Chapter I- The Nature of Auditing

Objectives
 Describe auditing
 Distinguish between auditing & accounting
 Explain the importance of auditing in information risk
 List the causes of information risk, & explain how this risk can be reduced
 Describe assurance services & distinguish audit services from other
assurance & non-assurance services provided by CPAs.
 Differentiate the three (3) main types of audit
 Identify the primary types of auditors, and
 Describe the requirements for becoming a CPA

Auditing defined
 It is accumulation & evaluation of evidence about information to determine
& report on the degree of correspondence between the information &
established criteria.
 Auditing should be done by a competent & independent person.
  is the on-site verification activity, such as inspection or examination, of a
process or quality system, to ensure compliance to requirements.

Definition of Key Words/Phrases

 Information in a verifiable forms & some standards or criteria by which the
auditor can evaluate the information. The criteria varies depending on the
information being audited.
• Audit of historical FS-GAAPs/IFRS
• Internal control-Internal control integrated framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission
(COSO)
• Audit of tax returns- Bureau of Internal Revenue

Definition of Key Words/Phrases

 Evidence is any information used by the auditor to determine whether the
 information being audited is stated in accordance with the established
criteria. Auditor obtains sufficient & appropriate evidence.
 Forms of Evidence
• Electronic & documentary data about transactions
• Written & electronic communication with outsiders
• Observations by the auditor
• Oral testimony of the auditee (client)

Definition of Key Words/Phrases

 Competent, independent person. The auditor must be qualified to
understand the criteria used & must be competent to know the types &
amount of evidence to accumulate in order to reach the proper conclusion
after examining the evidence. The auditor must also have an independent
mental attitude. The competence of those performing the audit is of little
value if they are biased in the accumulation & evaluation of evidence.

Definition of Key Words/Phrases

 Audit report. It is the phase of communicating the auditor’s findings to
users. The report informs the readers of the degree of correspondence
between the information audited & established criteria.
 Figure 1 illustrates the key parts of auditing. To determine whether the tax
return was prepared in a manner consistent with the requirements of the
BIR, the agent examines documents provided by the taxpayer & other
sources e.g. employer, bank

Figure 1.Audit of a Tax Return

Auditing vs. Accounting
 Accounting is the recording, classifying & summarizing of economic events
in a logical manner for the purpose of providing financial information for
decision making.
 Accountants must have a thorough understanding of the principles & rules
that provide the basis for preparing the accounting information.
 Accountants must develop a system to make sure that the entity’s
economic events are properly recorded on a timely basis & at a reasonable
cost.
 Auditing vs. Accounting
 Auditors focus on determining whether recorded information properly
reflects the economic events that occurred during the accounting period.
 Auditors must thoroughly understand the accounting standards.
 Auditors must possess expertise in the accumulation & interpretation of
audit evidence.
 Determining the proper audit procedures, deciding the number & types of
items to test, & evaluating the results are unique to the auditor.

Economic demand for auditing

 Consider the decision of a bank manager in making a loan to a business.
The decision will be based on such factors a previous financial
relationships with the business & the financial condition of the business as
reflected by its FS.
 Information risk reflects the possibility that the information upon which
the business risk decision was made was inaccurate. A likely cause of the
information risk is the possibility of inaccurate FS.

Reasons for unreliable information

 Remoteness of information
 Biases & motives of the provider
 Voluminous data
 Complex exchange transactions

Assurance Services
 It is an independent professional service that improves the quality of
information for decision makers. Such services are valued because the
assurance provider is independent & perceived as being unbias with
respect to the information examined.
 Decision makers seek assurance services to help improve the reliability &
relevance of the information used as basis for their decisions.

Attestation Service
 Audit of historical FS
 Audit of internal control over financial reporting
 Review of historical FS
 Attestation services on IT
 Other attestation services that may be applied to a broad range of subject
matter

Audit of historical FS

 Management asserts that the statements are fairly stated in accordance

with the accounting standards.
 The auditor issues a report expressing an opinion about whether the FS
are fairly presented in accordance with the applicable accounting
standards. These audits are the most common assurance service provided
by CPAs
 Auditors need accreditation. BOA, SEC, BIR, CDA, BSP, Insurance
Commission.
Audit of Internal Control (IC) Over Financial Reporting
 Management asserts that IC have been developed & implemented following
well established criteria. Publicly held companies are required to report
management’s assessment of the effectiveness of the IC.
 The auditor attests to the effectiveness of the IC over financial reporting.
 Increases the user confidence about future financial reporting because
effective IC reduce the likelihood of future misstatements in the FS.

Review of historical FS
 Management asserts that the statements are fairly stated in accordance
with standards, the same as audits. The CPA provides a lower level of
assurance for reviews of FS compared to a high level for audits, therefore
less evidence is required.
Attestation Services on IT
 Management makes various assertions about the reliability & security of
electronic information. Many business functions, such as ordering &
making payments, are conducted over the internet or directly between
computers using electronic data interchange (EDI). As transactions &
information are shared online, business people demand even greater
 assurances about information transactions, & the security protecting them.

Other Assurance Services

Non-assurance Services

 Accounting & bookkeeping services

 Tax services
 Management consulting services- to generate recommendation to
management
Types of Audits
Operational Audits
 Evaluation of the efficiency & effectiveness of any part of an organization’s
operating procedures & methods.
 Auditors submit recommendations for improving operations.
 Reviews are not limited to accounting.
 Relevancy & sufficiency of the info used by management in making
decisions to acquire new long-lived assets;
 efficiency of the information flow
Compliance Audits
 To determine whether the client is following specific procedures, rules or
regulations set by some higher authority.
 Accounting personnel are following the procedures prescribed by the
company comptroller
 Review wage rates for compliance with minimum wage laws
 Determine whether a mortgage bank is in compliance with newly –enacted
government regulations.
FS audits
 Determine whether the FS are stated in accordance with specified criteria.
 Risk of misstatements & operating controls intended to prevent
misstatements
 Auditors must have knowledge of the client’s industry & its regulatory &
operating environment, including external relationships, such as with
suppliers, customers & creditors.
Other relevant terms
 Internal revenue agents-auditors who work for the BIR& conduct
 examinations of tax-payers’ returns
 Information risks- the risk that information upon which a business
decision is made is incorrect.
 Attestation service-a type of assurance service in which the CPA issues a
report about a subject matter or assertion that is the responsibility of
another party.
 Assurance service-an independent professional service that improves the
quality of information for decision makers.

Legal Liability Considerations for Auditors

After studying this chapter, you should be able to:
 Understand the litigious environment in which CPAs practice;
 Explain why the failure of FS users to differentiate among business failure,
audit failure & audit risk has resulted in lawsuits;
 Use the primary legal concepts & terms concerning accountant’s liability as
a basis for studying legal liability of auditors;
 Describe accountant’s liability to clients & related defenses;
 Describe accountant’s liability to third parties under common law;
 Specify what constitutes criminal liability for accountants; and
 Describe how the profession & individual CPAs can reduce the threat of
litigation.

Concepts Affecting Liability

 The CPA is responsible for every aspect of his/her public accounting work,
including auditing, taxes, management advisory services & accounting &
bookkeeping services.
 The auditor is expected only to conduct audit with due care, and not
expected to be perfect. This standard of due care is often called the
prudent person concept. It is expressed in Cooley on Torts

Prudent Person Concept

“every man who offers his service to another & is employed assumes the duty
to exercise in the employment such skill as he possesses with reasonable
care & diligence. In all these employments where peculiar skill is pre-
requisite, if one offers his service, he is understood as holding himself out to
the public as possessing the degree of skill commonly possessed by others in
the same employment, &, if his pretensions are unfounded, he commits as
species of fraud upon every man who employs him in reliance on his public
profession. But no man, whether skilled or unskilled, undertakes that the task
he assumes shall be performed successfully, & without fault or error. He
undertakes for good faith & integrity, but not for infallibility, & he is liable to
his employer for negligence, bad faith, or dishonesty, but not for losses
consequent pure error errors of judgment.”

Liability for the Acts of Others

 Generally, the partners are jointly liable for the civil actions against any
owner. It is different, however, if the firm operates as a limited liability
partnership (LLP), a limited liability company (LLC), a general corporation
or a professional corporation with limited liability. Under these business
structures, the liability for one owner’s actions does not extend to another
owner’s personal assets, unless the other owner was directly involved in
the actions of the owner causing the liability. of course, the firm’s assets
are all subject to the damages that arise.
 The partners may also be liable for the work of others on whom they rely
under the laws of agency. The three groups an auditor is most likely to rely
on are employees, other CPA firms engaged to do part of the work, &
specialists called upon to provide technical information. If an employee
performs improperly in doing an audit, the partners can be held liable for
the employee’s performance.

Legal Terms Affecting CPA’s Liability

 Ordinary negligence. Absence of reasonable care that can be expected of a
person in a set of circumstances.
 Gross negligence. Lack of even slight care, tantamount to reckless
behaviour, that can be expected of a person.
 Constructive fraud. Existence of extreme or unusual negligence even
though there was no intent to deceive or do harm.
 Recklessness. In the case of audit, is present if the auditor knew an
adequate audit was not done but still issued an opinion, even though there
 was no intention of deceiving statement users
 Fraud. Occurs when a misstatement is made & there is both the knowledge
of its falsity & the intent to deceive.
 Breach of contract. Failure of one or both parties in a contract to fulfill the
requirements of the contract. An example is the failure of the CPA to
deliver a tax return on the agreed-upon date. Parties who have a
relationship that is established by a contract are said to have privity of
contract.
 Third-party beneficiary. A third party does not have privity of contract but
is known to the contracting parties & is intended to have certain rights &
benefits under the contract. E.g. is a bank that has a large loan
outstanding as at the balance sheet date & requires an audit as a part of
its loan agreement. While the contract for the audit engagement is
between the client & the audit firm, both parties are aware the bank will be
relying on the audited FS.
 Common law. Laws that have been developed through court decisions
rather than through government statutes.
 Statutory law. Laws that have been passed by the Congress & other
government units. E.g. RA 9482, RA 9520, RA 9262
 Joint & several liability. The assessment against the defendant of the full
loss suffered by a plaintiff, regardless of the extent to which other parties
shared in the wrongdoing. Example. If management intentionally misstates
financial statements, an auditor can be assessed the entire loss to
shareholders if the company is bankrupt & management is unable to pay
dividends/return shareholders’ investment.
 Separate & proportionate liability. The assessment against a defendant that
portion of the damage caused by the defendant’s negligence.

Sources of Legal Liability

 Liability to clients. E.g. client sues auditor for not discovering a material
fraud during the audit
 Liability to third parties under common law. Bank sues auditor for not
discovering that a borrower’s FS are materially misstated.
 Civil liability under the constitution. E.g. SHs sue auditor for not
 discovering materially misstated FS
 Criminal liability. The government prosecutes auditor for knowingly
issuing an incorrect audit report.

Level of Care Required

 The most common source of lawsuits against CPA is from clients.
 The principal issue in cases involving alleged negligence is usually the
level of care required. Although it is generally agreed that no one is
perfect, not even a professional, in most instances, any significant error or
mistake in judgment creates at least a presumption of negligence that the
professional will have to rebut. In audits, failure to meet auditing
standards is often conclusive evidence of negligence.
 The question of level of care becomes more difficult in the environment of
a review or a compilation of FS in which there are fewer accepted
standards to evaluate performance.
Auditor’s defenses against client suits
 Lack of duty to perform
 Non-negligent performance
 Absence of Causal Connection. E.g. Assume that the auditor failed to
complete an audit on the agreed-upon date. The client alleges that this
caused a bank not to renew an outstanding loan, which caused damages. A
potential auditor defense is that the bank refused to renew the loan for
other reasons, such as the weakening financial condition of the client

Liability to Third Parties under Common Law

 Third parties include actual & potential stockholders, vendors, banker &
other creditors, employees & customers. A CPA may be liable to the third
parties if a loss was incurred by the claimant due to reliance on misleading
FS. E.g. a bank is unable to collect a major loan from an insolvent
customer & the bank claims that misleading audited FS were relied on in
making the loan & that the CPA should be held liable because it failed to
perform the audit with due care.

Auditor Defenses Against Third -Party Suits

 Contributory negligence is ordinarily not available because a third party is
not in a position to contribute to misstated FS.