ALDERSGATE COLLEGE APPLIED AUDITING

SCHOOL OF BUSINESS AND ACCOUNTANCY

MODULE 1 OVERVIEW OF THE AUDIT PROCESS

OBJECTIVES

After this module, students are expected to:

1. Describe the nature of financial statement audits
2. Describe the objective and general principles governing an audit of financial statements
3. Discuss the major phases in the audit process

LEARNING FOCUS

Auditing Defined

Auditing is a systematic process by which a competent, independent person objectively obtains and evaluates
evidence regarding assertions about economic actions and events to ascertain the degree of correspondence
between those assertions and established criteria and communicating the results to interested users.

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Objective and General Principles Governing an Audit of Financial Statements (PSA 200)

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Objective of an Audit

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The objective of an audit of financial statements is to enable the auditor to express an opinion whether the
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financial statements are prepared, in all material respects, in accordance with an identified financial reporting
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framework. The phrases used to express the auditor's opinion is "present fairly, in all material respects."

Although the auditor's opinion enhances the credibility of the financial statements, the user cannot assume that
the opinion is an assurance as to the future viability of the entity nor the efficiency or effectiveness with which
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management has conducted the affairs of the entity.

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General Principles of an Audit

The auditor should comply with the "Code of Ethics for Certified Public Accountants" promulgated by the Board
of Accountancy and approved by the Philippine Professional Regulation Commission. Ethical principles
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governing the auditor's professional responsibilities are:

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1. independence
2. integrity
3. objectivity
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4. professional competence and due care

5. confidentiality
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6. professional behavior
7. technical standards

The auditor should conduct an audit in accordance with Philippine Standards on Auditing. These contain basic
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principles and essential procedures together with related guidance in the form of explanatory and other material.

The auditor should plan and perform the audit with an attitude of professional skepticism recognizing that
circumstances may exist which cause the financial statements to be materially misstated. For example, the
auditor would ordinarily expect to find evidence to support management representations and not assume they
are necessarily correct.

Scope of an Audit

The term "scope of an audit" refers to the audit procedures deemed necessary in the circumstances to achieve
the objective of the audit. The procedures required to conduct an audit in accordance with PSAs should be

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SCHOOL OF BUSINESS AND ACCOUNTANCY

determined by the auditor having regard to the requirements of PSAs, relevant professional bodies, legislation,
regulations and, where appropriate, the terms of the audit engagement and reporting requirements.

Reasonable Assurance

An audit in accordance with PSAs is designed to provide reasonable assurance that the financial statements
taken as a whole are free from material misstatement. Reasonable assurance is a concept relating to the
accumulation of the audit evidence necessary for the auditor to conclude that there are no material
misstatements in the financial statements taken as a whole. Reasonable assurance relates to the whole audit
process.

However, there are inherent limitations in an audit that affect the auditor's ability to detect material
misstatements. These limitations result from factors such as:

 The use of testing

 The inherent limitations of any accounting and internal control system (for example, the possibility of
collusion)

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 The fact that most audit evidence is persuasive rather than conclusive

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Also, the work undertaken by the auditor to form an opinion is permeated by judgment, in particular regarding:

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 the gathering of audit evidence, for example, in deciding the nature, timing and extent of audit
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procedures; and
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 the drawing of conclusions based on the audit evidence gathered, for example, assessing the
reasonableness of the estimates made by management in preparing the financial statements

Further, other limitations may affect the persuasiveness of evidence available to draw conclusions on particular
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financial statement assertions (for example, transactions between related parties). In these cases, certain PSAs
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identify specific procedures which will, because of the nature of the particular assertions, provide sufficient
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appropriate audit evidence in the absence of:

1. unusual circumstances which increase the risk of material misstatements beyond that which would
ordinarily be expected
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2. any indication that a material misstatement has occurred

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Responsibility for the Financial Statements

While the auditor is responsible for forming and expressing an opinion on the financial statements, the
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responsibility for preparing and presenting the financial statements is that of the management of the entity. The
audit of the financial statements does not relieve management of its responsibilities.
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Major Steps in the Systematic Process of Financial Statements Audit

Figure 1.1 presents in highly condensed form the overview and major components of an audit.
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The Audit Process

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Phase I Pre-engagement and Audit Planning Activities

Audit process begins with the preliminary arrangements with the client. Once the client has signed the
engagement letter, the planning process starts as the auditor concentrates his efforts in obtaining a detailed
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understanding of the client's business and an overall audit strategy. The auditor should observe PSA 300 on
"Planning." Basically, audit planning includes understanding the client's (1) industry environment, (2) business
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and management, (3) accounting and reporting systems, and (4) internal control.

On the basis of the initial information gathered by the auditor, he then assesses the "audit risk" relative to the
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engagement.
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Based on the initial understanding, the auditor may decide to assess control risk at the maximum level for some
assertions and below maximum for others. Maximum control risk is defined at the greatest probability that a
material misstatement that could occur in an assertion will not be prevented or detected on a timely basis by the
entity's internal control structure.
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Assessments of materiality, acceptable audit risk, inherent risk and control risk are used to develop an overall
audit plan and audit program.

Phase II Gathering and Evaluating Audit Evidence

When gathering and evaluating audit evidence, auditors perform two basic types of audit tests: test of controls
and substantive tests.

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Interim Audit Phase

In this phase, auditor focuses his attention on both the design and operation of aspects of the internal control
structure to determine whether the necessary controls were functioning as intended.

When the auditors' preliminary assessment of control risk is below the maximum level, they may decide to
perform tests of controls to establish the effectiveness of controls in preventing or detecting material
misstatements in a financial statement assertion. When auditors assess control risk at the maximum level, they
are not required to perform any tests of controls. Tests of controls are performed to determine whether a control
is working. Tests of controls may require inquiry, observation, or inspection of documents.

The tests of controls involve the following types of procedures:

1. Inquiries of client personnel

2. Inspection of documents and records
3. Observation of the application of specific policies and procedures
4. Reperformance of the application of specific policies and procedures.

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The compliance tests of controls over the basic transaction cycles, namely, (1) revenue and collection cycle, (2)

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expenditure cycle, and (3) financing and investing cycle may be done in this stage. Tests of controls precede

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substantive testing and performed to reduce the assessed level of control risk below the maximum level.

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Performance of the substantive tests of transactions may also be conducted at this stage. In fact, many of both
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types of tests, tests of controls and tests of transactions are done simultaneously on the same transactions.
When controls are not considered effective, or when control deviations are discovered, substantive tests can be
expanded in this phase or in the final audit phase.
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Results of the auditor's tests of controls whether obtained through reprocessing of transactions, observation or
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document testing and examination must be fully documented. Documentation is a necessary part of the overall
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evidence describing the thought processes leading to the design of substantive tests and this is especially critical
when the auditor assesses control risk to be below the maximum level.

Final Audit Phase

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This phase involves substantive tests of details of balances and analytical procedures. Substantive audit testing
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is the process of obtaining evidence in support of transactions and balance. The nature, timing and extent of
substantive testing is a function of the auditor's judgment concerning audit risk and materiality.
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Nature of Substantive Tests

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Test of balances refer to:

1. substantive tests of transactions and balances, and

2. analytical review procedures performed at or near the balance sheet date that are directed at the
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verification of an account balance.

In designing audit programs for tests of balances in a typical audit engagement, the following approaches are
often used:

1. When internal control over a specific class of transactions are effective, tests of balances are applied to
resulting balance sheet account balances and reliance is placed primarily on internal controls and on
analytical review procedures for related income statement account balances.
2. When internal control over a specific class of transactions are not tested or cannot be relied upon, tests
of balances are applied both to resulting balance sheet and income statement account balances.

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In performing substantive tests, the auditor aims to detect errors in account balances that are large enough,
individually or in the aggregate, to be material to the financial statements. These tests relate to "detection risk"
that is a key part of audit risk.

Substantive tests may be performed before the balance sheet date when the auditor can:

1. control the added audit risk that errors existing in the account at the balance sheet date will not be
detected and
2. reduce the cost of substantive tests at the statement date.

Audit Objectives for Substantive Tests

In performing substantive tests, the auditor aims to substantiate management's assertions relative to (1)
existence or occurrence, (2) completeness, (3) rights and obligation, (4) valuation, and (5) presentation and
disclosure of the items in the financial statements.

The specific audit objectives for substantive tests are to determine:

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1. Existence or occurrence and validity

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This relates to whether specific assets and liabilities exist at a given point in time and whether recorded

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transactions represent economic events that occurred during the year.
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2. Completeness and accuracy

This involves determining whether all transactions that should have been recorded by the client are
accurately included in the accounts.
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3. Rights and obligations

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This requires the auditor to obtain evidence that the client has rights to existing assets and that existing
liabilities and owners' equity claims against the entity are valid.
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4. Proper valuation or allocation

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This involves determining whether financial statement elements are stated at the proper amount in
accordance with GAAP.
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5. Proper statement presentation and disclosure

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This involves determining whether statement items are properly identified, classified and arranged in the
statements and whether accompanying disclosures are adequate.

The nature, timing, and extent of the procedures performed in the substantive tests depend upon the auditor's
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assessed level of control risk and the resulting detection risks he or she accepts for each assertion. For example,
a minimum level of control risk would result in a higher acceptable detection risk and therefore, in less extensive
substantive test.

The final audit phase will also include accumulation of some additional evidence for the financial statements,
summarization of the results that will enable the auditor to prepare his audit report. This will include review for
contingent liabilities, review for subsequent events performing final analytical procedures, evaluating the going
concern assumption and obtaining a client representation letter.

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 ALDERSGATE COLLEGE APPLIED AUDITING
SCHOOL OF BUSINESS AND ACCOUNTANCY

Phase III Issuing the Audit Report

The culminating step in the audit process is the preparation of the audit report. Expressing an audit opinion is the
auditor's overriding goal. The type of audit report issued depends on the evidence accumulated and the audit
findings.

The audit report concisely describes the auditor's responsibility, the nature of the examination, the audit finding
and his opinion on the financial statements. If upon completion of the audit field work, the auditor decides that an
opinion cannot be rendered, he must clearly disclaim an opinion and give reasons for the disclaimer. If an opinion
can be rendered, the auditor must decide whether to issue an unqualified, qualified or adverse opinion.

Figure 1.2 Standard Unqualified Audit Report.

INDEPENDENT AUDITORS' REPORT

To the Stockholders

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XYZ Company

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We have audited the accompanying balance sheet of XYZ Company as of December

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31, 2007 and 2006, and the related statements of income and retained earnings, and

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cash flows for the years then ended. These financial statements are the responsibility
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of the Company's management. Our responsibility is to express an opinion on these
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financial statements based on our audits.

We conducted our audit in accordance with generally accepted auditing standards.

Those standards require that we plan and perform the audit to obtain reasonable
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assurance about whether the balance sheet is free of material misstatement. An audit
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includes examining, on a test basis, evidence supporting the amounts and disclosures
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in the balance sheet. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the overall
balance sheet presentation. We believe that our audit of the balance sheet provides a
reasonable basis for our opinion.
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In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of XYZ Company as of December 31, 2007 and 2006
and the results of its operations and its cash flows for* the' years then ended in
conformity with generally accepted accounting principles.
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M. S. Cruz & Co., CPAs

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PTR No. 00711

Date of Issue: Jan. 5,2008
Place of Issue: Manila
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March 6,2008

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 ALDERSGATE COLLEGE APPLIED AUDITING
SCHOOL OF BUSINESS AND ACCOUNTANCY

POSTTEST

1. Explain why auditors' reports are important to users of financial statements.

2. In addition to an understanding of the business and the industry, what are the requirements for an
effective audit?

3. Differentiate between the scope and opinion paragraphs of the standard audit report.

4. What is an "engagement letter?” Why is its use recommended prior to the rendering of professional
services by CPAs?

5. What function is served by the audit program?

6. Who participates in the pre-audit conference, and what topics should be covered?

7. What distinguishes the interim audit phase from the final audit phase?

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8. Why must the auditor test the information system prior to testing transactions and balances?

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9. What purpose is served by the ten generally accepted auditing standards?

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10. Define attestation. In what way(s) is auditing a form of attestation?
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11. Discuss the role of risk in the audit process and how its existence is communicated to the user in the
audit report.
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12. Prior to naming Cruz and Company as its auditors, Del Pelayo of Verbatim, Inc., met with Gracie Cruz
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and inquired about the auditors who would work on Verbatim's audit. Pelayo wants Cruz to assign only
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persons who graduated from his alma mater.

Required:
How should Gracie Cruz respond?
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13. Describe the conditions under which an auditor is associated with financial statements.
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14. What factors should an auditor consider in determining whether financial statements are presented fairly
in conformity with GAAP?
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15. Why must the auditor identify the effect(s) of deviations from GAAP on the financial statements?
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16. Why must the auditor refrain from explaining why she or he is not independent?
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