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Unit III – ACCEPTING ENGAGEMENT

“Audit risk refers to the risk that the auditor might give an inappropriate
audit opinion on the financial statements. This occurs when the auditor
concludes that the financial statements are fairly presented when they are,
in fact, materially misstated. Audit risk is the complement of audit
assurance.”

Learning Outcomes

At the end of the unit, you will be able

 To have a thorough understanding of the sequence of the different activities

involved in an audit and apply the appropriate procedures to satisfy a particular
objective.

Pretest

Thank you for answering the test. Please see

the back content for the answer key or you may view
it in the google class.

The next section is the content of this unit. It

contains vital information. Please read the content.

Content

Financial statement assertion

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 are
in accordance with applicable financial reporting framework, management implicitly or
explicitly makes assertions regarding recognition, measurement, and presentation of
classes of transactions and events, account balances and disclosures. The auditor uses
these assertions to consider the different types of potential misstatements that may
occur in the financial statements
Financial statement assertions can be classified into:
 Rights and obligation

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That the entity has rights over the reported assets and that it has valid obligation to
settle the reported liabilities. An example of an audit procedure to test this assertion
is to examine ownership documents such as certificate of title tor real property.

 Valuation and allocation

That assets and liabilities are properly valued and that revenue and expenses are
properly measured. A typical audit procedure to test this assertion includes
recalculation of financial statement values such as depreciation, accrued interest and
amortized cost of financial assets and liabilities.

 Presentation and disclosure

That assets and liabilities are properly classified and disclosures in the notes to the
financial statements are adequate. Testing this assertion will require the application
of the relevant accounting standards. In addition, the auditor may review may review
major contracts such as loan agreements to identify important information that needs
to be disclosed in the notes to the financial statements.

 Existence or occurrence

That assets and liabilities exist as of the financial statement date and that revenues
and expenses occurred during the reporting period. One of the most effective audit
procedures to test the existence of an asset is the physical examination or ocular
inspection of the asset. In circumstances where physical examination is not feasible,
the auditor may obtain evidence about the existence of asset through external
confirmation.

 Completeness

That all items that should be reported in the financial statements are so included. A
typical procedure to satisfy this assertion is to start with a source documents such as
sales invoice and determine if it is recorded m the sales journal.

Existence and completeness emphasize two opposite audit concerns.

Existence/occurrence assertion is concerned with the potential overstatement of
accounts while completeness assertion is concerned with potential understatement
of accounts. When designing audit procedures, the direction of test is a crucial step
in satisfying the completeness or the existence/occurrence assertions.
When the auditor traces items from the source documents to the accounting records, the
auditor is obtaining evidence that all transactions (as represented by the source
documents) have been completely recorded. On the other hand, when the auditor works
from the accounting records back to the supporting documents, the auditor is obtaining
evidence that the recorded items exist and are supported by documents.
Tracing forward from the source documents to the accounting records is performed
primarily to test for understatement. This procedure will satisfy the completeness

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assertion. In contrast, tracing backwards or vouching is performed primarily in order to

satisfy the existence/occurrence assertion. It is performed to test for possible
overstatement of an account.
The PSA 500 classifies the financial statement assertion according to the categories of
financial statements affected
Assertion about classes of transactions and events for the period under audit (COCAC)

Completeness All transactions and events that should have been recorded
have been recorded
Occurrence Transactions and events that have been recorded have
occurred and pertain to the entity.
Cutoff Transactions an event have been recorded in the correct
accounting period.
Accuracy Amounts and other data relating to recorded transactions and
events have been recorded appropriately.
Classification Transactions and events have been recorded in the proper
accounts.

Assertions about account balances at the period end: (RCEV)

Rights and obligations the entity holds or controls the rights to assets, and liabilities
are the obligations of the entity.
Completeness all assets, liabilities and equity interests that should have
been recorded are in fact recorded.
Existence assets, liabilities, and equity interests exist.
Valuation and assets, liabilities, and equity interests are included in the
allocation financial statements at appropriate amounts and any
resulting valuation or allocation adjustments are appropriately
recorded.

Assertions about presentation and disclosure: (COCA)

Completeness all disclosures that should have been included in the

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

The auditor may use the above categories of assertions or may express them differently
so long as all aspects described in the assertions have been covered.
Audit procedures

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The objective of the audit is to determine the validity of the financial statement
assertions. To accomplish this, auditors normally develop specific audit objectives for
each of the relevant assertions. These audit objectives serve as a guide to auditors in
assessing the risks of material misstatement and in designing the appropriate audit
procedures to be performed.
The selection of the appropriate procedures, to satisfy a particular objective, 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 the
validity of an assertion.
Some of the common audit procedures used by the auditor to gather sufficient
appropriate evidence include:
 Inspection- involves examining of records, documents, tangible assets.

 Observation- consists of looking at a process or procedure being performed by

others.

 Inquiry- consists of seeking information from knowledge 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 and trends

including the resulting investigation of fluctuations and relationships that are
inconsistent with other relevant information or deviate from predicted amounts.
Audit Evidence
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 underling the financial statements and corroborating
information from other sources. This evidence will either prove or disprove the validity of
the assertions made by management on the financial statements.
Audit Opinion
The results of the procedures performed and the audit evidence obtained are carefully
evaluated to arrive at the appropriate opinion about the fair presentation of the financial
statements.
The Audit Process

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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
this process would basically include the following audit activities
I. Accepting an engagement

II. Audit planning

III. Considering internal control

IV. Performing substantive tests

V. Completing the audit

VI. Issuing report

Accepting an Engagement
The first step in the audit process is to make a decision on whether to accept or reject an
audit engagement. This process requires 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 the
"preliminary planning activities and would involve:
a. Performing procedures regarding the continuance of the client relationship and
the specific audit engagement,

b. Evaluating compliance with ethical requirements, including independence, and

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. Knowledge of the client's business and industry is important
because it helps the auditor in understanding the transactions and events affecting the
financial statements. In addition, such knowledge also helps in the early identification of
the potential problems that might be encountered in the audit.
The auditor's understanding of the client, combined with the assessment of risk and
materiality, should enable the auditor to develop an overall audit plan and a detailed
approach for the expected conduct and scope of the audit.
Considering the Internal Control
The auditor is required to 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 is, the more assurance it provides
about the reliability of the accounting data and the financial statements.

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Consideration of internal control involves obtaining understanding of the entity's internal

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 decides to assess control risk at less than high level, sufficient
appropriate audit evidence must be obtained to prove that the internal control is
functioning effectively and that it can be relied on. This evidence can be obtained by
performing tests of controls.
Performing Substantive Tests
Based on the results of audit planning and the consideration of internal control, the
auditor designs and performs substantive tests to obtain reasonable assurance that the
financial statements are presented fairly in accordance with the applicable financial
reporting framework. Substantive tests are audit procedures designed to detect material
misstatements in the financial statements.
The nature, timing and extent of the substantive tests are highly dependent on the
results of the auditor's consideration of interna 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 compensate for this weakness by performing more effective and 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 opinion to be
expressed in auditor's report. Some of the common procedures performed at this stage
of the audit include review of subsequent events and contingencies, assessing the
appropriateness of the use of 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 the 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:

 Its competence

 Its independence,

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 Its ability to serve the client properly;

 The integrity of the prospective client's management; and

 The adequacy of the accounting records

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 training and experience education,
Before accepting an audit engagement, the auditor should obtain 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.
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 requires that audit work be assigned to personnel who have
the appropriate capabilities, competence and time to perform the audit engagement in
accordance with the professional standards. In addition, there should be sufficient
direction, supervision and review of work at all levels in order to provide reason
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

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Communication with predecessor auditor is not only a matter of courtesy to the

predecessor auditor. This communication allows the successor auditor to obtain
information about the client that will be useful in determining whether the
engagement will be accepted.

But before the successor auditor contacts the predecessor auditor, the successor
auditor should obtain the client's permission to communicate with the
predecessor auditor. This is a necessary procedure because the Code of Ethics
for Professional Accountants 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 successor auditor should inquire
into matters that may affect the decision to accept the engagement. This includes
questions regarding:

 The predecessor auditor's understanding as to the reasons for the

change of auditors;

 Any disagreement between the predecessor auditor and the client; or

 Any facts that might have a bearing on the integrity of the prospective
client's management.
The predecessor auditor should respond fully to the successor auditor's inquiry
and advise the successor auditor if there are any professional reasons why the
engagement should not be accepted.
Adequacy of the Accounting Records
The audit of the financial statements is performed on the assumption that the
financial statements are verifiable. Therefore, the client's accounting records and
documents supporting the amounts and disclosures in the financial statements
must be adequate enough to permit examination of the accounts. Inadequacy of
the accounting records is sufficient reason for the auditor to decline an audit
engagement.
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. In general, conditions which would have
caused the auditor to reject a prospective client may also result or lead to a decision of
terminating an audit engagement.
Engagement letter

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According to PSA 210, the auditor and the client should agree on the terms of the
engagement and the agreed terms will have to be recorded in an engagement letter. The
engagement letter serves as the written contract between the auditor and the client. This
letter sets forth:
o The objective of the audit of financial statements which is to express an opinion
on the financial statements,

o The management’s responsibility for the fair presentation of the financial

statement,

o The scope of the audit

o The forms or any reports or other communication that the auditor expects to
issue,

o The fact that because of the limitations of the audit, there is an unavoidable risk
that material misstatements may remain undiscovered, and

o 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:
o Billing arrangements,

o Expectations of receiving management representation letter;

o Arrangements concerning the involvement of others (experts, other auditors,

internal auditors and other client personnel); and

o 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; and

 Document and confirm the auditor's acceptance of the appointment.

Recurring audits
For recurring audit engagements, an auditor does not normally send new engagement
letter every year. However, the following factors that may cause the auditor to send a
new engagement letter:

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 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, or

 Legal requirements and other government agencies pronouncements.

In cases where the auditor decides not to send a new engagement letter, the auditor
should remind the client of the terms of the original arrangement to reiterate the
objectives of the engagement as well as the responsibilities of both the auditor and the
client.
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;

 The extent of any work performed by other auditor

 Degree of ownership by parent; or

 Degree of independence of the component’s management.

AUDIT PLANNING
Audit planning involves developing a general audit strategy and a detailed approach for
the, expected conduct of the audit. The auditor's main objective in planning the audit is
to determine the scope of the audit procedures to be performed. The auditor should plan
the audit work so that audit will be performed in an effective and efficient manner. The
extent of planning will vary according to the size of the entity, the complexity of the audit,
and the auditor's experience with the entity, and knowledge of the business.
Adequate planning of the audit work is important because:

 Planning helps ensure that appropriate attention is devoted to important areas of

the audit;

 It helps identify potential problems;

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 It allows the work to be completed expeditiously;

 It assists in the proper assignment and coordination of work; and

 It helps ensure that the audit is conducted effectively and efficiently.

PSA 315 requires the auditor to obtain sufficient understanding of the entity and its
environment including its internal control. Such understanding involves obtaining
knowledge about the entity's:
a. Industry, regulatory, and other external tactors, including financial reporting
framework;

b. Nature of the entity, including entity's selection and application of accounting

policies,

c. Objectives and strategies and the related business risks that may result in a
material misstatement of the financial statements;

d. Measurement and review of the entity's performance; and

e. Internal Control.
Understanding the client
Knowledge of the client's business and industry- how and why a client does what it does-
is essential it the audit is to be carried out effectively and efficiently. The auditor should
obtain a sufficient level of knowledge of the entity's business to identify and understand
the events transactions and practices that may have a significant effect on the financial
statements. The better the auditor understands the client's operations, the more efficient
the examination is likely to be, and the greater the value to the client of the auditor's
services.
If the auditor understands the operations of the client, the auditor is often able to
evaluate the reasonableness of the client's estimates. In addition, procedures can be
selected with more assurance, or perhaps uniquely applicable procedures can be
designed.
Knowledge of the entity would also include understanding the entity's objectives and
strategies, and the related business risks. An auditor's understanding of business risks
encountered by the entity increases the likelihood of identifying risks of material
misstatement and helps the auditor design appropriate audit procedures. Furthermore,
the auditor should obtain understanding of entity's measurement performance as this
may create pressures on the entity that may either motivate management to take action
to improve the business performance or it may lead management to manipulate the
financial statements.
Sources of information

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The auditor can obtain knowledge of the business and industry from a number of
sources. These may include:
 Review of prior years working papers,

 Tour of the client’s facilities;

 Reading relevant books, periodicals and other publications

 Discussion with people within and outside the entity

 Reading corporate documents and financial reports:

The auditor should also ensure that assistants assigned to an audit engagement obtain
sufficient knowledge of the client’s business and industry to enable them to carry out the
work delegated to them.
Uses of information obtained
Knowledge of the client's business is a frame of reference within which the auditor
exercises professional judgment. Understanding the business and using this information
appropriately assists the auditor in:

 Assessing risks and identifying potential problems,

 Planning and performing the audit effectively and efficiently,

 Evaluating audit evidence as well as the reasonableness of client's

representations and estimates; and

 Providing better service to the client

To make effective use of the knowledge about the client's business and industry, the
auditor should consider how it affects the financial statements and whether the
assertions in the financial statements are consistent with the auditor's knowledge of the
entity.
Obtaining understanding of the client’s business is a continuous and cumulative process.
For continuing engagements, the auditor should re-evaluate information gathered
previously, including information in the prior year's working papers, and update this
information if needed.
Additional Consideration on New Engagements
A first-time audit engagement requires more work than a repeat engagement. This is
because there are additional audit procedures that need to be performed in connection
with the opening balances of the accounts. In this regard, PSA S10 requires the auditor
obtain sufficient appropriate audit evidence that:

 the opening balances do not contain misstatements that materially affect the
current year's financial statements,

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 the prior period's closing balances have been correctly brought forward to the
current period or, which appropriate, have been restated, and

 accounting policies are appropriate and have been consistently applied.

Where the prior year financial statements were audited by another auditor, the auditor
may be able to obtain sufficient appropriate evidence regarding opening balances by
reviewing the predecessor auditor's working papers. If not, the auditor should evaluate
whether the audit procedures performed in the current period provide evidence relevant
to opening balances, or may consider performing specific audit procedures to obtain
evidence regarding the opening balances.
Understanding the Internal Control
Another important step in assessing the risk of material misstatements’ the financial
statements is for the auditor to obtain sufficient understanding about the entity's internal
control systems. The main reason the auditor is required to understand the internal
control is for the auditor to anticipate the type of potential misstatements that can occur
in the financial statements and thus helping the auditor plan the appropriate audit
procedures.
Developing an Overall Audit Strategy
Once the auditor has gained sufficient understanding about the entity and its
environment including its internal control, the auditor should formulate an overall audit
strategy for the expected conduct engagement. The best audit strategy is the approach
that results in most efficient audit- that is, an effective audit performed at the least
possible cost. An audit plan should be made regarding
 how much evidence to accumulate;

 what are the procedures to be performed; and

 when should the procedures be performed.

Adequate consideration of materiality and audit risk should enable the auditor to answer
these questions.
Materiality
PSA 320 does not include a definition for materiality. This is because the principle of
materiality is first and foremost a financial reporting, rather than an auditing, concept.
Materiality is defined in accounting literature in the following terms: "Information is
material if its omission or misstatement could influence the economic decision of users
taken on the basis of the financial statements."
Financial reporting frameworks often discuss the concept of materiality in the context of
the preparation and presentation of financial statements. It is important therefore that
auditors understand the accounting concept of materiality as this will provide them with a
frame of reference in determining audit materiality.

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In designing an audit plan, PSA 320 requires the auditor to make a preliminary estimate
of materiality for use during the examination. The concept of materiality recognizes that
some matters are important for fair presentation of financial statements while other
matters are not. Materiality may be viewed as:
o the largest amount of misstatement that the auditor could tolerate in the
financial statements; or

o the smallest aggregate amount that could misstate any one of the financial
statements.
Note: Materiality is a matter of professional judgment and necessarily involves
quantitative factors (amount of the item in relation to the financial statements) and
qualitative factors (the nature of misstatement)
Importance of materiality in planning an audit
The auditors should make a preliminary estimate of materiality to assist them in
determining the amount of evidence needed to support their opinion. There is an inverse
relationship between materiality and the audit evidence. This means, more evidence is
needed as the level of materiality for the account decreases.
Uses of materiality
According to PSA 320, materiality should be considered by the auditor:
a. In the planning stage, to determine the scope of audit procedures, and

b. In the completion phase of the audit, to evaluate the effect of misstatements on

the financial statements.
The following steps may be used as a guide when using materiality levels. Steps 1 and 2
are performed in the planning phase, while Step 3 is performed in the completion phase
of the audit.
Step 1 Determine the Overall Materiality- Financial Statement Level
The auditor should determine the amount of misstatement that could be material to the
financial statements taken as a whole. If the materiality level is set too low, auditor will
be wasting his time auditing accounts that are not important. However, if materiality is
set too high, auditor may not be able detect misstatements that could be material to
some readers of the financial statements.
When establishing overall materiality at the financial statement level, the auditor should
consider that the financial statements are interrelated- that is, a misstatement in one
financial statement usually affects the other statements. For this reason, the auditor
should consider materiality in terms of the smallest aggregate level of misstatement that
could distort any one of the financial statements. For example, if the auditor believes that
misstatements aggregating PI00,000 would have a material effect on the client's income
statement and that these misstatements would have to aggregate P200,000 to materially
affect the statement of financial position. When planning the audit, the auditor must use
P100,000 as the overall materiality instead of P200,000. By using the lower amount of

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PI00,000 as the overall materiality level, the auditor will be able to design the audit to
provide reasonable assurance that both the income statement and the statement of
financial position are not misstated by more than this amount. A common method of
estimating the overall materiality at the financial statement level is to multiply a financial
statement base (total assets, sales, or net income) by a certain percentage.
Step 2 Determine the tolerable misstatement- Account Balance Level
Once the overall materiality has been established, the auditor determines materiality at
the account balance level. This is done by allocating the overall materiality to the
financial statement account balances. This allows the auditor to design the appropriate
audit procedures that will be applied to specific accounts. The allocated materiality to an
account is called the tolerable misstatement for that account. The professional standards
do not provide specific guidelines as to how the allocation should be done. This process
is highly subjective and requires the exercise of great deal of professional judgment.
Step 3 Compare the aggregate amount of uncorrected misstatements with the overall
materiality
After performing audit procedures, the auditor will have to compare the aggregate
uncorrected misstatements with the overall materiality (preliminary estimate of
materiality or revised materiality level) to determine whether or not the financial
statements are materially misstated. Before an unmodified opinion can be issued, the
auditor must be confident that the combined uncorrected misstatements do not exceed
the overall materiality level.
Performance Materiality
Planning the audit solely based on the materiality guidelines discussed in the preceding
section leaves no margin for possible undetected misstatements. When auditing
financial statements, it is common for auditors to exercise prudence by setting materiality
at an amount lower than the overall materiality. By using a lower level of materiality in
the performance of the audit, the extent of the audit procedures is increased thereby
reducing the risk that the amount of uncorrected and undetected misstatements will
exceed the overall materiality. The reduced level of materiality which the auditors use
both at the financial statement and account balance level is called the "performance
materiality". The determination of performance materiality involves the exercise of
professional judgment. It is affected by the auditor's understanding of the entity, updated
during the performance of the risk assessment procedures, and the nature and extent of
misstatements identified in previous audits and thereby the auditor's expectations in
relation to misstatements in the current period. Also, the level of performance materiality
can be set at different levels for different accounts.
Bases that can be used to determine the materiality level
Since audit planning is often performed before year-end, annual financial statements are
usually not available. As a result, the auditor uses alternative bases to compute tor the
preliminary estimate of materiality, such as
o Annualized interim financial statements;

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o Prior year financial statements; or

o Budgeted financial statements of the current year

Adjustments should be made to the preliminary estimates of materiality as the year-end

financial statement account balances become available.
AUDIT RISK
The audit of financial statements is not a guarantee that all material misstatements in the
financial statements are detected. Due to the inherent limitations of the audit, there is
always a risk that the auditor may not be able detect material misstatements in the
financial statements. The auditor's responsibility is to design the audit to provide
reasonable assurance that the financial statements taken as a whole are free from
material misstatements. The concept of reasonable assurance means that the auditor
accepts some level of uncertainty in performing the audit function. The auditor’s
objective is not to eliminate this risk but to reduce the risk an acceptably low level by
applying effective audit procedures.
When designing substantive tests, the auditor should consider three main issues:
a. What level of assurance does the auditor wish to attain that the financial
statements do not contain material misstatements? As this level of assurance
increases, the scope of the auditor substantive tests increases,

b. How susceptible is the account to material misstatement? As the susceptibility of

the account to material misstatement increases the scope of the auditor's
substantive tests also increases; and

c. How effective is the client's internal control in preventing or detecting

misstatements? As the effectiveness of the clients internal control increases, the
scope of auditor's substantive test decreases.
These three issues are the preliminary basis tor the development the audit risk model:
Audit Risk = Inherent Risk * Control Risk* Detection Risk

Audit risk refers to the risk that the auditor might give an inappropriate audit opinion
on the financial statements. This occurs when the auditor concludes that the financial
statements are fairly presented when they are, in fact, materially misstated. Audit risk
is the complement of audit assurance.

For example, a 5% audit risk means that there is 95% assurance or confidence level that
the opinion expressed by the auditor on the financial statements is appropriate in the
circumstances. The auditor's judgment about the acceptable level of audit risk is
influenced by the type of client. For example, auditors will choose a lower level for public
companies over private companies because more users depend on the financial
statements of publicly-held companies.

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NOTE: In general, as the acceptable level of audit risk decreases, the amount of audit
evidence needed to support the auditor's opinion increases.

Inherent risk is the susceptibility of an account balance or class of transactions to a

material misstatement assuming that there were no related internal controls. This
concept recognizes that some account balances, by nature, are more susceptible to
misstatement than other.

For example, those accounts that are susceptible to misappropriation like cash or
accounts that are subject to complex calculations, such as leases are more likely to be
misstated compared to other accounts. PSA 315 requires the auditor to assess inherent
risk at the financial statement and account balance or transaction class levels. Factors
that may influence the auditor’s assessment of the risk of misstatement at the financial
statement level include:
a. The management integrity
b. Management Characteristics (e.g., aggressive attitude toward financial reporting
c. Operating Characteristics (e.g., profitability of the entity relative to its industry is
inadequate); and
d. Industry Characteristics (e.g., the industry is experiencing large number of
business failures)
Factors affecting inherent risk at the account balance level may include the following:
a. Susceptibility of the account to theft;
b. Complexity of calculations related to account;
c. The complexity underlying transactions and other events and
d. The degree of judgment involved in determining account balances.
NOTE: As the assessed level of inherent risk increases, the auditor should design more
effective substantive procedures.

Control risk is the risk that a material misstatement that could occur in an account
balance or class of transactions will not be prevented or detected, and corrected in a
timely manner by accounting and internal control systems.

Control risk is directly related to the condition of the entity's internal control system. If the
entity's internal control is effective, then the risk that the control will fail to detect or
prevent material misstatement (control risk) decreases. Holding other planning
considerations equal, as the assessed level of control risk increases, the auditor should
design more effective substantive procedures.

Detection risk is the risk that an auditor may not detect material misstatement that
exists in an assertion.

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As regard minimizing this risk, the auditor relies primarily on substantive tests. The more
effective the substantive tests are, the lower the detection risk will be. Detection risk is
the complement of the assurance provided by substantive tests.
NOTE: As the acceptable level of detection risk decreases, the assurance provided by
substantive tests should increase with the application of more effective substantive
procedures.
Steps in using the audit risk model
1. Set the Acceptable Level of Audit Risk

There are no specific guidelines for setting individual audit risk. The auditor uses
professional judgment in determining the risk of accepting an assertion as fairly
stated when in fact it is materially misstated. The auditor should plan the audit in
such a way that, after performing audit procedures, an opinion can be issued on
the financial statements at a low level of audit risk. It is to be emphasized that it is
the auditor, not the entity being audited, who determines the acceptable level of
audit risk. The lower the level of acceptable audit risk, the higher the desired
level of assurance/ certainty, and vice versa.

2. Assess the Level of Inherent Risk

Every account or assertion has a built-in risk of being misstated. However, there
are some accounts that, by nature, are more likely to be misstated compared to
other accounts. These are the accounts that have high inherent risks. When
assessing inherent risks for each account, the auditor must consider specific
factors related to the client that may affect the risk of a material misstatement for
a particular account. In making this assessment, the auditor relies primarily on
the knowledge of the entity, and the results of preliminary analytical procedures.

3. Assess the Level of Control Risk

As stated earlier, control risk is the risk that the client's internal control may not
detect or prevent a material misstatement. Assessment of control risk would
involve studying and evaluating the effectiveness of the client's internal control
systems. An effective internal control reduces the risk of material misstatements
in the financial statements When assessing control risk, the auditor should
recognize that inherent limitations exist. Consequently, some control risk will
always be present no matter how effective the internal control may be.

4. Determine the Acceptable Level of Detection Risk

Based on the acceptable audit risk level (Step 1) and the auditor 's assessment
of inherent and control risks (Steps 2 and 3), the auditor determines the
acceptable level of detection risk. By rearranging the audit risk model,

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Audit Risk = Inherent Risk * Control Risk * Detection Risk

The acceptable level of detection risk can be determined as follows:

Acceptable level of Detection Risk = Acceptable level of Audit Risk

Inherent Risk * Control Risk

From this equation, we can conclude that for a given level of Audit Risk, there is an
inverse relationship between the Acceptable level of Detection Risk and the assessed
level of Inherent and Control Risks.
5. Design Substantive Tests

Designing substantive tests depends on the acceptable level of detection risk;

after giving consideration to the assessment of inherent and control risks. As the
acceptable level of detection risk decreases, the assurance provided by
substantive tests increases. In order to achieve that high level of assurance, the
auditor will have to modify the nature, timing and extent of substantive tests as
follows:
 performing more effective substantive procedures, (nature)

 applying the 'substantive procedures at year-end (timing); or

 using larger sample size (extent) when performing substantive

procedures.
Relating inherent, control, and detection risk to the overall audit risk
The inherent, control, and detection risks are components of the overall audit risk. An
increase or decrease in any of these components would cause a corresponding increase
or decrease in the overall audit risk.
NOTE: Only the detection risk can be controlled by the auditor. Inherent and control
risks are functions of management and its environment, and as such, the auditor cannot
change their levels. The auditor can only assess the levels inherent and control risk.
Detection risk, in contrast, is a function of the auditor which can be controlled by the
auditor by modifying the nature, timing and extent of substantive tests. During an audit,
the auditor performs procedures to assess levels of inherent and control risks. Based on
the results of such assessment, the auditor determines the acceptable level of detection
risk and modifies the scope of substantive tests
For example, if the assessed level of inherent and control risk is high, the auditor should
lower the acceptable level of detection risk to be able to maintain the acceptable audit
risk level. Conversely, if the assessed level of inherent and control risk is low, the auditor
may accept a higher level of detection risk and without sacrificing the desired audit risk
level.
Relationship between materiality and risk

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When planning the audit, the auditor considers what would make the financial
statements materially misstated. The auditor's as5essment of materiality, related to
specific account, helps the auditor select audit procedures that can be expected to
reduce audit risk to an acceptable level. There is an inverse relationship between
materiality and the level of audit risk, that is, the higher the materiality level, the lower the
audit risk and vice versa. The auditor takes the inverse relationship between materiality
and audit risk into account when determining the nature, timing and extent of audit
procedures. For example, it, after planning for specific audit procedure, the auditor
determines that the acceptable materiality level is lower, audit risk is increased. The
auditor would compensate for this by either:
a. reducing the assessed level of control risk, where this is possible, and supporting
the reduced level by carrying out extended or additional tests of control; or

b. reducing detection risk by modifying the nature, timing and extent of planned
substantive tests.
Risk Assessment Procedures
The procedures performed by auditors to obtain an understanding of the entity and its
environment including its internal control and to assess the risks of material
misstatements in the financial statements are called "risk assessment procedures".
These include the following
a. Inquiries of management and others within the entity

b. Analytical procedures, and

c. Observation and inspection

Information obtained from performing these risk assessment procedures may be used by
the auditor as evidence to support assessment of risk of material misstatement. In
addition, in performing risk assessment procedures, the auditor may obtain audit
evidence about the fair presentation of financial statements or about the operating
effectiveness of internal control even though such procedures were not specifically
planned as substantive tests or tests of control.
ANALYTICAL PROCEDURES
Analytical procedures involve analysis of significant ratios and trends, including the
resulting investigation of fluctuations and relationships that are inconsistent with other
relevant information or deviate from predicted amounts. A basic premise underlying the
use of analytical procedures is that plausible relationships among data may reasonably
be expected to exist and continue in the absence of known conditions to the contrary.
PSA requires the auditor to use analytical procedures in the planning and overall review
stages of the audit. In the planning stage of the audit, the application of analytical
procedures helps the auditor in assessing the risk of material misstatements in the
financial statements.
Steps in Applying Analytical Procedures

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Analytical procedures help the auditor in identifying unusual transactions and events that
may indicate possible misstatement of the financial statements. Application of analytical
procedures involves the following steps:
Step 1 Develop expectations regarding, financial statements using
 Prior years' financial statements

 Anticipated results such as budgets or forecasts

 Industry averages or financial statements of other entities operating within the

same industry.

 Non-financial information relevant to the financial statements

 Typical relationships among financial statement account balances

Step 2 Compare the expectations with the financial statements under audit.
The auditor compares the financial statements with the expectations to identity
significant fluctuations that are inconsistent with the auditor's expectations. This step
allows the auditor to identify unusual or unexpected balances in the financial statements
which may indicate risk of material misstatement.
Step 3 Investigate significant unexpected differences (unusual fluctuations to determine
whether financial statements contain material misstatements.
Investigation of unusual fluctuations ordinarily begins with inquiries of management,
followed by corroboration of management responses and applying other appropriate
audit procedures.
Uses of analytical procedures
Analytical procedures may be used for the following purposes
 As a planning tool, to determine the nature, timing, an extent of other auditing
procedures

 As a substantive test to obtain corroborative evidence about particular assertions

related to the account balance or transaction class; or

 As an overall review of the financial statements in completion phase of the audit.

Analytical procedures in planning an audit
Analytical procedures used in planning an audit should focus on:
a. Enhancing the auditor's understanding of the client's business; and

b. Identifying areas that may represent specific risks.

The auditor's understanding of the client's business enables the auditor to develop
certain expectations regarding the client's financial position and performance during the

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period. If the figures reflected in the financial statements do not conform to the auditor's
expectations, questions can be raised about the reliability of the financial statements or
about the accuracy of information obtained about the entity's business. Thus, analytical
procedures performed in the planning phase of the audit are useful for confirming or
challenging the auditors understanding of the client's business.
Documenting the Audit Plan
The final step in the planning process is the documentation of the audit planning process
by preparing an overall audit plan, audit program, and time budget.
 Audit Plan. An audit plan is an overview of the expected scope and conduct of
the audit. The overall audit plan sets out in broad terms the nature, timing, and
extent of the audit procedures to be performed. While the audit plan varies for
each client, it should be sufficiently detailed to guide in the development of an
audit program.

 Audit Program. The auditor should develop and document an audit program
setting out the nature, timing and extent of planned audit procedures required to
implement the overall audit plan. In effect, audit program executes the audit
strategy. It sets out in detail the audit procedures to be performed in each
segment of the audit. The audit program serves as a set of instructions to
assistants involved in the audit and as a means to control and record the proper
execution of the work. The form and content of the audit program may vary for
each, particular engagement but it should always include a detailed list of audit
procedures that the auditor believes are necessary to accomplish the audit
objectives.

 Time Budget. A time budget is an estimate of the time that will be spent in
executing the audit procedures listed in the audit program. This provides a basis
for estimating audit fees and assists the auditor in assessing the efficiency of the
assistants.

Changes to audit plan and program

Planning is continuous throughout the engagement because of changes in

conditions or unexpected results of audit procedures. The overall audit plan and
the audit program should be revised as necessary during the course of the audit,
and the reasons for significant changes should be recorded.

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