lOMoARcPSD|51783382

Chapter 1
AUDIT - An Overview
Dependable financial information is essential to our society. We often rely upon information provided by
others in making economic decisions. The need of various users for more reliable financial information
has created a demand for an independent audit of financial statements.

The primary function of an independent audit is to lend credibility to the financial statements prepared by
an entity. The auditor's opinion enhances the value and usefulness of the financial statements. By
attaching a report to the financial statements, the auditor provides increased assurance to users that the
financial statements are reliable.

 Auditing Defined
The Philippine Standards on Auditing (PSA) defines auditing by stating the objective of a financial
statement audit, that is, to enable the auditor to express an opinion whether the financial statements
are prepared, in all material respects, in accordance with an identified financial reporting framework.

This definition confines the audit to examination of the financial statements. Although the great
majority of audit work today deals with audit of financial statements, operational and compliance
auditing are becoming more and more important.

A more comprehensive definition of auditing is given by the American Accounting Association:

<An audit is 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 established criteria and communicating the results to interested
users."

This definition conveys the following thoughts.

1. Auditing is a systematic process

Auditing proceeds by means of an ordered and structured series of steps.

2. An audit involves obtaining and evaluating evidence about assertions regarding economic
actions and events
Assertions are representations made by an audience about economic actions and events. The
auditor's objective is to determine whether these assertions are valid. To satisfy this objective, the
auditor performs audit procedures and gathers evidence that corroborates or refutes the assertions.

3. An audit is conducted objectively

The auditor should conduct the audit without bias. Impartial attitude must be maintained by the
auditor when evaluating evidence and formulating his conclusion.

4. Auditors ascertain the degree of correspondence between assertions and established criteria
Established criteria are needed to judge the validity of the assertions. These criteria are important
because they establish and inform the users of the basis against which the assertions have been
evaluated and measured. In an audit, the auditor determines the degree by which the assertions
conform to the established criteria. For example, when auditing financial statements, the auditor
judges the fair presentation of the financial statements (assertions) by comparing the statements
with an identified financial reporting framework (criteria).

Downloaded by jan ([email protected])

 lOMoARcPSD|51783382

5. Auditors communicate the audit results to various interested users

The communication of audit finding is the ultimate objective of any audit. For the audit to be
useful, the results must be communicated to interested users on a timely basis.

Figure 1.1-Illustrative Definition of Auditing

Independent Auditor

Following a systematic process

Objectively obtains and evaluate evidence

Establishes the degree of correspondence between

Established
Assertions
criteria

Communicates the results to interested users

 Types of Audits
Based on primary audit objectives, there are three major types of audit financial, compliance and
operational audits.

 Financial statement audit

This is an audit conducted to determine whether the financial statements of an entity are fairly
presented in accordance with an identified financial reporting framework. This type of audit will be
the focus of the discussion in this text.

 Compliance audit
Compliance audit involves a review of an organization9s procedures to determine whether the
organization has adhered to specific procedures, rules. or regulations. The performance of compliance
audit 1s dependent upon the existence of verifiable data and recognized criteria established by an
authoritative body. A common example of this type of audit is the examination conducted by BIR
examiners to determine whether entities comply with tax rules and regulations.

 Operational audit
An operational audit is a study of a specific unit of an organization for the purpose of measuring its
performance. The main objective of this type of audit is to assess entity9s performance, identify areas
for improvements and make recommendations to improve performance. This type of audit is also
known as performance audit or management audit.

It should be noted that, although there are different types of audit, all audits possess the same general
characteristics. They all involve:

Downloaded by jan ([email protected])

 lOMoARcPSD|51783382

1. Systematic examination and evaluation of evidence which are undertaken to ascertain whether
assertions comply with established criteria; and
2. 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.

Unlike compliance and financial statement audits, where the criteria are usually defined, criteria used in
operational audit to evaluate the effectiveness and efficiency of operations are not clearly established.

 Types of auditors
Auditors can be classified according to their affiliation with the entity being examined.

 External auditors
These are independent CPAs who offer their professional services to different clients on a contractual
basis. External auditors are the ones who generally perform financial statement audits.

 Internal auditors
Internal auditors are entity9s own employees who investigate and appraise the effectiveness and efficiency
of operations and internal controls. The main function of internal auditors is to assist the members of the
organization in the effective discharge of their responsibilities. Internal auditors usually perform
operational audits.

 Government auditors
These are government employees whose main concern is to determine whether persons or entities comply
with government laws and regulations. Government auditors usually conduct compliance audits.

Figure 1.2 – Comparison among the different types of audit.

Financial audit Compliance audit Operational audit
That the organization9s
That the financial That the organization
Assertions made by activities are conducted
statements are fairly has complied with laws,
the auditee effectively and
presented regulations or contracts
efficiently.
Financial reporting
standards or other Laws, regulations and Objectives set by the
Established criteria
financial reporting contracts. board of directors.
framework.

An opinion about
whether the financial Reports on the degree of
statements are fairly compliance with Recommendations or
Content of the
presented in conformity applicable laws, suggestions on how to
auditor’s report
with an identified regulations and improve operations.
financial reporting contracts.
framework.
Auditors who
External auditors Government auditors Internal auditors
generally perform

 The Independent Financial Statement Audit

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 identified financial
reporting framework or acceptable financial reporting standards.

Downloaded by jan ([email protected])

 lOMoARcPSD|51783382

 Responsibility for the financial statements

The management is responsible for preparing and presenting the financial statements in accordance
with the financial reporting framework.

The auditor9s responsibility is to form and express an opinion on these financial statements based on
his audit. An audit of financial statements does not relieve management of its responsibilities. Hence,
it is management9s responsibility to adopt and implement adequate accounting and internal control
systems that will help ensure, among others, the preparation of reliable financial statements.

 Assurance provided by the auditor

The auditor9s opinion on the financial statements is not a guarantee that the financial statements are
dependable. An audit conducted in accordance with Philippine Standards on Auditing (PSAs) is
designed to provide only reasonable assurance (not absolute assurance) that the financial statements
taken as a whole are free from material misstatements. In every audit, there are always inherent
limitations that affect the auditor9s ability to detect material misstatements. These limitations result
from such factors as:

1. The use of testing / Sampling risk

For practical reasons, auditors do not examine all evidence available. Many audit conclusions are
made by examining only sample of evidence. Whenever a sample is taken, there is always a
possibility that the auditor9s conclusion, based on the sample, may be different from the
conclusion that would have been reached if the auditor examines the entire population.

2. Error in application of judgment / Non-sampling risk

The work undertaken by the auditor to form an opinion is permeated by judgment. Human
weaknesses can cause auditors to commit mistakes in the application of audit procedures and
evaluation of evidence.

3. Reliance on management’s representation

Some evidence supporting the financial statements must be obtained by obtaining oral or written
representations from management. For example, it is difficult for the auditor to determine the
proper valuation of accounts receivable without management9s honest assessment. If the
management lacks integrity, management may provide the auditor with false representations
causing the auditor to rely on unreliable evidence.

4. Inherent limitations of the client’s accounting and internal control systems

Although the auditor performs procedures to detect material misstatements when auditing
financial statements, such procedures may not be effective in detecting misstatements resulting
from collusion among employees or management9s circumvention of internal control.

5. Nature of evidence
Evidence obtained by the auditor does not consist of <hard facts= which prove or disprove the
accuracy of the financial statements. Instead, it comprises pieces of information and impressions
which are gradually accumulated during the course of 'an audit and which, when taken together,
persuade the auditor about the fairness of the financial statements. Thus, audit evidence is
generally persuasive rather than conclusive in nature.

Downloaded by jan ([email protected])

 lOMoARcPSD|51783382

Figure 1.3 – Role of Management and Independent Auditor

Management Independent Auditor

Prepares Financial Statements

Evaluates Financial
Unaudited Financial Statements
Statements

Audit Report on Financial

Audited Financial Statements
Statements

Users of Financial Statements

 General principles governing the audit of financial statements

The procedures required to conduct an audit in accordance with PSAs should be determined by the
auditor having regard to the requirements of PSAs, relevant professional bodies, legislations,
regulations, and where appropriate, the terms of the engagement and the reporting requirements. PSA
provides the following guidelines when auditing financial statements:

1. The auditor should comply with the <Code of Professional Ethics for Certified Public
Accountants= promulgated by the Board of Accountancy (BOA).

In order to retain public confidence in the credibility of the auditors9 work, auditors must adhere
to standards of ethical conduct that embody and demonstrate integrity, objectivity, and concern
for the public rather than self-interest.

2. The auditor should conduct an audit in accordance with Philippine Standards on Auditing.

These standards contain the basic principles and essential procedures which the auditor should
follow. The standards also include explanatory and other materials which, rather than being
prescriptive (that is mandatory), is designed to assist auditors in interpreting and applying the
auditing standards.

3. The 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.
An attitude of 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.

In planning and performing an audit, the auditor neither assumes that the management is honest
nor assumes unquestioned honesty. Thus, representations from management are not a substitute

Downloaded by jan ([email protected])

 lOMoARcPSD|51783382

for obtaining sufficient appropriate audit evidence to be able to draw reasonable conclusions on
which to base the audit opinion.

 Need for an independent financial statement audit

The need for an independent audit of financial statements stems from the following interrelated
sources:

1. Conflict of interest between management and users of financial statements.

In a sense, financial statements may be viewed as the report by 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 inherent conflict of interest, users of financial statements have become skeptical of unaudited
financial statements.

2. Expertise
The complexity of accounting and auditing requires expertise in verifying the quality of the
financial information. 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, a
qualified person is hired by users to verify the reliability of the financial statements on their
behalf.

3. Remoteness
Users of financial information are usually prevented from directly assessing the reliability of the
information. Most of the users do not have access to the entity9s records to personally verify the
quality of the financial information. Consequently, an independent auditor is needed to assist
them in verifying the reliability of the financial information.

4. Financial consequences
Misleading financial information could have substantial economic consequences for a decision
maker. It is therefore important that financial statements be audited first before they are used for
making important decisions.

 Theoretical framework of Auditing

The audit function operates within a theoretical framework. Below are selected postulates,
assumptions or ideas that support many auditing concepts and standards.

1. 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 exists in relation to the financial statements on which an
auditor is to express an opinion, then there can be no audit to perform.

2. The auditor should always maintain independence with respect to the financial statements under
audit
Independence is essential for ensuring the credibility of the auditor9s report. The report of the
auditor will be of little or no value to the readers of the financial statements if the readers are
aware that the auditor is not independent with respect to the client.

3. There should be no long-term conflict between the auditor and the client management.

Downloaded by jan ([email protected])

 lOMoARcPSD|51783382

Short-term conflicts may exist regarding the application of auditing procedures and accounting
principles, but in the end, both the auditor and the management must be interested in the fair
presentation of the financial statements.

4. Effective internal control system reduces the possibility of errors and fraud affecting the financial
statements.
The condition of the entity9s internal control system directly affects the reliability of the financial
statements. The stronger the internal control is, the more assurance it provides about the
reliability of the accounting data and financial statements.

5. Consistent application of generally accepted accounting principle (GAAP) or Philippine

Financial Reporting Standard (PFRS) results in fair presentation of financial statements.
We often use different criteria to verify the validity of an assertion. In the case of an independent
audit of financial statements, the criteria are usually the PFRS.

6. 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.

7. An audit benefits the public.

Financial statements are ordinarily prepared and presented in order to meet the common
information needs of wide range of users. These users who rely on the financial statements as
their major source of information are the primary beneficiary of the financial statement audit.

Downloaded by jan ([email protected])