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Lesson 4: Auditor’s Responsibility

Auditor’s Responsibility for the Audit of the Financial Statements

Our objectives are to obtain reasonable assurance about whether the financial statements as a whole
are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report
that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee
that an audit conducted in accordance with PSAs will always detect a material misstatement when it
exists. Misstatements can arise from fraud or error and are considered material if, individually or in
the aggregate, they could reasonably be expected to influence the economic decisions of users taken
on the basis of these financial statements.

Chapter 4

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 individuals 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. Misstatement resulting
from fraudulent financial reporting and misappropriation of assets.
1. Fraudulent financial reporting involves intentional misstatements or omissions of
amounts or disclosures in the financial statements to deceive financial statement users.
This type of fraud is also 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
2. Misappropriation of assets or employee fraud involves theft of an entity’s assets
committed by the entity’s employees. This may include
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 Embezzling receipts
 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 fraud 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.
 Individuals 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
 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
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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 individual 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 regards, PSA 240 requires the auditor to specifically “ assess the
risk of material misstatements due to fraud and consider that assessment in designing the audit
procedures 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.

Judgements 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
misstatement exist.
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.
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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 and in the aggregate to the
financial statements taken as whole. A summary of such items should be included in or
attached to the written representation;
 It has disclosed to the auditor all significant facts 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 express a qualified or adverse opinion.
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 examination, the auditor should either qualify or disclaim
his opinion on the financial statements.

Because of the inherent limitations of an audit there is 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 to 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
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do something or solicit their help to assist management in carrying out a fraud, with or without
the employees’ knowledge.

NONCOMPLIANCE WITH LAWS AND REGULATIONS

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

 Monitoring legal requirements and ensuring that operating procedures are designed to meet these
requirements.
 Instituting and 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 larger 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 a general understanding
of the legal and 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:
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 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 (example, if the subsidiary is required
to adhere to the securities regulations of the parent company).

2. 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 statements, such as:

 Inquiring of management as to whether the entity is in compliance

with 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 recognized 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 non-compliance, the auditor should obtain an understanding of
the nature of 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 considers:
 The potential financial consequences, such as fines, penalties,
damages, threat of expropriation of assets, enforced discontinuation
of operations and litigation.
 Whether the potential financial consequences require disclosure.
 Whether the potential financial consequences are so serious as to
call into question the fair presentation given by the financial
statements.
5. When the auditor believes there may be noncompliance, the auditor should
document the findings, discuss them with management, and consider the
implication on other aspects 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.
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CONSIDERING 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 disclaimer of
opinion.

An auditor 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
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 Misstatements 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 Factors Relating to Management’s Characteristics and influence over the Control
Environment

These fraud risk factors pertain to management’s abilities, pressures, style, and attitude relating to
internal control and the financial reporting process.
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 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 presented by bonuses, stock
options or other incentives, the value of which is contingent upon the entity
achieving unduly aggressive targets for 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 usually aggressive accounting
practices.
 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 such as effective oversight by those charged with governance.
 Management does not monitor significant controls adequately.
 Management fails to correct known material weaknesses in internal control on a
timely basis.
 Management sets unduly aggressive financial targets and expectations for operating
personnel.
 Management displays a significant disregards 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 estimates.
 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.
 Domineering 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.
 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
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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 the entity and its 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 may 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 or branch operations in tax-haven 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.
 Difficult in determining the organization or person (or persons) controlling the entity.
 Unusually rapid growth or profitability, especially compared with that of other companies in
the same industry.
 Especially high vulnerability to changes in interest rates
 Unusually high dependence on debt, a marginal ability to meet debt repayment requirements,
or debt covenants that are difficult to maintain.
 Unrealistically aggressive sales or profitability incentive programs.
 A threat of imminent bankruptcy, foreclosure or hostile takeover.
 Adverse consequences on significant pending transactions (such as a business combination or
contract award) if poor financial results are reported.
 A poor or deteriorating financial position when management has personally guaranteed
significant debts of the entity.

Fraud Risk Factors Relating to Misstatements Resulting from Misappropriations of Assets

Fraud risk factors that relate to misstatements resulting from misappropriation of assets may be grouped in the
following two categories:
1. Susceptibility of Assets to Misappropriation.
2. Controls
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For each of these two categories, examples of fraud risk factors relating to misstatements resulting from
misappropriation of assets are set out below. The extent of the auditors consideration of the fraud risk factors
in category 2 is influenced by the degree to which fraud risk factors in category 1 are present.

1. Fraud Risk Factors Relating to Susceptibility of Assets to Misappropriation

These fraud risk factors pertain to the nature of an entity’s assets and the degree to which they are
subject to theft.
 Large amounts of cash on hand or processed.
 Inventory characteristics, such as small size combined with high value and high demand.
 Easily convertible assets, such as bearer bonds, diamonds or computer chips.
 Fixed assets characteristics, such as small size combined with marketability and lack of
ownership identification.
2. Fraud Risk Factors Relating to Controls

These fraud risk factors involve the lack of controls designed to prevent or detect misappropriation of
assets.
 Lack of appropriate management oversight (for example, inadequate supervision or
inadequate monitoring of remote locations).
 Lack of procedures to screen job applicants for positions where employees have access to
assets susceptible to misappropriation.
 Inadequate record keeping for assets susceptible to misappropriation.
 Lack of an appropriate segregation of duties or independent checks.
 Lack of an appropriate system of authorization and approval of transactions (for example, in
purchasing).
 Poor physical safeguards over cash, investments, inventory or fixed assets.
 Lack of timely and appropriate documentation for transactions (for example, credits for
merchandise returns).
 Lack of mandatory vacations for employees performing key control functions.

Multiple choice –Questions

1. Material misstatements may emanate from all of the following except

a. fraud
b. error
c. noncompliance with laws and regulations
d. inadequacy of accounting records.
2. Which of the following factors is most important concerning an auditor’s responsibility to detect errors and
fraud?
a. The susceptibility of the accounting records to intentional manipulations, alterations, and
the misapplication of accounting principles
b. The probability that unreasonable accounting estimates result from unintentional bias or
intentional attempts to misstate the financial statements.
c. The possibility that management fraud, defalcations, and the misappropriation of assets
may indicate the existence of illegal acts.
d. The risk that mistakes, falsifications, and omissions may cause the financial statements to
contain material misstatements.
3. The auditor gives an audit opinion on the fair presentation of the financial statements and associates his or
her name with it when, on the basis of adequate evidence, the auditor concludes that the financial statements
are unlikely to mislead
a. investors
b. management
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c. a prudent user
d. the reader
4. The level of assurance provided by an audit of detecting a material misstatement is referred to as:
a. Reasonable assurance
b. Moderate assurance
c. Absolute assurance
d. Negative assurance
5. The responsibility for the detection and prevention of errors, fraud and noncompliance with laws and
regulations rests with
a. Auditor
b. Client’s legal counsel
c. Client management
d. Internal auditor
6. The responsibility for adopting sound accounting policies, maintaining adequate internal control, and
making fair representation in the financial statement rests
a. With the management
b. With the independent auditor
c. Equally with management and the auditor
d. With the internal audit department
7. The management responsibility to detect and prevent fraud and error is accomplished by
a. Implementing adequate quality control system.
b. Having an annual audit of financial statements.
c. Implementing adequate accounting and internal control system
d. Issuing a representation letter to the auditor.
8. Which of the following statements best describes the auditor’s responsibility regarding the detection of
material errors and frauds?
a. The auditor is responsible for the failure to detect material errors and frauds only when such
failure results from the misapplication of PSA.
b. The audit should be designed to provide reasonable assurance that material errors and frauds will
be detected.
c. The auditor is responsible for the failure to detect material errors and fraud only when the auditor
fails to confirm receivables or observe inventories.
d. Extended auditing procedures are required to detect unrecorded transactions even if there is no
evidence that material errors and frauds may exist.
9. The auditor’s best defense when material misstatements in the financial statements are not uncovered in the
audit is that
a. The audit was conducted in accordance with generally accepted accounting principles.
b. Client is guilty of contributory negligence.
c. The audit was conducted in accordance with PSA.
d. The financial statements are client’s responsibility.
10. The auditor’s responsibility for failure to detect fraud arises
a. When the failure clearly results from non-compliance to PSA.
b. Whenever the amounts involved are material.
c. Only when the examination was specifically designed to detect fraud.
d. Only when such failure clearly results from negligence so gross as to sustain an inference of fraud
on the part of the auditor.

Evaluation
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1. Explain Management Responsibility?

2. Discuss Auditor’s responsibility?

Chapter 5. The Audit Process – Accepting an Engagement

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

General approach when auditing financial statements

1. Financial statement assertions

1. Existence or Occurrence
2. Rights and Obligations
3. Completeness
4. Valuation and Allocation
5. Presentation and Disclosure

2. Audit Procedures
3. Audit Evidence
4. Audit Opinion

Financial statement assertions

Management is responsible for the fair presentation of financial statements that reflect the nature and
operations of the entity. In representing that the financial statements in accordance with the applicable
financial reporting framework, management implicitly or explicitly makes assertions regarding the recognition,
measurement, presentation and disclosure of the various elements of financial statements and related
disclosures.

These assertions may fall into the following categories:

Assertions about classes of transactions and events for the period under audit:

 Occurrence – transactions and events that have been recorded have occurred and pertain to the entity.
 Completeness – all transactions and events that should have been recorded have been recorded.
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 Accuracy – amounts and other data relating to recorded transactions and events have been recorded
appropriately.
 Cutoff – transactions and events have been recorded in the correct accounting period.
 Classification – transactions and events have been recorded in the proper accounts.

Assertions about account balances at the period end:

 Existence – assets, liabilities, and equity interests exist.

 Rights and obligations – the entity holds or controls the rights to assets, and liabilities are the
obligations of the entity.
 Valuation and allocation – assets, liabilities, and equity interests are included in the financial
statements at appropriate amounts and any resulting valuation or allocation adjustments are
appropriately recorded.

Assertions about presentations and disclosure:

 Occurrence and rights and obligations – disclosed events, transactions, and other matters have
occurred and pertain to the entity.
 Completeness – all disclosures that should have been included in the financial statements have been
included.
 Classification and understandability – financial information is appropriately presented and described,
and disclosures are clearly expressed.
 Accuracy and valuation – financial and other information are disclosed fairly and at appropriate
amounts.

Audit procedures

The auditor should use assertions for classes of transactions, account balances, and presentation and
disclosures in sufficient detail to form a basis for the assessment of risks of material misstatement and the
design and performance of further audit procedures. The auditor uses assertions in assessing risks by
considering the different types of potential misstatements that may occur, and thereby designing audit
procedures that are responsive to the assessed risks.

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

Some of audit procedures used by the auditor to gather sufficient appropriate evidence include:
 Inspection – involves examining of records, documents, or tangible assets.
 Observation – consists of looking at a process or procedure being performed by others.
 Inquiry – consists of seeking information from knowledgeable persons inside or outside the entity.
 Confirmation – consists of the response to an inquiry to corroborate information contained in the
accounting records.
 Computation – consists of checking the arithmetical accuracy of source documents and accounting
records or performing independent calculations.
 Analytical procedures – consist of the analysis of significant ratios ad trends including the resulting
investigation of fluctuations and relationships that are inconsistent with other relevant information or
deviate from predicted amounts.

Audit Evidence
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Audit procedures are the means used by the auditor to obtain sufficient appropriate evidence. Audit evidence
refers to the information obtained by the auditor in arriving at the conclusions on which the audit opinion is
based. Audit evidence will comprise source documents and accounting records underlying the financial
statements and corroborating information from other sources. This evidence about the financial statements
will either prove or disprove the validity of management assertions. At the conclusion of the audit, the auditor
should carefully evaluate the audit evidence obtained in order to come up with an appropriate opinion.

Overview of the audit process

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

The Audit Process

1. Accepting an Engagement
2. Audit Planning
3. Considering Internal Control
4. Performing Substantive Tests
5. Completing the Audit
6. Issuing a Report

Accepting an Engagement

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

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

a. Performing procedures regarding the continuance of the client relationship and the specific
audit engagement.
b. Evaluating compliance with ethical requirements, including independence.
c. Establishing an understanding of the terms of the engagement.

Audit Planning

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

Considering the Internal Control

The auditor should give adequate consideration to the entity’s internal control because the condition of the
entity’s internal control directly affects the reliability of the financial statements. The stronger the internal
control, the more assurance it provides about the reliability of accounting data and financial statements.
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Consideration of internal control involves obtaining understanding of the entity’s control systems and
assessing the level of control risk that is, the risk that the client’s internal control may not prevent or detect
material misstatements in the financial statements.

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

Performing Substantive Tests

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

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

Completing the Audit

The auditor must have sufficient appropriate evidence in order to reach a conclusion on the fairness of the
financial statements. After the auditor has completed testing the account balances, the auditor performs
additional audit procedures to complete the audit and become satisfied that the evidence gathered is consistent
with the auditor’s events and contingencies, assessing the going concern assumption, performing overall
analytical review procedures, and obtaining written representations from the client’s management.

Issuing a Report

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

Accepting an Engagement

An important element of a firm’s quality control policies and procedures is a system for deciding whether to
accept or reject an audit engagement. In making this decision, the firm should consider: (1) its competence, (2)
its independence, (3) its ability to serve client properly, and (4) the integrity of the prospective client’s
management.

 Competence

One of the primary considerations before accepting an audit engagement is to determine whether the
auditor has the necessary skills and competence to handle the engagement. According to the Code of
Ethics, professional accountants should not portray themselves as having expertise which they do not
possess. Competence is acquired through a combination of education, training and experience.

Before accepting an audit engagement, the auditor should obtain a preliminary knowledge of the
client’s business and industry to determine whether the auditor has the degree of competence required
by the engagement or whether such competence can be obtained before the completion of the audit.
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 Independence

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

 Ability to serve the client properly

Closely related to competence is the auditor’s ability to serve the client properly. An engagement
should not be accepted if there are no enough qualified personnel to perform the audit. PSA 220
suggests that audit work should be assigned to personnel who have the appropriate capabilities,
competence and time to perform the audit engagement in accordance with professional standards. In
addition, there should be sufficient direction, supervision and review of work at all levels in order to
provide reasonable assurance that the firm’s standard of quality is maintained in the performance of
the engagement.

 Integrity of management

The recent wave of litigation involving auditors has made pre-acceptance investigation procedures
very important. PSA 220 requires the firm to conduct a background investigation of the prospective
client in order to minimize the likelihood of association with clients whose management lacks
integrity. This task would involve:
 Making inquiries of appropriate parties in the business community such as prospective
client’s banker, legal counsel, or underwriter to obtain information about the reputation of the
client.
 Communicating with the predecessor auditor. Communication with predecessor auditor is not
only a matter of courtesy to the predecessor auditor. This information about the client that
will be useful in determining whether the engagement will be accepted.

But before the incoming auditor contacts the predecessor auditor, the incoming auditor should
obtain client’s permission to communicate with the predecessor auditor. This is a necessary
procedure because the code of ethics prevents an auditor from disclosing any information
obtained about the client without the client’s explicit permission. Refusal of the prospective
client’s management to permit this will raise serious questions as to whether the engagement
will be accepted.

Once permission of the client is obtained, the incoming auditor should inquire into matters
that may affect the decision to accept the engagement.
 The predecessor auditor’s understanding as to the reasons for the change of auditors.
 Any disagreement between the predecessor auditor and the client.
 Any facts that might have a bearing on the integrity of the prospective client’s
management.

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

Retention of Existing Clients

The auditor’s evaluation of clients is not a one-time consideration. Clients should be evaluated at least once a
year or upon occurrence of major events such as changes in management, directors, ownership, nature of
client’s business, or other changes that may affect the scope of the examination.
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In general, conditions which would have caused an accounting firm to reject a prospective client may also
result or lead to a decision of terminating an audit engagement.

Engagement letter

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

 The objective of the audit of financial statements which is to express an opinion on the financial
statements.
 The management’s responsibility for the fair presentation of the financial statements
 The scope of the audit
 The forms or any reports or other communication that the audit expects to issue.
 The fact that because of the limitations of the audit, there is an unavoidable risk that material
misstatements may remain undiscovered.
 The responsibility of the client to allow the auditor to have unrestricted access to whatever records,
documentation and other information requested in connection with the audit.

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

 Billing arrangements
 Expectations of receiving management representation letter
 Arrangements concerning the involvement of others (experts, other auditors, internal auditors and
other client personnel)
 Request for the client to confirm the terms of the engagement.

Importance of the engagement letter

It is in the interest of both the auditor and the client that the auditor sends engagement letter in order to:
 Avoid misunderstandings with respect to the engagement.
 Document and confirm the auditor’s acceptance of the appointment.
Recurring audits

The auditor does not normally send new engagement letter every year. However, the following factors may
cause the auditor to send a new engagement letter.
 Any indication that the client misunderstands the objective and scope of the audit.
 Any revised or special terms of the engagement
 A recent change of senior management, board of directors or ownership
 A significant change in the nature or size of the client’s business
 Legal requirements and other government agencies pronouncements

When the auditor decides not to send a new engagement letter, it may be appropriate for the auditor to remind
the client of the original arrangements.

Audits of Components

When the auditor of a parent entity is also the auditor of its subsidiary, branch or division (component), the
auditor should consider the following factors in making a decision of whether to send a separate letter to the
component:
 Who appoints the auditor of the component
 Whether a separate audit report is to be issued on the component.
 Legal requirements.
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 The extent of any work performed by other auditor.

 Degree of ownership by parent
 Degree of independence of the component’s management

An example of an engagement letter is presented below.

To the Board of Directors of ACE Company.

You have requested that we audit the balance sheet of ACE Company as of December 31, 2020 and the related
statement of income and cash flows for the year then ended. We are pleased to confirm our acceptance and our
understanding of this engagement by means of this letter. Our audit will be made with the objective of our
expressing an opinion on the financial statements.

We will conduct our audit in accordance with Philippine Standard on Auditing. Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement presentation.

Because of the test nature and other inherent limitations of an audit together with the inherent limitations of
any accounting and internal control system, there is an unavoidable risk that even some material misstatements
may remain undiscovered.

In addition to our report on the financial statements, we expect to provide you with a separate letter concerning
any material weaknesses in accounting and internal control systems which come to our notice.
We remind you that the responsibility for the preparation of financial statements including adequate disclosure
is that of the management of the company. This includes the maintenance of adequate accounting records and
internal controls, the selection and application of accounting policies, and the safeguarding of the assets of the
company. As part of our audit process, we will request from management written confirmation concerning
representation made to us in connection with the audit.

We look forward to full cooperation with your staff and we trust that they will make available to us whatever
records, documentation and other information are requested in connection with our audit. our fees, which will
be billed as work progresses, are based on the time required by the individuals assigned to the engagement plus
out of pocket expenses. Individual hourly rates vary according to the degree of responsibility involved and the
experience and skill required.

This letter will be effective for future years unless it is terminated, amended or superseded.

Please sign and return the attached copy of this letter to indicate that it is in accordance with your
understanding of the arrangements for our audit of the financial statements.

JMV & Co. CPAs

Acknowledged on behalf of ACE Company by

-------------------------------------
Name and Title

Date
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Multiple Choice.

1. The objective of the ordinary audit of financial statements is the expression of an opinion on:
a. The fairness of the financial statements in all material respects.
b. The accuracy of the financial statements.
c. The accuracy of the annual report.
d. The accuracy of the balance sheet and income statement.
2. The responsibility for the preparation of the financial statements and the accompanying footnotes belong to:
a. the auditor
b. management
c. both management and the auditors equally
d. management for the statements and the auditor for the notes
3. Auditors accumulate evidence to:
a. Defend themselves in the event of a lawsuit.
b. Justify the conclusions they have otherwise reached.
c. Satisfy the requirements of the Securities and Exchange Commission.
d. Enable them to reach conclusions about the fairness of the financial statements.
4. Management assertions are:
a. Directly related to the financial reporting framework used by the company.
b. Stated in the footnotes to the financial statements.
c. Explicitly expressed representations about the company’s financial condition.
d. Provided to the auditor in the assertion letter, but are not disclosed on the financial statements.
5. Which of the following is not one of the five broad categories of management assertions?
a. General or specific transaction objectives
b. Existence or occurrence
c. Valuation and allocation
d. Presentation and disclosure
6. This assertion addresses whether all transactions that should be included in the financial statements are in
fact included.
a. Occurrence
b. Completeness
c. Rights and obligation
d. Existence
7. Which of the following statements is not correct?
a. It would be a violation of the completeness assertion if management would record a sale that did
not take place.
b. The completeness assertion deals with matters opposite from those of the existence assertion.
c. The completeness assertion is concerned with the possibility of omitting items from the financial
statements that should have been included.
d. The existence assertion is concerned with inclusion of amount that should not have been.
8. Which of the following assertion does not relate to balances at period end?
a. Existence
b. Occurrence
c. Valuation or allocation
d. Rights and obligation
9. Which of the following statement is correct?
a. Existence relates to whether the amounts in accounts are understated.
b. Completeness relates to whether balances exist.
c. Existence relates to whether the balance are valid.
d. Occurrence relates to whether the amounts in accounts occurred in the proper year.
10. Which of the following management assertions is not associated with transaction-related audit objectives?
a. Occurrence
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b. Classification and understandability

c. Accuracy
d. Completeness

Evaluation:
1. Explain the importance of Engagement Letter?