiree D. Cemefrania, CPA
 5. Computation - consists of checking the arithmetical accuracy of source documents
and accounting records or performing independent calculations.

6. Analytical Procedures - consist of the analysis of significant ratios ad trends

including the resulting investigation of fluctuations and relationships that are
inconsistent with other relevant information or deviate from predicted amounts.

AUDIT EVIDENCE

Audit evidence refers to the information obtained by the auditor in arriving at the
conclusions on which the audit opinion is based. Audit procedures are the means used by
the auditor to obtain sufficient appropriate evidence.

Audit evidence will comprise source documents and accounting records underlying the
financial statements and corroborating information from other sources. This evidence about
the financial statements will either prove or disprove the validity of management assertions.
At the conclusion of the audit, the auditor should carefully evaluate the audit evidence
obtained in order to come up with an appropriate opinion.

AUDIT OPINION

The results of the procedures performed and the audit evidence obtained are carefully
evaluated to arrive at the appropriate opinion about the fair presentation of the financial
statements.

B. THE AUDIT PROCESS

The audit process is the sequence of different activities involved in an audit. The emphasis
and order of certain activities may vary depending upon a particular audit, but basically this
process should include the following audit activities:

1. Accepting and engagement

The first in the audit process is to make a decision of whether to accept or reject an audit
engagement. This process would require evaluation of the auditor’s qualifications as well as
the auditability of the prospective client‘s financial statements. A preliminary understanding
of the client’s business and background investigation of a prospective client are usually
performed at this stage of the audit.

The procedures performed at this stage of the audit are referred to in PSA 300 as
“preliminary planning activities”. These procedures involve:

a. Performing procedures regarding the continuance of the client relationship and

the specific audit engagement.

b. Evaluating compliance with ethical requirements, including independence.

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 4

Desiree D. Cemefrania, CPA
 c. Establishing an understanding of the terms of the engagement.

2. Audit Planning

In planning an audit, the auditor obtains more detailed knowledge about the client’s business
and industry in order to understand the transactions and events affecting the financial
statements, and to identify potential problems that might be encountered during the audit. A
preliminary assessment of risk and materiality should also be made to be able to develop an
overall audit strategy and a detailed approach for the expected conduct and scope of the
examination.

3. Internal Control Consideration

The auditor should give adequate consideration to the entity’s internal control because the
condition of the entity’s internal control directly affects the reliability of the financial
statements. The stronger the internal control, the more assurance it provides about the
reliability of accounting data and financial statements.

Consideration of internal control involves obtaining understanding of the entity’s control

systems and assessing the level of control risk that is, the risk that the client’s internal
control may not prevent or detect material misstatements in the financial statements.

If the auditor wants to assess control risk at less than high level, sufficient appropriate
evidence must be obtained to prove that the internal control is functioning effectively and that
it can be relied upon. This evidence can be obtained by performing tests of controls

4. Performing Substantive Tests

Using the information obtained in audit planning and consideration of internal control, the
auditor performs substantive tests to determine whether the entity’s financial statements are
presented fairly in accordance with financial reporting standards. These procedures would
involve examination of the documents and evidence supporting the amounts and disclosures
in the financial statements.

The extent of the substantive tests is highly dependent on the results of the auditor’s
consideration of internal control. If based on the evaluation of internal control, the auditor has
obtained evidence that the internal control is functioning effectively; the scope of the
auditor’s substantive tests can be reduced. On the other hand, if the results of tests of
control prove that the internal control is weak, the auditor will have to compensate for this
weakness by performing more extensive substantive procedures

5. Completing the Audit

The auditor must have sufficient appropriate evidence in order to reach a conclusion on the
fairness of the financial statements. After the auditor has completed testing account

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 5

Desiree D. Cemefrania, CPA
balances, the auditor performs additional audit procedures to complete the audit and
become satisfied that the evidence gathered is consistent with the auditor’s report. These
procedures include review of subsequent events and contingencies, assessing the going
concern assumption, performing overall analytical review procedures, and obtaining written
representations from the client’s management.

6. Issuing the Report

On the basis of audit evidence gathered and evaluated, the auditor forms a conclusion about
the financial statements. This conclusion (in the form of an opinion) is communicated to
various interested users through an audit report.

C. ACCEPTING THE ENGAGEMENT

An important element of a firm’s quality control policies and procedures is a system for
deciding whether to accept or reject an audit engagement. In making this decision, the firm
should consider:

a. Competence

One of the primary considerations before accepting an audit engagement is to determine

whether the auditor has the necessary skills and competence to handle the engagement.
According to the Code of Ethics, professional accountants should not portray themselves as
having expertise which they do not possess. Competence is acquired through a combination
of education, training and experience. Before accepting an audit engagement, the auditor
should obtain a preliminary knowledge of the client’s business and industry to determine
whether the auditor has the degree of competence required by the engagement or whether
such competence can be obtained before the completion of the audit.

b. Independence

Essential to the credibility of the auditor’s report is the concept of independence. Before
accepting an audit engagement, the auditor should consider whether there are any threats to
the audit team’s independence and objectivity and, if so, whether adequate safeguards can
be established.

c. Ability to serve the client properly

Closely related to competence is the auditor’s ability to serve the client properly. An
engagement should not be accepted if there are no enough qualified personnel to perform
the audit.

PSA 220 suggests that audit work should be assigned to personnel who have the
appropriate capabilities, competence and time to perform the audit engagement in
accordance with professional standards.

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 6

Desiree D. Cemefrania, CPA
In addition, there should be sufficient direction, supervision and review of work at all levels in
order to provide reasonable assurance that the firm’s standard of quality is maintained in the
performance of the engagement.

d. Integrity of management

The recent wave of litigation involving auditors has made pre-acceptance investigation
procedures very important. PSA 220 requires the firm to conduct a background investigation
of the prospective client in order to minimize the likelihood of association with clients whose
management lacks integrity.

This task would involve:

a. Making inquiries of appropriate parties in the business community such as prospective

client’s banker, legal counsel, or underwriter to obtain information about the reputation of
the client.

b. Communicating with the predecessor auditor. Communication with predecessor auditor

is not only a matter of courtesy to the predecessor auditor. This communication allows
the incoming auditor to obtain information about the client that will be useful in
determining whether the engagement will be accepted. But before the incoming auditor
contacts the predecessor auditor, the incoming auditor should obtain client’s permission
to communicate with the predecessor auditor. This is a necessary procedure because
the code of ethics prevents an auditor from disclosing any information obtained about the
client without the client’s explicit permission. Refusal of the prospective client’s
management to permit this will raise serious questions as to whether the engagement
will be accepted. Once permission of the client is obtained, the incoming auditor should
inquire into matters that may affect the decision to accept the engagement. This includes
questions regarding:

 The predecessor auditor’s understanding as to the reasons for the change of

auditors.
 Any disagreement between the predecessor auditor and the client.
 Any facts that might have a bearing on the integrity of the prospective client’s
management.

The Code of Ethics requires the predecessor auditor to respond fully to the incoming
auditor’s inquiry and advise the incoming auditor if there are any professional reasons why
the engagement should not be accepted.

e. Adequacy of the Accounting Records

The audit of financial statements is performed on the assumption that the financial
statements are verifiable. The client’s accounting records and documents supporting the
amounts and disclosures in the financial statements must be adequate enough to permit

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 7

Desiree D. Cemefrania, CPA
examination of the accounts. Inadequacy of the accounting records is sufficient for the
auditor to decline an audit engagement.

Retention of Existing Clients

The auditor’s evaluation of clients is not a one-time consideration. Clients should be

evaluated at least once a year or upon occurrence of major events such as changes in
management, directors, ownership, nature of client’s business, or other changes that may
affect the scope of the examination.

In general, conditions which would have caused an accounting firm to reject a prospective
client may also result or lead to a decision of terminating an audit engagement.

Engagement letter

After accepting the audit engagement, an engagement letter should be prepared. This
serves as the written contract between the auditor and the client.

This letter sets forth:

 The objective of the audit of financial statements which is to express an opinion on

the financial statements.

 The management’s responsibility for the fair presentation of the financial

statements.  The scope of the audit.

 The forms or any reports or other communication that the auditor expects to issue.

 The fact that because of the limitations of the audit, there is an unavoidable risk
that material misstatements may remain undiscovered.

 The responsibility of the client to allow the auditor to have unrestricted access to
whatever records, documentation and other information requested in connection with
the audit.

In addition, the auditor may also include the following item in the engagement letter:

 Billing arrangements.

 Expectations of receiving management representation letter

 Arrangements concerning the involvement of others (experts, other auditors,

internal auditors and other client personnel)

 Request for the client to confirm the terms of the engagement

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 8

Desiree D. Cemefrania, CPA
Recurring audits

The auditor does not normally send new engagement letter every year. However, the
following factors may cause the auditor to send a new engagement letter.

 Any indication that the client misunderstands the objective and scope of the audit
 Any revised or special terms of the engagement
 A recent change of senior management, board of directors or ownership  A significant
change in the nature or size of the client’s business
 Legal requirements and other government agencies’ pronouncements When the auditor
decides not to send a new engagement letter, it may be appropriate for the auditor to
remind the client of the original arrangements.

Audits of Components

When the auditor of a parent entity is also the auditor of its subsidiary, branch or division
(component), the auditor should consider the following factors in making a decision of
whether to send a separate letter to the' component:

 Who appoints the auditor of the component?

 Whether a separate audit report is to be issued on the component.
 Legal requirements.
 The extent of any work performed by other auditor.
 Degree of ownership by parent.
 Degree of independence of the component’s management

V. References

 Auditing Theory by J. Salosagcol, Tiu and Hermosilla

 PSA 300 – Planning and Audit of Financial Statements
 PSA 220 – Quality Control for Audit Work
 PSA 210 – Agreeing on the Terms of Audit Engagement

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 9

Desiree D. Cemefrania, CPA