PRACTICAL AUDITING Prepared by: Roda R.

Santos

Module 1
BASIC CONCEPTS OF FINANCIAL STATEMENT AUDIT

EXPECTED LEARNING OUTCOMES

After reading this chapter, you should be able to

a) recall the purpose of a financial statement audit;

b) identify the management's assertions when presenting the financial statements;
c) describe each major phase in financial statement audit;
d) identify the most common procedures applied in financial statement audit;
e) understand the purpose of audit documentation;
f) identify the different types of audit reports and state the type appropriate for each conclusion
drawn based on assessment of audit documentation,
g) formulate appropriate audit adjusting entries; and
h) complete a working trial balance.

THE PURPOSE OF FINANCIAL STATEMENT AUDIT AND MANAGEMENT'S ASSERTIONS

An entity's financial statements are the representations and responsibility of the entity's
management. External users, mainly investors and other stakeholders, use the information
contained in the financial statements in making judgments about the enterprise to formulate
decisions. A certified public accountant, acting as an external auditor, lends credibility to the
financial statements by expressing an opinion as to the fairness by which financial statements are
presented. Financial audits aim to determine whether the financial statements are prepared in
accordance with the appropriate financial reporting framework. At present, the generally accepted
accounting principles in most parts of the world are the International Financial Reporting
Standards.

In a financial statement audit, the auditor addresses each management's written financial
statement assertions, which are as follows:

● Existence or occurrence - management asserts that all assets, liabilities and equity
reported in the financial statements actually existed at the reporting date and that reported
income is earned and reported expenses are incurred during the reporting period.

● Completeness - management asserts that all transactions and accounts that should be
presented in the financial statements are the results of the transactions and other events
that actually occurred during the reporting period.

● Rights and obligations - management asserts that the entity has property rights to or
control over all recorded assets, and that all liabilities represent obligations at the reporting
date.

● Measurement and allocation - management asserts that the measurement bases of all
assets, liabilities, equities, income and expenses are appropriate in accordance with the
reporting standards and that revenues, costs and expenses are recognized during the
proper reporting period based on the appropriate revenue and expense recognition
principles.

● Presentation and disclosure - management asserts that all financial statement

components are presented, classified and described properly and all relevant and required
disclosures are included and that the financial statement elements presented and the
related notes represent the substance and not merely the legal form of the recorded
transactions.

THE AUDIT PROCESS

PRACTICAL AUDITING Prepared by: Roda R. Santos

The audit process involves both an investigation and a report. This process starts when a
reporting entity engages the services of an independent auditor and ends when the auditor issues
an audit report. The auditor evaluates the internal control procedures of the client to determine
the extent and types of audit procedures necessary to gather evidence as basis for the audit
opinion.

Major Phases in Financial Statement Audit

The following are the major phases in a financial statement audit:

a) pre-engagement activities;
b) audit planning and evaluation of internal control;
c) evidence gathering; and
d) reporting.

A. Pre-Engagement Activities

Pre-engagement activities include procedures conducted to determine whether or not to

accept a new engagement or retain an existing client. The pre engagement activities are designed
to manage conflicts and threats to the auditor. The auditor should not accept an engagement,
when based on his or her assessment, his or her independence would be compromised. In repeat
engagements, subsequent relationships established shall be assessed to determine whether
independence has not been compromised. In making an assessment as to whether to accept or
reject a prospective client, the auditor should consider the client's business reputation, the
changes in client's ownership or management and the client's reporting practices. Likewise, the
auditor should determine whether he or she and his or her audit team possess the necessary
skills, resources and competence to complete the audit within the period specified by the
engagement. If the engagement is accepted or retained, the terms shall be documented in an
engagement letter

B. Audit Planning

Audit planning involves evaluation of internal control to determine the extent of audit
procedures necessary to be performed. The audit planning phase requires active involvement of
the whole audit team, from the partner in charge down to the audit staff. It includes the following
tasks:

(1) obtaining an understanding of the client, its business, industry and accounting policies;
(2) obtaining an understanding of the client's internal control system;
(3) assessing materiality and audit risk;
(4) identifying audit objectives;
(5) determining whether reliance can be placed on certain controls in the system;
(6) determining the nature, extent and timing of substantive tests to be performed; and
(7) designing and finalizing the audit program.

C. Evidence-Gathering or Audit Documentation

The evidence-gathering (audit documentation) phase must accomplish the objective of

documenting the fact that the audit was adequately planned and sufficient, competent evidential
matter is obtained that serves as the basis for the audit opinion reached (International Standards
on Auditing 230 Audit Documentation par. 5).

The evidence gathered must both be sufficient and competent. Sufficiency refers to the
quantity of evidence an auditor acquires and competence refers to the relevance, validity and
reliability of the evidence acquired. Audit evidence consists of both accounting data (business
documents, journals and ledgers) and corroborating information (cancelled checks, invoices,
contracts, promissory notes, written representations from customers and vendors, etc.) that
supports accounting data. Because of the time element involved in completing the audit, the
PRACTICAL AUDITING Prepared by: Roda R. Santos

examination of evidence is made on a test basis. The auditors test samples of transactions and
generalize the results to the population from which the samples were drawn. This requires that
the evidence there be persuasive rather than merely convincing.

The audit procedures applied by the auditor are selected based on the audit objectives, the
quantity and types of evidence available, materiality and the assessed level of audit risk. An audit
evidence acquired may address one or more audit objectives, and in some instances, a series of
audit procedures may be necessary to address one audit objective. The following are the most
common audit procedures applied by the auditor:

● Confirmation - obtaining written statements from a third party:

● Physical count and observation;
● Inquiry obtaining written and oral information from management, employees and others;
● Documentation - obtaining internal evidence and external evidence (for example:
contracts, minutes of meetings, vouchers, bank statements, etc.);
● Comparisons - establishing trends and valid relationships of information;
● Recalculations - establishing correctness of account balances; and Mechanical tests of
data - verifying mathematical accuracy of accounting data (tracings, footings and cross-
footings).

The foregoing and other audit procedures are carried out to perform tests of controls and
substantive tests. Tests of controls are conducted to assess the ability of the company's internal
controls to prevent or detect material misstatements. Substantive tests, on the other hand, are
tests of details and analytical procedures performed to detect material misstatements in account
balance, transaction class or financial statement presentation and disclosure. Substantive tests
may be classified into tests of details or analytical procedures. Tests of details are intended to
detect material misstatement and allow an auditor to test aggregated data. Analytical procedures
are evaluations of financial information made by a study of plausible relationships among both
financial and non-financial data. Analytical procedures allow the auditor to test aggregated data
to reach a conclusion.

Audit evidence must both be sufficient and competent. The documentation shall contain
the source of the document, the clear purpose of the audit procedure performed, and the
conclusions reached based on the procedure performed and evidence gathered. The extent of
the documentations should be sufficient for an experienced auditor with no previous connection
with the engagement to understand the nature, timing, extent and results of procedures
performed, evidence obtained, and conclusions reached.

Documentation must be made immediately after completing an audit procedure.

Typical examples of audit documents are

(a) information that enables the auditor to accept reject an entity as a client information
relating to the prospective client's industry, members of the Board of Directors, products
manufactured, etc.);

(b) information that enables the auditor to determine the audit approach (information relating
to the effectiveness of internal control procedures and whether or not such procedures are
being complied with);

(c) information as to whether a particular financial statement account balance is complete,

valid and accurate and

(d) information relating to the completeness, validity and accuracy of the financial statements
taken as a whole including information relating to the consistency of the financial
statements with the auditor's knowledge of the business

The form, content and extent of audit documentation depend on factors, such as (ISA 230 A2)
PRACTICAL AUDITING Prepared by: Roda R. Santos

● the size and complexity of the entity;

● the nature of the audit procedures to be performed;
● the identified risks of material misstatements;
● the significance of the audit evidence obtained;
● the nature and extent of exceptions identified;
● the need to document a conclusion or the basis for a conclusion not readily determinable
from the documentation of the work performed or evidence obtained;
● the audit methodology and tools used.

Specifically, the audit file documentation serves to:

(a) organize and coordinate all phases of the audit engagement;

(b) provide evidence to demonstrate that the planned audit procedures were in fact performed;
(c) aid partners in reviewing the work performed by audit staff members;
(d) provide evidence that the auditors complied with the auditing standards;
(e) document the judgments involved in forming the audit opinion,
(f) aid in planning and conducting future audits of the client; and
(g) provide information in rendering additional services to the audit client (say, in preparing
income tax returns and in making recommendations for improvement of the client's internal
control procedures.)

In the risk response phase, typical audit documentation normally includes the following items:
an audit plan that addresses all material financial statement areas, the assessed risk of material
misstatement at the financial statement and assertion levels, the nature, timing and extent of the
further audit procedures performed that respond to the assessed audit risks, and significant risks
identified. Also documented are the nature and extent of consultation with others, significance
and nature of the evidence obtained at the assertion being tested, a clear explanation of the
results obtained from the test and the exceptions followed up, actions taken as a result of auditing
procedures, changes if any to the overall audit strategy, use of significant judgments applied in
performing work and evaluating results, discussions with management on significant matters,
memoranda and details of assumptions used, establishment of validity of assumptions
established, cross references to supporting documentation and evidence that the financial
statements agree with the underlying accounting records.

The auditors usually maintain two files of audit documentation for each client: (1) current files
for each year's engagement and pertain to documentation relating to that year's examination and
(2) the permanent file of relatively unchanging data (for example, articles of incorporation).

The following are examples of current files in the audit documentation:

● working trial balance;

● a summary of audit adjusting and classifying entries;
● lead schedule; bank reconciliation; aged accounts receivable;
● minutes of meetings during the reporting period; and
● narrative documentation summarizing bases for resolutions involving uncertainties.

Examples of permanent file in audit documentation are as follows:

● articles of incorporation;
● corporate by laws;
● copy of pension contract with funding agency;
● copy of trust indentures for long-term debt; and
● copy of the effective collective bargaining agreement.

The audit documentation, which generally is in the form of audit working papers, must be
organized in a logical manner using an indexing system so that the working papers and other
documents can be easily located and shared among audit team members. The working papers
and other documents should be organized in a manner that facilitates file review and quality
control monitoring by the manager, engagement partner, quality control reviewer/monitor.
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Audit documents are the property of the audit firm. However, much of the information in
working papers is confidential, and generally must not be made available to outsiders without the
consent of the client.

Under no circumstances should the working papers be destroyed after they have been
subpoenaed or after an announcement has been made for litigation involving an engagement. If
the auditors are charged with negligence, their audit working papers serve as a major basis to
refute or substantiate such a charge.

The major types of audit working papers include administrative working papers, supporting
schedules, adjusting journal entries and reclassification entries, supporting schedules, analyses,
reconciliations and other computational working papers, and corroborating documents,

Administrative working papers aid the auditors in the planning and administration of
engagements, and include the audit plans and audit programs, time budgets, internal control
questionnaires and flowcharts and engagement letter. They may take the form of a narrative
documentation that summarizes the phases of audit work performed on the engagement.

In the risk assessment phase, the documentation related to pre engagement procedures,
independence and ethics assessment, terms of engagement, materiality consideration, overall
audit strategy, audit team discussions which may include possible causes of material
misstatements in the financial statements, risk assessment procedures performed and the results,
assessed risk of material misstatement identified based on the understanding of the entity and
related internal control, significant risks, and communication with management and those charged
with governance. (Guide to Using ISAs in the Audits of SMEs)

D. Reporting

The auditor should review and assess the conclusions drawn from the audit evidence obtained
as the basis for the expression of an opinion on the financial statements. The auditor's report
should contain a clear written expression of an opinion on the financial statements taken as a
whole.

Based on the results of the evaluations made, the auditor would determine what form of audit
report is appropriate in the circumstances.

Types of Audit Reports

The auditor should evaluate the conclusions drawn from the audit evidence obtained as
the basis for forming an opinion on the financial statements (ISA 700, The Independent Auditor's
Report on the Financial Statements, par 4). There are two general types of audit report:
unmodified and modified

(1) Unmodified opinion

When the auditor concludes that the financial statements are presented fairly, in all material
respects, with the applicable financial reporting framework (at the present time, the International
Financial Reporting Standards or the International Financial Reporting Standards for Small and
Medium Sized Entities), an unmodified (or unqualified) opinion would be appropriate. An
unqualified opinion should be expressed when the auditor concludes that the financial statements
give a true and fair view (or are presented fairly, in all material respects) in accordance with the
applicable financial reporting framework (par. 35 ISA 700).

(2) Modified opinion

When based on the audit evidence obtained, the financial statements as a whole are not free
from material misstatement or when sufficient appropriate audit evidence could not be obtained
to conclude that the financial statements as a whole are free from material misstatement, a
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modified opinion is expressed. A modified opinion may take the form of a qualified opinion,
adverse opinion or disclaimer of opinion.

A qualified opinion should be expressed when either (1) sufficient appropriate audit evidence
was obtained, but the auditor concludes that misstatements exist, individually or in the aggregate,
that are material but not pervasive to the financial statements or (2) the auditor is unable to obtain
sufficient appropriate audit evidence on which to base the opinion and that the possible effects
on the financial statements of undetected misstatements, if any, could be material but not
pervasive. A qualified opinion should be worded as being except for the effects (or the possible
effects of the matter to which the qualification related

An adverse opinion should be expressed when the effects of misstatements are both material
and pervasive. This opinion applies where sufficient appropriate evidence was obtained, but the
auditor concludes that misstatements, individually or in the aggregate, are both material and
pervasive to the financial statements. An adverse opinion states that the financial statements do
not present fairly the financial position, financial performance, and cash flows of the entity audited.

A disclaimer of opinion (which basically means giving no opinion) should be expressed when
the possible effects of undetected misstatements, if any, could be both material and pervasive.
This opinion is expressed when the auditor is unable to obtain sufficient appropriate audit
evidence on which to base the opinion, and concludes that the possible effects of undetected
misstatements, if any, could be both material and pervasive. This opinion also applies to
extremely rare circumstances where in conditions of major uncertainties and their possible effects
on the financial statements, it is not possible to form an opinion.

The Working Trial Balance and the Audit Adjusting Entries

The working trial balance is a schedule listing the balances of accounts in the general
ledger for the current and previous year, with columns for adjusting entries, reclassification
entries, and the financial statement amounts.

The working trial balance is of two types:

(1) one-section trial balance, which looks like an ordinary worksheet and lists all ledger
accounts. A pair of columns is maintained for each of the following: trial balance, adjustments and
reclassifications, adjusted profit or loss accounts and adjusted financial position accounts.

(2) two-section trial balance, which is divided into two components: the working
comprehensive income and the working financial position. Each section provides a separate
column for unadjusted balances, adjustments and reclassifications and adjusted balances.

The working trial balance shows the results of all adjustments and reclassifications made
as a result of detailed audit of account balances. Thus, audit adjusting entries developed from a
cash count of petty cash, bank reconciliation statement, confirmation and analysis of accounts
receivable, analysis of property, plant and equipment, etc. are summarized in the working trial
balance.

Adjusting and reclassifying entries are a list of auditors' adjustments in the client prepared
financial statements to bring the account balances to correct balances. When the auditors
discover errors or Irregularities in the accounting records of a client, they propose adjusting entries
to correct the accounting records. Also, the auditors develop reclassification entries for items that,
although correctly recorded in the accounting records, must be reclassified for fair presentation
of the financial statements.

A lead schedule is used to combine several amounts which total to a line item in the
financial statements. For example a lead schedule is prepared to list the different cash on hand
and cash in bank that is shown as a single line item "Cash" on the face of the statement of financial
position.
PRACTICAL AUDITING Prepared by: Roda R. Santos

MULTIPLE CHOICE

1. A financial statement audit aims to

A. present financial information about an entity for use by external users.
B. determine whether financial statements presented by the management are prepared in
accordance with an applicable financial reporting framework.
C. determine whether the entity appropriately pays its income tax due.
D. determine whether the entity is able to pay its maturing obligations.

2. What management's assertion does the auditor address when he/she obtains evidential
matter on the appropriate balance of Trade and Other Payables" that will be shown in the
statement of financial position?
A. Existence or occurrence
B. Completeness
C. Rights and obligations
D. Measurement and allocation

3. What management's assertion does the auditor address when he/she reviews the
classification of a tract of land acquired exclusively for capital appreciation?
A. Existence or occurrence
B. Rights and obligations
C. Measurement and allocation
D. Presentation and disclosure

4. What management's assertion does the auditor address when he/she obtains evidence on
the shipping terms of inventories in transit shipped by a vendor?
A. Existence or occurrence
B. Completeness
C. Rights and obligations
D. Measurement and allocation

5. Which of the following is the main objective of the conduct of pre engagement activities?
A. to determine whether or not to accept a new client or retain an existing client.
B. to set the amount of the audit fee to be charged to the client.
C. to be familiar with the working staff of the audit client.
D. to assess the likelihood of issuing an unqualified opinion.

6. What is the main purpose of an auditor in his/her evaluation of the client's internal control
system?
A. to properly distribute the different tasks to the members of the audit team.
B. to make a decision whether or not to accept a new engagement or retain an existing client.
C. to determine the extent of audit procedures necessary to be performed
D. to gather sufficient evidential matter as basis for audit opinion.

7. Which of the following pairs of accounts would an auditor most likely analyze on the same
working paper?
A. Notes receivable and accounts payable.
B. Notes receivable and interest payable.
C. Notes receivable and interest income.
D. Interest income and interest expense.

8. The current file of an audit documentation most likely would include

A. Bond indenture of 20-year bonds payable.
B. Articles of incorporation.
C. Pension plan contract
D. Analysis of accounts receivable

9. An audit documentation should

A. not contain comments concerning management.
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B. show that the accounting records agree or reconcile with the management.
C. be destroyed after an announcement has been made for litigation Involving an audit
engagement.
D. be made available to others even without the consent of the audit client.

10. In which of the following circumstances would an auditor choose between issuing a qualified
opinion and issuing a disclaimer of opinion on a client's financial statements?
A. Departure from reporting framework
B. Inadequate disclosure of accounting policies
C. Inability to obtain sufficient appropriate evidence.
D. Unreasonable justification for a change in accounting policy.

11. Which of the following factors are considered in the selection of audit procedures to be
performed in an engagement?
I. composition of the audit team
II. audit objectives
III. level of audit risk
IV. type of audit evidence available
A. II, III and IV
B. I, II, and IV
C. I, II, and III
D. III and IV only

12. All of the following are normally included in the auditor's current file of audit documentation,
except
A. copy of prior year's financial statements.
B. minutes of meetings of the board of directors during the reporting period.
C. working trial balance.
D. A copy of the entity's organizational chart.

13. A working paper that gives the components of a line item to be presented on the face of the
financial statements is called
A. working trial balance.
B. supporting schedule.
C. lead schedule.
D. draft of financial statements.

14. An auditor gathers audit documentation mainly to

A. detect fraud and misstatements.
B. evaluate management effectiveness.
C. evaluate internal control,
D. form an opinion on the fairness of the financial statements.

15. Which of the following is classified as a substantive test?

A. Review of payroll checks
B. Reconcile disbursements per books with checks appearing in the bank statement.
C. Scanning of employment contracts
D. Accounting for a sequence of issued credit memoranda.

16. Which of the following is a list of activities to be undertaken by the auditor to gather audit
evidence?
A. Audit documentation
B. Audit plan
C. Audit program
D. Audit strategy