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).

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 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 organization’s 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 entity’s 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:

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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 entity’s 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 organization’s
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.

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

The auditor’s 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 management’s 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 audit or’s 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 auditor’s 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 audit or’s 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 management’s 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 management’s circu mvention 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.

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 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 auditors’ 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

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 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 entity’s 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 auditor’s 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.

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 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 entity’s 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.

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 Chapter 3

AUDITOR’S RESPONSIBILITY
The fair presentation of the financial statements in accordance with the applicable financial reporting
standards is the responsibility of ' the client’s management. The auditor’s responsibility is to design the
audit to provide reasonable assurance of detecting material misstatements in the financial statements.
These misstatements may emanate from;

1. Error,

2. Fraud, and

3. Noncompliance with Laws and Regulations

ERROR

The term “error” refers to unintentional misstatements in the financial statements, including the omission
of an amount or a disclosure, such as:

 Mathematical or clerical mistakes in the underlying records and accounting data

 An incorrect accounting estimate arising from oversight or misinterpretation of facts.

 Mistake in the application of accounting policies.

FRAUD

Fraud refers to intentional act by one or more individual among management, those charged with
governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal
advantage. Although fraud is a broad, legal concept, the auditor is primarily concerned with fraudulent
acts that cause a material misstatement in the financial statements

Types of Fraud

There are two types of fraud that are relevant to financial statement audit. Misstatements resulting from
fraudulent financial reporting and misstatements resulting from misappropriation of assets.

1. Fraudulent financial reporting involving intentional misstatements or omissions of amounts or

disclosures in the financial statements to deceive financial statement users. This type of fraud is also I
known as management fraud because it usually involves members of management or those charged with
governance. This may involve:

 Manipulation, falsification or alteration of records or documents

 Misrepresentation in or intentional omission of the effects of transactions from records or

documents

 Recording of transactions without substance

 Intentional misapplication of accounting policies

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2. Misappropriation of assets or employee fraud

involves theft of an entity’s assets committed by the entity’s employees. This may include:

 Embezzling receipt

 Stealing entity’s assets such as cash, marketable securities, and inventory.

 Lapping of accounts receivable.

This type of fraud is often accompanied by false or misleading records or documents in order to conceal
the fact that the assets are missing.

Fraud involves motivation to commit it and a perceived opportunity to do so. For example, an
employee might be motivated to steal company’s assets because 'this employee lives beyond his means.
Also, a member of management may be forced to manipulate the financial statements in order to meet an
overly optimistic projection. A perceived opportunity to commit fraud may exist when there is no proper
segregation of duties among employees or when management believes that internal control can be easily
circumvented.

The primary factor that distinguishes fraud from error is whether the underlying cause of misstatement in
the financial statements is intentional or unintentional Although the auditor may be able to identify
opportunities for fraud to be perpetrated, it is often difficult, if not impossible, for the auditor to determine
intent, particularly in matters involving management judgment, such as accounting estimates and the
appropriate application of accounting principles. Consequently, the auditor’s responsibility for the
detection of hand and error is essentially the same.

Responsibility of Management and Those Charged with Governance

The responsibility for the prevention and detection of fraud and error rests with both management and
those charged with the governance of the entity. In this regard; PSA 240 requires

 Management to establish a control environment and to implement internal control policies and
procedures designed to ensure, among others, the detection and prevention of fraud and error.

 Individual charged with governance of an entity to ensure the Integrity of an entity’s

accounting and financial reporting systems and that appropriate controls are in place.
Auditor’s Responsibility

Although the annual audit of financial statements may act as deterrent to fraud and error, the auditor is not
and cannot be held responsible for the prevention of fraud and error. The auditor’s responsibility is to
design the audit to obtain reasonable assurance that the financial statements are free from material
misstatements, whether caused by error or fraud.

PLANNING PHASE

1. When planning an audit, the auditor should make inquiries of management about the possibility of
misstatements due to fraud and error. Such inquiries may include

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  Management’s assessment of risks due to fraud

 Controls established to address the risks

 Any material error or fraud that has affected the entity or suspected fraud that the entity is
investigating
The auditor’s inquiries of management may provide useful information concerning the risk of material
misstatements in the financial statements resulting from employee fraud. However, such inquiries are
unlikely to provide useful information regarding the risk of material misstatements in the financial
statements resulting from management fraud. Accordingly, the auditor should also inquire of those
individuals in charge of governance to seek their views on the adequacy of accounting and internal
control systems in place, the risk of fraud and error, and the integrity of management.

2. The auditor should assess the risk that fraud or error may cause the financial statements to contain
material misstatements. In this regard, PSA 240 requires the auditor to specifically

“assess the risk of material misstatement due to fraud and consider that assessment in designing the audit
procedure to be performed. ”

The fact that fraud is usually concealed can make it very difficult to detect. Nevertheless, using the
auditor’s knowledge of the business , the auditor may identify events or conditions that provide an
opportunity, a motive or a means to commit fraud or, indicate that fraud may already have occurred. Such
events or conditions are referred to as “fraud risk factors”. Fraud risk factors do not necessarily indicate
the existence of fraud; however, they often have been present in circumstances where frauds have
occurred. Examples of fraud risk factors taken from PSA 240 are set out at the end of this chapter:

Judgments about the increased risk of material misstatements due to fraud may influence the auditor’s
professional judgments in the following ways:

 The auditor may approach the audit with a heightened level of professional skepticism.

 The auditor’s ability to assess control risk at less than high level may be reduced and the auditor
should be sensitive to the ability of the management to override controls.

 The audit team may be selected in ways that ensure that the knowledge, skill, and ability of
personnel assigned significant responsibilities are commensurate with the auditor’s assessment of
risk.

 The auditor may decide to consider management selection and application of significant
accounting policies, particularly those related to income determination and asset valuation.
TESTING PHASE

3. During the course of the audit, the auditor may encounter circumstances that may indicate the
possibility of fraud or error. For example, there are discrepancies found in the accounting records,
conflicting or missing documents or lack of cooperation from management. In these circumstances, the
auditor should perform procedures necessary to determine whether material misstatements exist.

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4. After identifying material misstatement in the financial statements, the auditor should consider whether
such a misstatement resulted from a fraud or an error. This is important because errors will only result to
an adjustment of financial statements but fraud may have other implications on an audit.

If the auditor believes that the misstatement is, or may be the result of fraud, but the effect on the financial
statements is not material, the auditor should

 Refer the matter to the appropriate level of management at least one level above those involved,
and

 Be satisfied that, given the position of the likely perpetrator, the fraud has no other implications
for other aspects of the audit or that those implications have been adequately considered.
However, if the auditor detects a material fraud or has been unable to evaluate whether the effect on
financial statement is material or immaterial, the auditor should:

 Consider implication for other aspects of the audit particularly the reliability of management
representations.

 Discuss the matter-and the approach to further investigation with an appropriate level of that is at
least one level above those involved,

 Attempt to obtain evidence to determine whether a material fraud in fact exists and, if so, their
effect, and

 Suggest that the client consult with legal counsel about questions of law.
COMPLETION PHASE

5. The auditor ‘should obtain a written representation from the client’s management that

 it acknowledges its responsibility for the implementation and operations of accounting and
internal control systems that are designed to prevent and detect fraud and error.

 it believes the effects of those uncorrected financial statement misstatements aggregated by the
auditor during the audit are immaterial. both individually end in the aggregate, to the financial
statements taken as a whole. A summary of each items should be Included in or attached to the
written representation:

 it has disclosed to the auditor all significant fact relating to any frauds or suspected frauds known
to management that may have affected the entity; and

 it has disclosed to the auditor the results of its assessment of the risk that the financial statements
may be materially misstated as a result of fraud.
CONSIDER THE EFFECT ON THE AUDITOR 'S REPORT

6. When the auditor believes that material error or fraud exists, he should request the management to
revise the financial statements. Otherwise, the auditor will expect a qualified or adverse opinion.

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7. If the auditor is unable to evaluate the effect of fraud on the financial statements because 'of a
limitation on the scope of the auditor’s exa mination, the auditor should either qualify to disclaim his
opinion or; the financial statements.

Because of the inherent limitations of an audit there in an unavoidable risk that material misstatements in
the financial statements resulting from fraud and error may not be detected. Therefore, the subsequent
discovery of material misstatement in the financial statements resulting from fraud or error does not, in
and of itself, indicate that the auditor has failed to adhere to the basic principles and essential procedures
of an audit.

The risk of not detecting a material misstatement resulting from fraud is higher than the risk 'of not
detecting misstatements resulting from error. This is due to the fact that fraud may involve sophisticated
and carefully organized schemes designed to conceal it, such as forgery, ' deliberate failure to record
transactions, or intentional misrepresentation being made to the auditor. Hence, audit procedures that are
effective for detecting material errors may be ineffective for detecting material fraud; especially those
concealed through collusion.

Furthermore, the risk of the auditor not detecting a material misstatement resulting from management
fraud is greater than for employee fraud, because those charged with governance and management are
often in a position that assumes their integrity and enables them to override the formally established
control procedures. Certain levels of management may be in a position to override control procedures
designed t6 prevent similar frauds by other employees, for example, by directing subordinates to record
transactions incorrectly or to conceal them. Given its position of authority within an entity, management
has the ability to either direct employees to do something or solicit their help to assist management in
carrying out a fraud, with or without the employee’s knowledge.

NONCOMPLIANCE WITH LAWS AND REGULATIONS

Noncompliance refers to acts of omission or commission by the entity being audited, either intentional
on: unintentional, which are contrary to the prevailing laws or regulations. Such acts include transactions
entered into by, or in the name cg the entity or on its behalf by its management or employees. Common
examples include:

 Tax evasion

 Violation of environmental protection laws

 Inside trading of securities

Management’s Responsibility

It is management’s responsibility to ensure that the entity’s operations are conducted in accordance with
laws and regulations. The responsibility for the prevention and detection of noncompliance rests with
management. (PSA 250)

The following policies and procedures, among others, may assist management in discharging its
responsibilities for the prevention and detection of noncompliance:

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  Monitoring legal requirements and ensuring that operating procedures are designed to meet these
requirements.

 Instituting end operating appropriate systems of internal control.

 Developing, publicizing and following a Code of Conduct.

 Ensuring employees are properly trained and understand the Code of Conduct.

 Monitoring compliance with the Code of Conduct and acting appropriately to discipline
employees who fail to comply with it.

 Engaging legal advisors to assist in monitoring legal requirements.

 Maintaining a register of significant laws with which the entity has to comply within its particular
industry and a record of complaints.

In large entities, these policies and procedures may be supplemented by assigning appropriate
responsibilities to an internal audit function an audit committee.

Auditor’s Responsibility

An audit cannot be expected to detect noncompliance with all laws and regulations. Nevertheless, the
auditor should recognize that noncompliance by the entity with laws and regulations may materially affect
the financial statements.

PLANNING PHASE

1. In order to plan the audit, the auditor should obtain. General understanding of legal regulatory
framework applicable to the entity and the industry and how the entity is complying with that framework.

To obtain the general understanding of laws and regulations, the auditor would ordinarily.

 Use the existing knowledge of the entity’s industry and business.

 Inquire of management concerning the entity’s policies and procedures regarding compliance
with laws and regulations.

 Inquire of management as to the laws or regulations that may be expected to have a fundamental
effect on the operations of the entity.

 Discuss with management the policies or procedures adopted for identifying, ' evaluating and
accounting for litigation claims and assessments.

 Discuss the legal and regulatory framework with auditors of ' subsidiaries in other countries (for
example, if the subsidiary is required to adhere to the securities regulations of the parent
company).
After obtaining the general understanding, the auditor should design procedures to help identify
instances of noncompliance with those laws and regulations where noncompliance should be considered
when preparing financial statement such as:

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  Inquiring of management as to whether the entity is in compliance with such laws ‘ and
regulations.

 Inspecting correspondence with the relevant licensing or regulatory authorities

3. The auditor should also design audit procedures to obtain sufficient appropriate audit evidence about
compliance with those laws and regulations generally regularized by the auditor to have an effect on the
determination of material amounts and disclosures in financial statements.

TESTING PHASE

4. When the auditor becomes aware of information concerning a possible instance of noncompliance, the
auditor should obtain an understanding of the nature 6f the act and the circumstances in which it has
occurred, and sufficient other information to evaluate the possible effect on the financial statements.
When evaluating the possible effect on the financial statements, the auditor considered:

 The potential financial consequences such as fines, penalties, damages, threat of expropriation of
users, enforced documentation of operations and litigation.

 Whether the potential financial consequences require disclosure.

 Whether the potential financial consequences are so serious to call into question the fair
presentation given by the financial statements.
5. When the audits believe there may be noncompliance, the auditor should document the findings,
discuss them with management and consider the implication on other aspect of the audit

COMPLETION PHASE

6. The auditor should obtain written representations that management has disclosed to the auditor all
known actual or possible noncompliance with laws and regulations that could materially affect the
financial statements

CONSIDER THE EFFECT ON THE AUDITOR ’S REPORT

7. When the auditor believes that there is noncompliance with laws and regulations that materially affects
the financial statements, he should request the management to revise the financial statements. Otherwise,
a qualified or adverse opinion will be issued.

8. If a scope limitation has precluded the auditor from obtaining sufficient appropriate evidence to
evaluate the effect of noncompliance with laws and regulations, the auditor should express a qualified
opinion or a disclaimer of opinion.

An audit is subject to the unavoidable risk that some material misstatements in the financial statements
will not be detected, even though the audit is properly planned and performed in accordance with PSAs.
This risk is higher with regard to material misstatements resulting from noncompliance with laws and
regulations because:

 There are many laws and regulations relating principally to the operating aspects of the entity that
typically do not have a material effect on the financial statements and are not captured by the

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 accounting and internal control systems. Auditors are primarily concern with the noncompliance
that will have a direct and material effect in the financial statements. Hence, auditors do not
normally design audit procedures to detect noncompliance that will not directly affect the fair
presentation of the financial statements unless the results of other procedures that were applied
cause the auditor to suspect that a material indirect effect noncompliance may have occurred.

 Noncompliance may involve conduct designed to conceal it, such as collusion, forgery, deliberate
failure to record transactions, senior management override of controls or intentional
misrepresentations being made to the auditor.
Examples of Risk Factors Relating to Misstatements Resulting from Fraud

The fraud risk factors identified below are examples of such factors typically faced by auditors in a broad
range of situations. However, the fraud risk factors listed below are only examples; not all of these factors
are likely to be present in all audits, nor is the list necessarily complete. Furthermore, the auditor exercises
professional judgment when considering fraud risk factors _ individually or in combination and whether
there are specific controls that mitigate the risk.

Fraud Risk Factors Relating to Misstatement Resulting from fraudulent financial Reporting

Fraud risk factors that relate to misstatements resulting from fraudulent financial reporting may be
grouped in the following three categories:

1. Management’s Characteristics and Influence over the Control Environment.

2. Industry Conditions

3. Operating Characteristics and Financial Stability.

For each of these three categories, examples of fraud risk factors relating to misstatements arising from
fraudulent financial reporting are set out below.

1. Fraud Risk Factor Relating to Management’s Characteristics and influence over their control
environment

These fraud risk factors pertain to management’s abilities Pressures, style, and attitude relating to internal
control and the financial reporting process.

 There is motivation for management to engage in fraudulent financial reporting specific

indicators might ‘ include the following:

 A significant portion of management’s compensation is represented by bonuses, stock

options or other incentives, the value of which is contingent upon ' the entity achieving
unduly aggressive targets fox. I operating results, financial position or cash flow.

 There is excessive-interest by management in maintaining or increasing the entity’s stock

price or earnings trend through the use of unusually aggressive accounting practices.

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  Management commits to analysts’ creditors and other third parties to achieving what
appear to be unduly aggressive or clearly unrealistic forecasts.

 Management has an interest in pursuing inappropriate means to minimize reported

earnings for tax-motivated reasons.

 There is a failure by management to display and communicate an appropriate attitude regarding

internal control and the financial reporting process. Specific indicators might include the
following:

 Management does not effectively communicate and support the entity’s values or ethics,
or management communicates inappropriate values or ethics.

 Management is dominated by a single person or a small group without compensating

controls each as effective oversight by those charged with governance.

 Management does not monitor significant controls adequately.

 Management fails to correct known material weaknesses 1n internal control on a timely

basis.

 Management sets unduly aggressive financial targets and expectations for operating
personnel.

 Management displays a significant disregard for regulatory authorities.

 Management continues to employ ineffective accounting, information technology or

internal auditing staff.

 Non-financial management participates excessively in, or is preoccupied with, the selection of

accounting principles or the determination of significant estimate;

 There is a high turnover of management, counsel or board members.

 There is a strained relationship between management and the current or predecessor auditor.
Specific indicators might include the following:

 Frequent disputes with the current or a predecessor auditor on accounting, auditing or

reporting matters.

 Unreasonable demands on the auditor, including unreasonable time constraints regarding

the completion of the audit or the issuance of the auditor’s report.

 Formal or informal restrictions on the auditor that inappropriately limit the auditor’s
access to people or information, or limit the auditor’s ability to communicate effectively
with those charged with governance.

 Dominating management behavior in dealing with ' the auditor, especially involving
attempts to influence the scope of the auditor’s work.

 There is a history of securities law violations, or claims against the entity or its management
alleging fraud or violations of securities laws.

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  The corporate governance structure is weak or ineffective, which may be evidenced by, for
example:

 A lack of members who are independent of management.

 Little attention being paid to financial reporting matters and to the accounting and
internal control systems by those charged with governance
2. Fraud Risk Factors Relating to Industry Conditions

These fraud risk factors involve the economic and regulatory environment in which the entity operates.

 New accounting, statutory or regulatory requirements that could impair the financial stability or
profitability of the entity.

 A high degree of competition or market saturation, accompanied by declining margins.

 A declining industry with increasing business failures and significant declines in customer
demand.

 Rapid changes in the industry, such as high vulnerability to rapidly changing technology or rapid
product obsolescence.
3. Fraud Risk Factors Relating to Operating Characteristics and Financial Stability.

These fraud risk factors pertain to the nature and complexity of th e entity and 1ts transactions, the entity’s
financial condition, and its profitability.

 Inability to generate cash flows from operations while reporting earnings and earnings growth.

 Significant pressure to obtain additional capital necessary to stay competitive, considering the
financial position of the entity (including a need for funds to finance major research and
development or capital expenditures).

 Assets, liabilities, revenues or expenses based on significant estimates that involve unusually
subjective judgments or uncertainties, or that are subject to potential significant change in the
near term in a manner that have a financially disruptive effect on the entity (for example, the
ultimate collectability of receivables, the timing of revenue recognition, the realizability of
financial instruments based on highly-subjective valuation of Collateral or difficult to assess
repayment sources, or a significant deferral of costs).

 Significant related party transactions which are not in the ordinary course of business.

 Significant related party transactions which are not audited or are audited by another firm.

 Significant, unusual or highly complex transactions (especially those close to year-end) that pose
difficult questions concerning substance over form.

 Significant bank accounts or subsidiary 01.1i branch operations in tax-heaven jurisdictions for
which there appears to be no clear business justification.

 An overly complex organizational structure involving numerous or unusual legal entities,

managerial lines of authority or contractual arrangements without apparent business purpose.

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