OVERVIEW OF AUDIT AND ASSURANCE

Assurance services – it is professional services that enhance the quality of information, or its context, for decision makers. Many assurance
services involve some form of attestation.

Attest engagement - an engagement in which the CPAs issue an examination, a review, or an agreed-upon procedures report on subject matter
or an assertion about subject matter that is the responsibility of another party (e.g., management).

Assurance Engagements/ Services– means an engagement in which a practitioner (professional accountant or auditor), expresses a conclusion
that is designed to enhance the degree of confidence users have about the evaluation of a subject matter against identified criteria.

5 elements of an assurance engagement

1. a three party relationship involving a practitioner, a responsibility party and intended party
2. subject matter
3. suitable criteria
4. sufficient appropriate evidence
5. written assurance report in the form appropriate to a reasonable assurance engagement or a limited assurance engagement

Types of Assurance
1. Reasonable assurance
2. Limited assurance
3. Assignment with no assurance is given

Difference between reasonable assurance engagements and limited assurance engagements

Reasonable Assurance Engagement Limited Assurance Engagement
High but not absolute level of assurance Moderate/lower level of assurance
Opinion expressed is positive Conclusion is expressed negatively
e.g. audit of financial statements e.g. engagement to examine forecast
Audit report – “In our opinion, financial statements show a true and fair Audit report – “Nothing has come to our attention which
view…” causes us to believe that these assumptions do not provide a
reasonable basis for the forecast.”

Types of Assurance Engagement

1. Audit - an examination designed to provide an opinion, the CPA’s highest level of assurance that the financial statements follow
generally accepted accounting principles, or another acceptable basis of accounting.
2. Review - involves performing limited procedures, such as inquiries and analytical procedures. In performing a review, the practitioners
endeavor to gather sufficient evidence to drive attestation risk to a moderate level. Accordingly, the resulting report provides only
limited assurance that the information is fairly presented.
3. Agreed-upon procedures - An attest engagement in which the CPAs agree to perform procedures for a specified party and issue a
report that is restricted to use by that party.
4. Compilation - the objective of a compilation engagement is for the accountant to use accounting expertise, as opposed to auditing
expertise, to collect, classify and summarize financial information. This ordinarily entails reducing detailed data to a manageable and
understandable form without a requirement to test the assertions underlying that information

Difference between among the types of assurance engagement

Types of Level of Assurance Risk of Material Nature of Assurance in Procedures
Engagements Provided Misstatement Report
Audit High (reasonable) Low “In our opinion…” Select from all available
procedures any combination that
can limit attestation risk to a
lower level.
Review Moderate (limited) Moderate “We are not aware of any Generally limited to inquiry and
material modification that analytical procedures
should be made…”
Agreed-upon Summary of findings Varies by specific Includes a summary of Procedures agreed upon with the
procedures engagement procedures followed and specified user/s
findings

Engagement Acceptance – A practitioner accepts an assurance engagement only where the practitioner’s preliminary knowledge of the
engagement circumstances indicates that:
1. Relevant ethical requirements, such as independence and professional competence will be satisfied; and
2. The engagement exhibits all of the following characteristics:
a. The subject matter is appropriate
b. The criteria to be used are suitable and are available to the intended users
c. The practitioner has access to sufficient appropriate evidence to support the practitioner’s conclusion

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 d. The practitioner’s conclusion, in the form appropriate to either a reasonable assurance or a limited assurance engagement,
is to be contained in a written report
e. The practitioner is satisfied that there is a rational purpose for the engagement.

 Having accepted an assurance engagement, a practitioner may not change that engagement to a non-assurance engagement. Or
from a reasonable assurance engagement to a limited assurance engagement without reasonable justification. A change in
circumstances that affects the intended users’ requirements, or a misunderstanding concerning the nature of the engagement,
ordinarily will justify a request for a change in the engagement. If such a change is made, the practitioner does not disregard evidence
that was obtained prior to the change.

Audit – is systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to
ascertain the degree of correspondence between these assertions and established criteria and communicating the results to interested users.
(American Accounting Association)
• Audit is an independent, objective and expert examination and evaluation of evidence.
• The auditor obtains and evaluates evidence. The auditor assesses the reliability and sufficiency of the information contained in the
underlying accounting records and other source data by: a) evaluation of accounting systems and internal controls; b) carrying out
substantive tests.
• The evidence obtained and evaluated by the auditor regards assertions about economic actions and events. Assertions are
representations by management that are embodied in the financial statements. (PERCV- MO Presentation, Existence, Rights &
obligations, Completeness, Valuation, Measurement, Occurrence) The basis of evidence gathering objectives, the thing that the
evidence must “prove” is the assertions of management.
• The auditor ascertains the degree of correspondence between assertions and established criteria. The audit program tests most
assertions by examining the physical evidence of documents, confirmation, inquiry and observation. An established criterion is GAAP,
PAS and PFRS.
• The goal, or objective, of the audit is communicating the results to interested users. The audit is conducted with a view of expressing
an informed and credible opinion, in a written report stating that the statements ‘give a true and fair view’ or ‘present fairly, in all
material respects’ the financial position of the company. The communication of the auditor's opinion is called "attestation”, or the
"attest function".
• The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are
prepared, in all material respects, in accordance with an identified financial reporting framework. (PSA 200)
• The primary objective of an audit is to provide a report by the auditor of his opinion of the truth and fairness of the financial statements
examined by him. The secondary objectives are (1) to detect errors and fraud that cause material misstatements in the accounting
records and/or the financial statements and (2) to provide constructive advice on the client’s internal control system.
• The audit is designed to provide reasonable assurance that the financial statements as a whole are free from material misstatement
as required by auditing standards.

General Principles Governing an Audit of Financial Statements

1. An auditor should comply with the Code of Ethics for Professional Accountants.
2. An auditor should conduct an audit in accordance with Standards on Auditing.
3. The scope of an audit – the audit procedures deemed necessary to achieve the objective of the audit.
4. Certain inherent limitations in an audit affect the auditor’s ability to detect material misstatements.
5. Management is responsible for the financial statements, accounting and internal control.

Economic Demand for Auditing

1. Complexity – company’s transactions can be voluminous and complicated, so users of financial information need the expertise of
professional accountants.
2. Remoteness – it’s uneconomical for the users of financial statements to employ professional accountants to do that job.
3. Consequences – financial decisions can involve large amounts of money and massive efforts. Good information, obtained through
accounting experts, is beneficial for that type of decisions.

Types of Audit
1. Financial statement audit – examine financial statements, determine if they give a true and fair view or fairly present the financial
statements. It is to determine whether the overall financial statements are stated in accordance with GAAP.
2. Operational audit – review of the operating procedures of an organization for the purpose of evaluating and improving its efficiency
and effectiveness.
3. Compliance audit – to determine whether the procedures and regulations prescribed by management are complied with.

Types of Audit
1. External Audit – commonly performed by an independent person or firms and result in an auditor’s opinion which is included in the
audit report.
2. Internal Audit – performed by an employee within the company or entity. Its purpose is to ensure compliance with laws and regulations
and to help maintain accurate and timely financial reporting and data collection. Its report will serve as a managerial tool to make
improvements to processes and internal controls.

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Difference between Internal and External Auditors
Area of Difference External Auditor Internal Auditor
Scope Determine by rules, regulation and statute Determine by management
Objective To give reasonable assurance that the financial To ensure that the accounting system is efficient, effective
statements are free from errors, fraud and and economic and providing management with accurate
misstatements. and material information.
Responsibility To shareholders and interested users To management
Qualification Must be a Professional Accountant None
Independence Staff of the company/entity Auditor who is independent of the company

EXERCISES

I. Read each question carefully. Encircle your correct answer.

1. The most important benefit of having an annual audit by a public accounting firm is to:
a. Provide assurance to investors and other outsiders that the financial statements are reliable.
b. Enable officers and directors to avoid personal responsibility for any misstatements in the financial statements.
c. Meet the requirements of government agencies.
d. Provide assurance that illegal acts, if any exist, will be brought to light.
2. Which of the following is an example of a compliance audit?
a. An audit of financial statements.
b. An audit of a company’s policies and procedures for adhering to environmental law and regulations.
c. An audit of a company’s internal control over financial reporting.
d. An audit of the efficiency and effectiveness of a company’s legal department.
3. Which of the following has primary responsibility for the fairness of the representations made in financial statements?
a. Client’s management. c. Independent auditor.
b. Audit committee. d. AICPA.
4. Which of the following levels of assurance will be provided by the independent auditor’s report?
a. Absolute assurance c. Moderate assurance
b. Reasonable assurance d. Limited assurance
5. Which of the following statements is NOT a benefit of an audit?
a. Increased credibility of the financial statements. c. Fraud may be detected during the audit.
b. Deficiencies in controls may be identified during testing. d. Sampling is used.
6. Which of the following statements is FALSE?
a. The auditor will express an opinion as to whether the financial statements show a true and fair view.
b. The auditor must be able to obtain sufficient appropriate evidence to be able to form an opinion.
c. If the financial statements are found to contain material misstatements a negative audit opinion will be given.
d. An audit may not detect all fraud and error in the financial statements.

II. CPAs become involved in a variety of types of engagements. For each of the following statements, indicate whether it relates to an
examination (E), review (R), or agreed-upon procedures (A) engagement. If the statement does not relate to examinations, reviews, or
agreed-upon procedures, reply N.

Statement Type of Engagement

1. When financial statements are involved, this is referred to as an audit. E
2. The term, “We are not aware of any material modifications that should be made” is often included in the R
report.
3. The report issued provides a summary of procedures followed and findings. A
4. The report issued provides “reasonable assurance.” E
5. The procedures involved are generally limited to inquiry and analytical procedures. R
6. The report issued provides “absolute assurance.” N
7. The report issued provides “limited assurance.” R
8. The procedures followed are agreed upon with the specified user or users. A
9. This type of engagement provides more assurance than a review. E
10. The CPA need not be independent to perform this service. N

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ROLE OF AUDITING AND ASSURANCE AND PROFESSIONAL STANDARD IN THE CONDUCT OF AUDIT AND ASSURANCE

Role of Audit and Auditor in Modern Society

 Auditors are charged with the responsibility of expressing an opinion regarding the fairness and truth of financial statements.
 The role of the auditor is to scrutinize the financial data of a company and ensure that there is accuracy and regulatory compliance.
 The role of the auditor is to reduce the information risk by providing truthful and fair financial information.
 The work of an auditor is to reinforce trust, strengthening accountability and confidence in financial reporting.

5 Characteristics of an Auditor
1. Have the required experience 4. Dependable
2. Ability to make independent decision 5. Effective Communication Skills
3. Auditors have the ability to understand different business needs

Responsibilities of an Auditor to Detect Misstatement

 The objective of audit is to determine whether the financial statements are free of material misstatement, regardless of whether that
misstatement is intentional or not; in other words, fraud examiner’s priority is proving the nature and extent of a particular fraud, but an
auditor’s focus is detecting material misstatements.
 Auditors have a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatements.

Responsibility of an Auditor for the Compliance to Laws and Regulations

 The auditor’s responsibility for identifying client noncompliance with laws and regulations.
 The auditor should obtain an understanding of the legal and regulatory framework applicable to the entity and how the organization
complies with that framework.
 When the violations are considered intentional and material, the auditors should communicate the matter to those charged with
governance as soon as practicable.
 If the auditors suspect that management or those charged with governance are involved in noncompliance, they should communicate
the matter to the next higher level of authority in the organization. When no higher authority exists that is uninvolved, or if the auditors
believe that the communication may not be acted upon or do not know whom to report to, they should consider the need to obtain
legal advice.

Responsibility of an Auditor for Audit Reports

 The end product of an audit is a report expressing the auditor’s opinion on the client’s financial statements.

AICPA Attestation Standards on the Conduct of Audit (10 standards according to Generally Accepted Auditing Standards)
 General Standards
1. The auditor must have adequate technical training and proficiency to perform the audit.
2. The auditor must maintain independence in mental attitude in all matters relating to the audit.
3. The auditor must exercise due professional care in the performance of the audit and the preparation of the report.
 Standards of Fieldwork
4. The auditor must adequately plan the work and must properly supervise any assistants.
5. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the
risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing and extent
of further audit procedures.
6. The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an
opinion regarding the financial statements under audit.
 Standard of Reporting
7. The auditor must state in the auditor’s report whether the financial statements are presented in accordance with generally
accepted accounting principles.
8. The auditor must identify in the auditor’s report those circumstances in which such principles have not been consistently
observed in the current period in relation to the preceding period.
9. When the auditor determines that informative disclosures are not reasonably adequate, the auditor must so state in the auditor’s
report.
10. The auditor must either express an opinion regarding the financial statements, taken as a whole, or state that an opinion cannot
be expressed, in the auditor’s report. When the auditor cannot express an overall opinion, the auditor should state the reasons
therefor in the auditor’s report. In all cases where an auditor’s name is associated with financial statements, the auditor should
clearly indicate the character of the auditor’s work, if any, and the degree of responsibility the auditor is taking, in the auditor’s
report.

Public Company Accounting Oversight Board (PCAOB) Auditing Standards

 General Standards
1. The audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor.
2. In all matters relating to the assignment, independence in mental attitude is to be maintained by the auditor or auditors.
3. Due professional care is to be exercised in the performance of the audit and the preparation of the report.
 Standards of Fieldwork
1. The work is to be adequately planned and assistants, if any, are to be properly supervised.
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 2. A sufficient understanding of internal control is to be obtained to plan the audit and to determine the nature, timing, and extent of
tests to be performed.
3. Sufficient appropriate evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a
reasonable basis for an opinion regarding the financial statements under audit.
 Standards of Reporting
1. The report shall state whether the financial statements are presented in accordance with generally accepted accounting
principles (GAAP).
2. The report shall identify those circumstances in which such principles have not been consistently observed in the current period
in relation to the preceding period.
3. Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the
report.
4. The report shall contain either an expression of opinion regarding the financial statements, taken as a whole, or an assertion to
the effect that an opinion cannot be expressed. When an overall opinion cannot be expressed, the reasons therefor should be
stated. In all cases where an auditor’s name is associated with financial statements, the report should contain a clear cut
indication of the character of the auditor’s work, if any, and the degree of responsibility the auditor is taking.

Ethical Requirements Relating to an Audit of Financial Statements

 Auditor should comply with the relevant ethical requirements relating to audit engagements.
 The auditor should conduct an audit in accordance with Philippine Standard on Auditing (PSA).
 The auditor should plan and perform an audit with an attitude of professional skepticism recognizing that circumstances may exist that
cause the financial statements to be materially misstated.
o Professional skepticism – attitude that includes a questioning mind and a critical assessment of audit evidence. An attitude
that includes a questioning mind, being alert to conditions that may indicate possible misstatements due to fraud or error,
and a critical assessment of audit evidence.
 Auditor must be independence in mind and in appearance. Independence in appearance is the avoidance of circumstances that would
cause a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, to reasonably
conclude that the integrity, objectivity, or professional skepticism of a firm or a member of the attest engagement team has been
compromised. Independence of mind is the state of mind that permits the performance of an attest service without being affected by
influences that compromise professional judgment, thereby allowing an individual to act with integrity and exercise objectivity and
professional skepticism.

Principles Underlying an Audit Conducted in Accordance with Generally Accepted Auditing Standards
Purpose of an The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial
Audit statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.
An auditor’s opinion enhances the degree of confidence that intended users can place in the financial statements.
Premise of an An audit in accordance with generally accepted auditing standards is conducted on the premise that management and,
Audit where appropriate, those charged with governance, have responsibility:
a. For the preparation and fair presentation of the financial statements in accordance with the applicable financial
reporting framework; this includes the design, implementation, and maintenance of internal control relevant to
the preparation and fair presentation of financial statements that are free from material misstatement, whether
due to fraud or error.
b. To provide the auditor with:
 All information, such as records, documentation, and other matters that are relevant to the preparation
and fair presentation of the financial statements.
 Any additional information that the auditor may request from management and, where appropriate, those
charged with governance.
 Unrestricted access to those within the entity from whom the auditor determines it necessary to obtain
audit evidence.
Personal Auditors are responsible for having appropriate competence and capabilities to perform the audit; complying with relevant
Responsibilities ethical requirements; and maintaining professional skepticism and exercising professional judgment throughout the
of the Auditor planning and performance of the audit.
Auditor Actions To express an opinion, the auditor obtains reasonable assurance about whether the financial statements as a whole are
in Performing free from material misstatement, whether due to fraud or error.
the Audit To obtain reasonable assurance, which is a high, but not absolute, level of assurance, the
auditor:
• Plans the work and properly supervises any assistants.
• Determines and applies appropriate materiality level or levels throughout the audit.
• Identifies and assesses risks of material misstatement, whether due to fraud or error, based on an
understanding of the entity and its environment, including the entity’s internal control.
• Obtains sufficient appropriate audit evidence about whether material misstatements exist, through designing
and implementing appropriate responses to the assessed risks.
The auditor is unable to obtain absolute assurance that the financial statements are free from material misstatement
because of inherent limitations, which arise from:
• The nature of financial reporting;
• The nature of audit procedures; and

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 • The need for the audit to be conducted within a reasonable period of time in order to achieve a balance
between benefit and cost.
Reporting Based on an evaluation of the audit evidence obtained, the auditor expresses, in the form of a written report, an opinion in
Results of an accordance with the auditor’s findings, or states that an opinion cannot be expressed. The opinion states whether the
Audit financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting
framework.

Suggested Readings: PSA 200, Code of Ethics for Professional Accountants

EXERCISES

Case Study 1: Enormo Corporation is a large multinational audit client of your CPA firm. One of Enormo’s subsidiaries, Ultro, Ltd., is a
successful electronics assembly company that operates in a small Caribbean country. The country in which Ultro operates has very strict laws
governing the transfer of funds to other countries. Violations of these laws may result in fines or the expropriation of the assets of the company.
During the current year, you discover that $50,000 worth of foreign currency was smuggled out of the Caribbean country by one of Ultro’s
employees and deposited in one of Enormo’s bank accounts. Ultro’s management generated the funds by selling company automobiles, which
were fully depreciated on Ultro’s books, to company employees. You are concerned about this illegal act committed by Ultro’s management and
decide to discuss the matter with Enormo’s management and the company’s legal counsel. However, Enormo’s management and board of
directors seem to be unconcerned with the matter and express the opinion that you are making far too much of a situation involving an
immaterial dollar amount. They also believe that it is unnecessary to take any steps to prevent Ultro’s management from engaging in illegal
activities in the future. Enormo’s legal counsel indicates that the probability is remote that such an illegal act would ever be discovered, and that
if discovery were to occur, it would probably result in a fine that would not be material to the client’s consolidated financial statements. Your CPA
firm is ready to issue the integrated audit report on Enormo’s financial statements and internal control for the current year, and you are trying to
decide on the appropriate course of action regarding the illegal act.
a. Discuss the implications of this illegal act by Ultro’s management.
b. Describe the courses of action that are available to your CPA firm regarding this matter.
c. State your opinion as to the course of action that is appropriate. Explain.

Case Study 2: Joe Rezzo, a college student majoring in accounting, helped finance his education with a part-time job maintaining all accounting
records for a small business, White Company, located near the campus. Upon graduation, Rezzo passed the CPA examination and joined the
audit staff of a national CPA fi rm. However, he continued to perform all accounting work for White Company during his “leisure time.” Two years
later, Rezzo received his CPA certificate and decided to give up his part-time work with White Company. He notified White that he would no
longer be available after preparing the year-end financial statements. On January 7, Rezzo delivered the annual financial statements as his final
act for White Company. The owner then made the following request: “Joe, I am applying for a substantial bank loan, and the bank loan officer
insists upon getting audited financial statements to support my loan application. You are now a CPA, and you know everything that’s happened
in this company and everything that’s included in these financial statements, and you know they give a fair picture. I would appreciate it if you
would write out the standard audit report and attach it to the financial statements. Then I’ll be able to get some fast action on my loan
application.”
a. Would Rezzo be justified in complying with White’s request for an auditor’s opinion? Explain.
b. If you think Rezzo should issue the audit report, do you think he should first perform an audit of the company despite his detailed
knowledge of the company’s affairs? Explain.
d. If White had requested an audit by the national CPA firm for which Rezzo worked, would it have been reasonable for that firm to
accept and to assign Rezzo to perform the audit? Explain.

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TRANSACTION CYCLES

Transaction Cycle - refers to the policies and the sequence of procedures for processing a particular type of transaction.

Types of Transaction Cycle

1. Revenue and Collection Cycle
2. Expenditure and Disbursement Cycle
3. Payroll Cycle
4. Financing and Investing Cycle

Revenue and Collection Cycle – consist of activities relating to the exchange of goods and services with customers and the collection of
revenue in cash. It involves the receiving of customer orders, approving credit for a sale, determining whether goods are available for shipment,
shipping the goods, billing the customers, collecting cash and recognizing effect of this process on other related accounts.

Expenditure and Disbursement Cycle - including processes, procedures, and policies for initiating purchases of inventory, other assets, and
services; placing purchase orders, inspecting goods upon receipt, and preparing receiving reports; recording liabilities to vendors; authorizing
payment; and making and recording cash disbursements.

Conversion Cycle - including processes, procedures, and policies for storing materials, placing materials into production, assigning production
costs to inventories, and accounting for the cost of goods sold.

Payroll Cycle - including processes, procedures, and policies for hiring, terminating, and determining pay rates; timekeeping; computing gross
payroll, payroll taxes, and amounts withheld from gross pay; maintaining payroll records; and preparing and distributing paychecks.

Financing Cycle - including processes, procedures, and policies for authorizing, executing, and recording transactions involving bank loans,
leases, bonds payable, and capital stock.

Investing Cycle—including processes, procedures, and policies for authorizing, executing, and recording transactions involving investments in
fixed assets and securities.

Supplemental Reading:
1. Chapters 6 – 8. Applied Auditing by Cabrera

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 AUDIT PROCESS

Audit Process - may be viewed as including the following six stages: (a) Plan the audit; (b) obtain an understanding of the client and its
environment, including internal control; (c) assess the risks of misstatement and design further audit procedures; (d) perform further audit
procedures; (e) complete the audit; and (f) form an opinion and issue the audit report.

Stages of an Audit

1. Plan the audit  Establish an understanding with the client as to the nature of the engagement.
 Develop an audit: Strategy and Plan

6. Obtain understanding of client, its Perform risk assessment procedures, including

environment, and internal control
 Inquiries of management and others within entity
 Analytical procedures
 Observation and inspection of activities
 Inquiries of others outside the company (e.g. legal counsel, valuation experts)
 Review information from external sources

5. Assess risks of material  Identify and assess risks of material misstatement for account balances, classes of
misstatement and design further transactions and disclosures. Consider:
audit procedures  What can go wrong
 The magnitude involved
 The likelihood of a material misstatement
 Design further audit procedure

2. Perform further audit procedures  Approaches:

 Test of controls
 Analytical procedures
 Test of details of transactions and balances
 Audit procedures:
 Inquiry
 Inspection
 Observation
 Confirmation
 Recalculation
 Re-performance
 Analytical procedures

4. Complete the audit Audit procedures:

 Search for unrecorded liabilities
 Review of minutes of meetings
 Perform final analytical procedures
 Perform procedures to identify loss contingencies
 Perform review of subsequent events
 Obtain representation letter
 Evaluate audit findings

3. Form an opinion and issue the audit  Public company reporting requires reporting on internal control and on the financial
report statements.
 Nonpublic company reporting ordinarily involves only reporting on the financial
statements

Obtaining Clients
 As a starting point, it is essential for a CPA firm or practitioner to maintain its integrity, objectivity, and reputation for providing high-
quality services
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  Before the engagement, CPAs should investigate the history of the prospective client, including such matters as the identities and
reputations of the directors, officers, and major stockholders. To help assess engagement risk, the auditors generally obtain
management’s permission to make inquiries of other third parties about a prospective audit client.
 Practitioner must be independent of the client to perform an audit. Therefore, the auditors must determine whether there are any
conditions that would prevent them from performing an independent audit of the client. Consideration also will be given to whether the
partners and staff have appropriate training and experience to competently complete the engagement. If the auditors have no experience
in a particularly complex industry, they may decide that a competent audit of a prospective client in that industry cannot be performed
unless the CPA firm hires appropriately experience personnel.

Submitting a Proposal
 To obtain the audit, the auditors may be asked to submit a competitive proposal that will include information on the nature of services
that the firm offers, the qualifications of the firm’s personnel, anticipated fees, and other information to convince the prospective client to
select the firm.

Communication with Predecessor Auditors

 PSA requires the successor auditors to attempt to communicate with the predecessor before accepting the engagement. Because the
predecessor auditors are an excellent source of information about a prospective client, in many circumstances this communication will
occur before a formal proposal is presented to a prospective client.
 Because auditors are ethically prohibited from disclosing confidential client information without the client’s consent, the successor
auditors must ask management of the prospective client to authorize the predecessor auditors to respond fully to the successor’s
inquiries. If a prospective client is reluctant to authorize communications with the predecessor auditors, the successor auditors should
seriously consider the implications in deciding whether to accept the engagement.
 When permission has been granted, the successor auditors’ inquiries (which may be written or oral) are aimed at matters that will assist
the auditors in determining whether to accept the engagement. Accordingly, the auditors may include inquiries aimed at obtaining
information about:
a. Integrity of management
b. Disagreements with management over accounting, auditing or similarly significant matters.
c. Predecessor auditors’ communications to those charged with governance regarding fraud and noncompliance with laws or
regulations
d. Predecessor auditors’ communications to management and those charged with governance regarding internal control significant
deficiencies and material weaknesses
e. The predecessor auditors’ understanding about the reasons for the change of auditors
This communication is extremely important since it aids the successor auditors in evaluating the integrity of management and other
issues related to the risk of the audit.

Planning the Audit

 Audit planning involves developing an overall audit strategy for the conduct, organization and staffing of the audit. The nature, timing
and extent of planning vary by characteristics of the company being audited and the auditors’ experience with the company.

1. Establishing an Understanding with the Client. The auditor should establish an understanding with the client regarding the terms of the
audit engagement. This understanding should include:
a. the objective and scope of the audit
b. auditor and management responsibilities
c. inherent limitations of an audit
d. applicable financial reporting framework; and
e. the expected form and content of reports to be issued by the auditor

This understanding should be in the form of a written engagement letter. When the engagement letter is accepted by the authorized
client official, it presents an executor contract between the auditor and the client.

For recurring audits, the auditors should assess whether the terms of the audit engagement need to be revised. Examples of factors
that may make such revision appropriate include:
a. indication that management misunderstanding the objective and scope of the audit
b. a change of senior management
c. a significant change in the nature or size of the client
d. a change in reporting requirements

If the terms of the audit engagement do not need to be revised for the current year audit, the auditor should decide whether they wish
to issue an engagement letter for the current year. Alternatively, they may remind management, in writing or orally, of the terms of the
engagement and document the reminder.

2. Develop an overall audit strategy and audit plan. When the auditors have obtained a sufficient understanding of the client, they
establish an overall audit strategy that considers those characteristics of the audit which determine its scope, such as industry
reporting requirements, client locations and the basis of reporting followed by the client. Issues such as timing of the audit, deadlines
for reporting, and key dates that information will be received from management will be determined. Also, the auditors will make

9
 preliminary judgments on areas of high risk of material misstatement, material locations, and accounts; determine the expected
approach to considering internal control; and consider recent significant client and industry factors.

When the overall audit strategy has been established, the auditors are able to start developing the audit plan. Audit plan should
include a description of the nature, timing and extent of:
a. Planned risk assessment procedures sufficient to assess the risks of material misstatement
b. Planned further audit procedures for each material class of transactions, account balance and disclosure. This includes test
of controls and substantive procedures
c. Other audit procedures in order to comply with generally accepted auditing standards (GAAP)

The audit plan includes a detailed list of the audit procedures to be performed in the course of audit. A tentative audit plan is
developed based on the auditors’ initial risk assessments. This tentative plan, however, may require frequent modification as the audit
progresses. Thus, not until test of controls have been completed can a final version of the audit plan be completed.

Obtaining an Understanding of the Client and its Environment

 The required understanding of the client is used by the auditors to help plan the audit and to assess the risks of material misstatement
at the financial statement and relevant assertion levels.

1. Risk assessment procedure. To obtain the understanding of the entity and its environment, auditors perform risk assessment
procedures, which include:’
a. Inquiries of management and others within the company
b. Analytical procedures
c. Observation and inspection relating to client activities, operations, documents, reports and premises
d. Other procedures, such as inquiries of other outside the company and reviewing information from external sources
These risk assessment procedures are supplemented by further audit procedures in the form of tests of control and substantive
procedures to obtain sufficient audit evidence to express an opinion on the financial statements.

2. Source of information. Much information about the nature of the client may be obtained through inquiries of management and other
personnel. It includes electronic research, tour of plant and offices, analytical procedures, statement of cash flow and obtaining an
understanding of the client.

3. Determining materiality. Materiality recognizes that some matters are important to the fair presentation of financial statements, while
others are not. It is basic to the audit because the audit report states that an audit is performed to obtain reasonable assurance
whether the financial statements are free of material misstatement. Materiality judgments depend both upon the financial reporting
framework being used on the auditors’ professional judgment.

Assessing Risk of Material Misstatement and Designing Further Audit Procedures

 Audit risk – refers to the possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements
that are materially misstated. At the overall financial statement level, audit risk is the chance that a material misstatement exists in the
FS and the auditors do not detect it with their audit procedures.

1. Assessing Risks of Material Misstatement. The auditor should plan and perform the audit to obtain reasonable assurance that material
misstatements, whether caused by errors or fraud, are detected. Accordingly, in designing an audit, the auditors should identify and
assess the risks of material misstatement of the financial statements. Risk is a combination of inherent and control risk.

Auditors try to relate each identified risk to “what can go wrong” at the assertion level. In assessing this risk, the auditors will consider
any controls established by management to mitigate this risk. Then, the auditor considers whether this risk could result in material
misstatement and the likelihood that the material misstatement could actually occur. Finally, they use all of these risk assessments to
plan and perform the audit.

In performing risk assessment, it is important for the auditors to recognize that risks of material misstatement occur at both the
financial statement level and the relevant assertion level for account balances, transaction classes, and disclosures.

 Financial statement risk – risk that relate to the overall financial statements and potentially affect may individual assertions.
Financial statement risk level potentially affects relevant assertions about many accounts and disclosures. As a result,
assessing their audit impact often requires considerable judgment.

 Relevant Assertion level risk – most risks of misstatement relate to one or a few relevant assertions that relate to one or
more significant accounts or disclosures. These assertions includes:
a. Existence or occurrence – assets, liabilities and equity interests exist and recorded transactions and events have
occurred.
b. Rights and obligations – company holds rights to the assets, and liabilities are the obligations of the company
c. Completeness – all assets, liabilities, equity interests, and transactions that should have been recorded have been
recorded.
d. Cut-off – transactions and events have been recorded in the correct accounting period.

10
 e. Valuation, allocation and accuracy – all transactions, assets, liabilities and equity interests are included in the
financial statements at proper amounts.
f. Presentation and disclosure – accounts are described and classified in accordance with generally accepted
accounting principles, and financial statement disclosures are complete, appropriate and clearly expressed.

 Significant risk that requires special audit consideration – while assessing risks, the auditors should determine which of the
identified risks require special audit consideration. Significant risks often involve risks related to fraud. Because of the
importance and unique nature of fraud, Auditing Standards Board (ASB) provide more specific guidance for the auditor in
assessing the risks of material misstatement of the financial statements for the auditors in assessing the risks of material
misstatement of the financial statements due to fraud.

2. Addressing the risks of material misstatement due to fraud. The auditor’s consideration of risks of material misstatement from fraud
recognizes that there are two distinct types: (1) misstatements arising from fraudulent financial reporting (management fraud) and)
and (2) misstatements arising from misappropriation of assets (defalcations). The auditor’s fraud risk assessment involves identifying
risks of material misstatement of the financial statements due to fraud and determining the appropriate audit response. To identify
fraud risks, the auditors perform a number of procedures including having discussions with engagement personnel, making inquires of
management and others within the organization, performing analytical procedures, and considering fraud risk factors.
 Discussion with Engagement Personnel. PSA requires that auditors have a discussion with the audit team members about
the susceptibility of the client’s financial statements to material misstatements and requires a discussion on susceptibility to
fraud.
 Making inquiries related to fraud. Inquiries of management and other personnel assist the auditors in identifying fraud risks.
Therefore, the auditors are required to inquire of members of management as to their knowledge of fraud and alleged fraud,
their understanding of the risks of fraud, and programs or controls that have been implemented to mitigate those risks. The
auditors also inquire about how management monitors operating units or business segments in other locations, and how
management communicates its views about ethical behavior to employees. The auditors should obtain management’s
perspective regarding the effectiveness of internal control in detecting fraud and whether this perspective has been reported
to the audit committee.
 Performing risk assessment analytical procedures to identify fraud risk. Risk assessment analytical procedures also may
provide the auditors with indication fraud risks. When the results of analytical procedures reveal an unusual or unexpected
relationship, this may provide an indication that the financial statements may be misstated due to fraud.
 In response to fraud risks, the auditors may modify their overall approach to the audit in one or more of the following ways:
a. Professional skepticism and audit evidence
b. Assigning personnel and supervision
c. Accounting principles
d. Predictability of auditing procedures
 Designing further audit procedures in response to assessed risks. The auditors’ selection of further audit procedures is
based on the materiality of the account balance, transactions, and disclosures being audited and the assessed risks of
material misstatement. These further audit procedures include substantive procedures for all relevant assertions and, if
needed, test of controls. Test of controls are needed when the auditors’ risk assessment includes an expectation that
controls are operating audit evidence. When designing further audit procedures, auditors consider the nature, timing and
extent of appropriate procedures.

For the risk assessment, the auditors should document (1) the discussion of the audit team concerning the risk of material
misstatements due to error or fraud, (2) key elements of the understanding of the entity and its environment, (3) the
assessment of the risk of material misstatement at both the financial statement level and the relevant assertion level and (4)
the risk identified. After the procedures have been performed, the auditors should document:
a. The auditors’ overall responses to address the assessed risk of misstatement at the financial statement level
b. The nature, timing and extent of further audit procedures performed
c. The linkage of those procedures with the assessed risks at the relevant assertion level
11
 d. The result of the audit procedures
e. With regard to the use of audit evidence, the conclusions reached about the operating effectiveness of controls
obtained in a prior audit
f. Significant risks identified and related controls
g. Those circumstances in which substantive procedures alone will not provide sufficient evidence
 Audit Trail and Directional Testing. In developing audit procedures, the auditors are assisted by the organized manner in
which accounting systems record, classify and summarize data. The flow of accounting data begins with the recording of
thousands of individual transactions on such documents as invoices and checks. The information recorded on these original
source documents is summarized in journal and the amounts in the journals are posted to ledger accounts. At the end of the
year, the balances in the ledger accounts are arranged in the form of financial statements.

Audit Trail – consists of source documents, journal entries and ledger entries. An audit trail also exists within a computer-
based accounting system, although it may have a substantially different form.

Audit Plan’s System and Substantive Portions

 The systems portion of the audit plan is generally organized around the major transaction cycles of the client’s accounting system.
Audit procedures in the systems portion of the plan typically include obtaining and understanding of the controls for each transaction
cycle, preparing a flowchart for each cycle, testing the significant controls, and assessing control risk for the related financial
statement assertions.
 Auditors’ overall objective is to determine whether the ending financial statement balance is correct, two approaches are possible (1)
testing controls over transactions that occurred during the year or (2) testing the ending account balance directly. That is, if the
controls over the transactions that are recorded into the account are effective, assurance is obtained regarding the ending balance.
Alternatively, auditors may directly test the ending balance of the account. As a practical matter, auditors use a combination of these
two approaches. Indeed, even if controls are considered extremely strong, some substantive procedures should be performed for all
significant financial statement accounts.
 The system portion of the audit plan includes tests of controls over transactions. The evidence obtained from these tests may be of
two types: evidence about the effectiveness of controls and evidence that substantiates the recorded amount of the transactions.
 Accordingly, some tests of controls provide substantive evidence about an account or class of transactions. These procedures are
referred to as dual-purpose procedures (tests) since they serve as both a test of controls and a substantive test of the details of the
transactions that occurred during the year.

 Substantive Procedures Portion of the Plan. It aimed at substantiating financial statement amounts is organized in terms of major
financial statement accounts and classes of transactions, such as cash, accounts receivable, sales, inventories and plant and
equipment. Substantive procedures are used to restrict detection risk for these accounts.

 Relationship between Test of Controls and Substantive Procedures. Test of controls provide auditors with evidence as to whether
prescribed controls are in use and operating effectively. The results of these tests assist the auditors in evaluating the likelihood that
material misstatements have occurred. Substantive procedures, on the other hand, are designed to detect material misstatements if
they exist in the financial statements. The amount of substantive testing done by the auditors is greatly influenced by their assessment
of the likelihood that material misstatement exists.

Financial Statements

Management Assertions  Existence or Occurrence

 Rights and Obligations
 Completeness
 Cutoff
 Valuation
 Presentation and Disclosure

Audit Objectives  Designed based on Management Assertion

Audit Procedures  Determined based on the risks of material

misstatement (inherent risks and control risk)
at the assertion (audit objective) level and
documented in the audit plan

Audit Evidence  Summarized in Audit Documentation

Audit Report on Financial

Statements 12
Substantiation of Account Balance
 The central purpose of the auditors’ risk assessment process, including their assessment of control risk, it is to determine the nature,
timing, and extent of the audit work necessary to substantiate the account.

1. Existence of Assets – to verify the existence of the item. It may be verified by physical observation or inspection, and by vouching from the
recorded entry to the documents created when the assets were acquired.
2. Rights to the assets – to verify existence also establish the company’s rights of the asset.
3. Establishing completeness – Effective internal control provides assurance that acquisitions are recorded and helps the auditors to establish
the completeness of recorded assets. When such controls are found to be ineffective, the scope of substantive procedures should be
increased, but this is often a difficult task. When the auditors are testing the completeness of assets, they are looking for assets that have
been acquired but not recorded in the accounting records. It may be verified by tracing from the source documents, observation and
physical examination and analytical procedures.
4. Cutoff – verify the client’s cut-off of transactions included in the period. The financial statements should reflect all transactions occurring
through the end of the period and none that occur subsequently. The term cut-off refers to the process of determining that transactions
occurring near the balance sheet date are assigned to the proper accounting period.
5. Valuation – determining the proper valuation of assets requires a thorough knowledge of generally accepted accounting principles. The
auditors should not only establish that the accounting method of valuation is appropriate and properly applied in the circumstances. Once
the auditors are satisfied as to the appropriateness of the method, the auditors will perform procedures to test the accuracy of the client’s
application of the method of valuation to the asset.
6. Financial statement presentation and disclosure – auditors should perform procedures to ensure that the financial statement presentation
conforms to the requirements of authoritative accounting pronouncements and the general principle of adequate disclosure.

SUBSTANTIVE TEST OF CASH AND CASH EQUIVALENT

Auditor’s Objectives in the Audit of Cash

1. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to cash.
2. Obtain an understanding of internal control over cash.
3. Assess the risks of material misstatement of cash and design tests of controls and substantive procedures that:
a. Substantiate the existence of recorded cash and the occurrence of cash transactions.
b. Determine the accuracy of cash transactions
c. Establish the completeness of recorded cash
d. Verify the cutoff of cash transactions
e. Determine that the client has rights to recorded cash
f. Determine that the presentation and disclosure of cash, including restricted funds, are appropriate

Internal Control over Cash Transaction

1. All cash that should have been received was in fact received, recorded accurately, and deposited promptly.
2. Cash disbursements have been made for authorized purposes only and have been properly recorded.
3. Cash balances are maintained at adequate, but not excessive, levels by forecasting expected cash receipts and payments related to
normal operations. The need for obtaining loans or for investing excess cash is thus made known on a timely basis.
4. Do not permit any one employee to handle a transaction from beginning to end.
5. Separate cash handling (custody) from record keeping

Audit Procedures:
1. Use the understanding of the client and its environment to consider inherent risks including fraud risks, related to cash.
2. Obtain an understanding of internal control over cash.
3. Assess the risks of material misstatement and design further audit procedures.
4. Perform further audit procedures – test of controls
a. Examples of test of controls:
i. Test the accounting records and reconciliation by re-performance
ii. Compare the details of a sample of cash receipts listing to the cash receipts journal, account receivable postings
and authenticated deposit slips
iii. Compare the details of a sample of recorded disbursement in the cash payments journal to accounts payable
postings, purchase orders, receiving reports, invoices, and paid checks.
b. If necessary, revise the risks of material misstatement based on the results of test of controls.
5. Perform further audit procedures – substantive procedures for cash transactions and balances
a. Obtain analyses of cash balances and reconcile them to the general ledger
b. Send standard confirmation forms to financial institutions to verify amounts on deposit
c. Obtain or prepare reconciliations of bank accounts as of the statement of financial position date and consider the need to
reconcile bank activity for additional months.
d. Obtain a cutoff bank statement containing transactions of at least seven business days subsequent to the statement of
financial position date.
e. Count and list cash on hand.
f. Verify the client’s cutoff of cash receipts and cash disbursements.
g. Analyze bank transfers for the last week of the audit year and the first week of the following year.
13
 h. Investigate any checks representing large or unusual payments to related parties.
i. Evaluate proper financial statement presentation and disclosure of cash

Summary of Audit Objectives and Procedures:

Assertions Audit Objectives Audit Procedures
1. Existence or Occurrence a. To determine whether cash exists at year- 1. Obtain analysis of cash balance and reconcile to
end and cash-related transactions occur the general ledger.
within the year. 2. Confirm bank balances as of statement of
b. To determine that all cash balances of client financial position date.
are reflected on the statement of financial 3. Perform cash count procedures for cash on hand.
position at year-end. 4. Obtain (prepare) bank reconciliations as of the
statement of financial position date.
5. Trace all transfers occurring between banks near
year-end.
2. Completeness c. To determine whether all cash transactions 6. Obtain a cutoff bank statement containing
are recorded in the proper accounting period transactions several days subsequent to the
statement financial position date. Examine items
returned with the cutoff bank statements.
7. Prepare proof of cash and reconcile cash
transactions occurring during a specified period
as they are recorded by the bank and the client.
8. Verify the client’s cutoff of cash receipts and cash
disbursement.
3. Rights and Obligations d. To determine that cash balances are 9. Review bank statements and the bank replies to
available for use without restrictions or if with confirmation letters.
restrictions, properly indicated in the
statement of financial position.
4. Valuation or allocation e. To determine if cash is recorded and 10. Verify existence of cash in banks under
presented at the proper amount. receivership, cash subject to court’s restraining
order, in foreign banks and in foreign currency.
This is in addition to the foregoing procedures
which will enable the auditor to verify proper
valuation of cash.
5. Presentation and disclosure f. To determine whether cash is presented in 11. Investigate any checks representing large or
accordance with generally accepted unusual payments to related parties.
accounting principle. 12. Evaluate proper financial statement presentation
and disclosure of cash.

EXERCISE

PROBLEM 1: In connection with your examination, the Pound Company presented to you the following information regarding its Cash in Bank
account for the month of December, 2019:
a. Balances per bank statements: November 30, P 107,800, and December 31, P 115,200.
b. Balances of cash in bank account in company’s books: November 30, P 82,725, and December 31, P 113,400.
c. Total receipts per books were P 1,110,950 of which P 6,050 was paid in cash to a creditor on December 24.
d. Total charges in the bank statement during December were P 1,094,850.
e. Undeposited receipts were: November 30, P 45,300 and December 31, P 50,600.
f. Outstanding checks were: November 30, P 13,375, and December 31, P 9,650, of which a check for P 2,500 was certified by the bank
on December 26.
g. NSF checks returned, recorded as reduction of cash receipts, were:
 Returned by bank on December, recorded also in December, P 5,200.
 Returned by bank on December but recorded in January, P 4,300
h. Collections by bank not recorded by Company were P 60,750 in November and P 58,200 in December.
i. Bank service charges not entered in company’s books were: November 30, P 3,750 and December 31, P 2,100.
j. A check for P 4,750 of Found Company was charged to Pound Company in error.
k. A check drawn for P 4,200 was erroneously entered in the books as P 2,400.

QUESTIONS: Based on the above and the result of your audit, answer the following:
1. How much is the adjusted cash balance as of November 30, 2019?
2. How much is the adjusted book receipts for December, 2018?
3. How much is the adjusted book disbursements for December, 2018?
4. How much is the adjusted cash balance as of December 31, 2018?
5. How much is the cash shortage of December 31, 2018?

14
PROBLEM 2: Your audit senior instructed you to prepare a four column proof of cash receipts and disbursements for the month of August,
2019. The bank reconciliation prepared by Franc Company at July 31 is reproduced below: (All book adjustments were recorded in August).

Upon inquiry about the client’s August 31 bank reconciliation, you were informed that it has been lost and that the client is too busy at this time
to prepare another. Your senior told you to get the August bank statement and paid checks and to prepare the August 31 reconciliation so that
you may complete the August proof of cash. The August bank statement is reproduced below:

The paid checks accompanying this bank statement (all clearing in August) were (checks listed in order of payment by bank).
No. 450 P 1,800 No. 455 P 1,000 No. 458 P 1,440
451 1,400 456 700 459 1,820
454 600
The check register revealed that the last check issued in August was no. 460 for P 1,000 and that check no. 457 was for P 2,400. Cash received
for the period August 21 through 31 of P 9,400 was deposited in the bank on September 1. The debit memo on August 12 and August 31 were
customer NSF checks returned by the bank. The check on August 12 was immediately redeposited without entry. The check returned on August
31 was redeposited by the client in the bank on September 1 without entry.

QUESTIONS: Based on the application of the necessary audit procedures and appreciation of the above data, you are to provide the answers to
the following:
1. How much is the unadjusted book receipts for August?
2. How much is the unadjusted book disbursements for August?
3. How much is the adjusted book receipts for August?
4. How much is the adjusted book disbursements for August?
5. How much is the adjusted cash balance as of August 31, 2019?

PROBLEM 3: You were able to obtain the following information in connection with your audit of the Cash account of the Piso Company as of
December 31, 2019:
November 30 December 31
a. Balances per bank P 742,800 P 774,696
b. Balances per books 619,304 670,392
c. Outstanding checks 254,096 300,184
d. The bank statement for the month of December showed total credits of P 5,401,800 while the cash receipts per books totaled P
9,341,780.
e. NSF checks are recorded as a reduction of cash receipts. NSF checks which are later re-deposited are then recorded as regular
receipts. Data regarding NSF checks are as follows:
 Returned by the bank in Nov. and recorded by the company in Dec., P 1,000.
 Returned by the bank in Dec. and recorded by the company in Dec., P 25,000.
 Returned by the bank in Dec. and recorded by the company in Jan., P 9,200.
f. Check of Sopi Company amounting to P 9,292 was charged to the company account by the bank in error on December 31.
g. A bank memo stated that the company’s account was credited for the net proceeds of TM’s note for P 8,060. This is not yet recorded
on the books.
h. The company has hypothecated its accounts receivable with the bank under an agreement whereby the bank lends the company 80%
of the hypothecated accounts receivable. The company performs accounting and collection of the accounts. Adjustments of the loan
are made from daily sales reports and deposits.
i. The bank credits the company account and increases the amount of the loan for 80% of the reported sales. The loan agreement states
specifically that the sales report must be accepted by the bank before the company is credited. Sales reports are forwarded by the
company to the bank on the first day following the date of sale. The bank allocates each deposit 80% to the payment of the loan, and
20% to the company account. Thus, only 80% of each day’s sales and 20% of each collection deposits are entered on the bank
statement. The company accountant records the hypothecation of new accounts receivable (80% of sales) as a debit to Cash and a
credit to the bank loan as of the date of sales. One hundred percent of the collection on accounts receivable is recorded as a cash
15
 receipt; 80% of the collection is recorded in the cash disbursements books as a payment on the loan. In connection with the
hypothecation, the following facts were determined:
 Included in the undeposited collections is cash from the hypothecation of accounts receivable. Sales were P 162,000 on
November 30, and P 169,000 at December 31, the balance was made up of from collections of P 128,440 which was entered on
the books in the manner indicated above.
 Collections on accounts receivable deposited in December, other than deposits in transit, totaled P 4,800,000.
j. Interest on the bank loan for the month of December charged by the bank but not recorded in the books, amounted to P 24,560.

QUESTIONS: Based on the above and the result of your audit, answer the following:
1. How much is the adjusted cash balance as of November 30, 2019?
2. How much is the adjusted book receipts for December, 2019?
3. How much is the adjusted book disbursements for December, 2019?
4. How much is the adjusted cash balance as of December 31, 2019?
5. How much is the cash shortage as of December 31, 2019?

PROBLEM 4: In connection with the audit of the financial statements of Rupee Company for the year ended December 31, 2019, you performed
a surprise count of the petty cash fund and undeposited collections under the custody of Ms. Au at 8:15 a.m. on January 3, 2020. Your count
disclosed the following:
Bills and Coins
Bills Coins
P100 10 pieces P1.00 410 pieces
50 80 pieces 0.50 324 pieces
20 70 pieces 0.25 64 pieces
10 54 pieces
Unused postage stamps – P730
Checks
Date Payee Drawer Amount
Dec. 30 Cash Ms. Au P 2,400
Dec. 30 Rupee Company Emong De Leon 28,000
Dec. 31 Rupee Company Apol Boba, sales manager 3,360
Dec. 31 Rupee Company Datu Macmod 35,600
Dec. 31 Rupee Company Tom Guts 16,600
Dec. 31 German Corp. Rupee Company 54,000
(not endorsed)
Expense Vouchers
Date Payee Description Amount
Dec. 23 Apol Boba, Cash advance for trip to P 14,000
sales manager Baguio City
Dec. 27 Central Post Office Postage stamps 3,240
Dec. 29 Messengers Transportation 300
Dec. 29 PC Express Computer repair 1,600
Other items found inside the cash box:
a) Two pay envelopes which had been opened and the contents aggregating P 15,000 representing unclaimed salaries had been removed.
b) The sales manager’s liquidation report for his Baguio trip:
Cash advance received on Dec. 23 P 14,000
Less: Hotel accommodation P 9,000
Bus fare for two 800
Cash given to Pedro, salesman 600 10,400
Balance P 3,600
Accounted for as follows:
Cash returned by Pedro to the sales manager P 240
Personal check of sales manager 3,360
Total P 3,600
Additional information:
a) The custodian is not authorized to cash checks.
b) The last official receipt included in the deposit on December 30 is No. 351 and the last official receipt issued for the current year is No. 355.
The following official receipts are all dated December 31, 2019.
O.R. No. Amount Form of payment
352 P 27,200 Cash
353 35,600 Check
354 7,200 Cash
355 16,600 Check
c) The Petty Cash balance per general ledger is P 20,000. The last replenishment of the fund was made on December 22, 2019.
REQUIRED:
1. Computation of shortage or overage, if any
2. Adjusting entries as of December 31, 2019
16
 SUBSTANTIVE TEST OF RECEIVABLE

Auditors’ Objectives in Auditing Receivables

1. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to receivables and
revenue.
2. Obtain an understanding of internal control over receivables and revenue.
3. Assess the risks of material misstatement and design tests of controls and substantive procedures that:
a. Substantiate the existence of receivables and the occurrence of revenue transactions.
b. Establish the completeness of receivables and revenue transactions.
c. Verify the cutoff of revenue transactions.
d. Determine that the client has rights to recorded receivables.
e. Establish the proper valuation of receivables and the accuracy of revenue transactions.
f. Determine that the presentation and disclosure of information about receivables and revenue are appropriate, including the
separation of receivables into appropriate categories, adequate reporting of any receivables pledged as collateral, and
disclosure of related party sales and receivables.

Audit Documentation
1. Aged trial balance of trade accounts receivable
2. Analysis of other accounts receivable
3. Analysis of notes receivable and related interest
4. Analysis of allowance for uncollectible accounts and notes
5. Comparative analyses of revenue by month, by product or by territory or by relating forecasted revenue to actual revenue
6. Documentation of internal controls
7. Risk analyses and audit plan (program)

Internal Control for Receivable

17
Audit of Receivable and Revenue
1. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to receivables and
revenue.
2. Obtain an understanding of internal control over receivables and revenue.
3. Assess the risks of material misstatement and design further audit procedures.
4. Perform further audit procedures—tests of controls.
a. Examples of tests of controls:
 Examine signifi cant aspects of a sample of sales transactions.
 Compare a sample of shipping documents to related sales invoices.
 Review the use and authorization of credit memoranda.
 Reconcile selected cash register tapes and sales tickets with sales journals.
 Test IT application controls.
 Examine evidence of review and approval of revenue estimates.
b. If necessary, revise the risks of material misstatement based on the results of tests of controls.
5. Perform further audit procedures—substantive procedures for receivables and revenue.
a. Obtain an aged trial balance of trade accounts receivable and analyses of other accounts receivable and reconcile to ledgers.
b. Obtain analyses of notes receivable and related interest.
c. Inspect notes on hand and confirm those with holders.
d. Confirm receivables with debtors.
e. Review the year-end cutoff of sales transactions.
f. Perform analytical procedures for accounts receivable, notes receivable, and revenue.
g. Review significant year-end sales contracts for unusual terms.
h. Test the valuation of notes receivable, computation of interest income, interest receivable, and amortization of discount or
premium.
i. Evaluate the propriety of the client’s accounting methods for receivables and revenue.
j. Evaluate accounting estimates related to revenue recognition.
k. Determine the adequacy of the client’s allowance for uncollectible accounts.
l. Ascertain whether any receivables have been pledged.
m. Investigate any transactions with or receivables from related parties.
n. Evaluate the business purpose of significant and unusual sales transactions.
o. Evaluate financial statement presentation and disclosure of receivables and revenue.

18
 EXERCISE

PROBLEM 1. You have assigned to audit the accounts receivable accounts of Pretty Co. the balance of Accounts Receivable control account is
P 788,000. The entries that were posted in the Doubtful Accounts Expense were:
a. A debit on December 31 for the amount of credit to Allowance for Doubtful Accounts.
b. A credit of P 1,296 on December 3, 2019 because Pumasana Co. remitted in full for the accounts charged off on December 31, 2019.

Allowance for Doubtful Accounts

Debit Credit Balance
January 1, 2019 14, 632
October 31, 2019 Uncollectible Accounts
 Naksuno Co. - P 1,296
 Lakasdos Co. – P 3,280
 Sawakastres Co. – P 2,256 6,032 8,600
December 31, 2019 39,400 48,000

Aging Schedule of Accounts Receivable

Age Balance Rate
0 – 30 days 372,960 1%
31 – 90 days 307,280 2%
91 – 180 days 88,720 3%
Over 181 days 24,000 4,000 – definitely uncollectible
8,000 – 50% uncollectible
12,000 – 20% uncollectible

Additional information:
a. The credit balance of P 8,000 in the 0-30 days represents an advance sales contract.
b. A credit balance of P 2,000 in the 31-60 days for which merchandise will be accepted by custoemer.
c. Ledger accounts are still open as of December 31, 2019.
d. The accounts receivable control account is not in agreement with the subsidiary ledger.

Note: Adjust the control account to the sum of the subsidiaries after the corrections are made.

Required: Compute for the following on December 31, 2019:

1. Adjusted balance of Accounts Receivable
2. Adjusted balance of Allowance for Doubtful Accounts
3. Net adjustment to the Allowance for Doubtful Accounts
4. Doubtful Accounts Expense
5. Net adjustment to the Doubtful Accounts Expense account

PROBLEM 2: You are examining the financial statements of Merlyn Inc. for the year ended December 31, 2019. Your analysis of the 2019
entries in the Notes Receivable account follows:
Merlyn Inc.
Analysis of Notes Receivable
For the year ended December 31, 2019
Date Debit Credit
Jan. 1 Balance Forwarded Received P 25,000 6% note due 118,000
10/29/2019 from Anna whose trade account was past due
Feb 28 Discounted Anna note 24,960
Mar. 31 Received non-interest bearing demand note from Julia, the 6,200
corporation’s treasure for a loan
Aug. 30 Received principal and interest due from Robinson in 34,200
accordance with agreement, two principal payments in advance
Sept. 4 Paid protest fee on note dishonored by Pepper 500
Nov. 1 Received check dated 2/1/2020 in settlement of Tripper note. 8,120
The check was included in cash on hand 12/31/2019
Nov. 4 Paid protest fee and maturity value of Anna note to bank. Note 26,031
discounted 2/28/2019 was dishonored
Dec. 27 Accepted equipment with a fair market value of P 24,000 in full 24,000
settlement from Anna
Dec. 31 Received check dated 1/2/2020 from Julia in payment of 6,200
3/31/2019 note. (The cash was included in petty cash until
1/2/2020 when it was returned to Julia in exchange for new
demand note for the same amount.)
Dec. 31 Received principal and interest on Pepper note 42,437
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 Dec. 31 Accrued interest on Robinson note 1,200
151,931 139,917

The following information is available:

1. Balance at January 1, 2019 was a debit of P 1,400 in the Accrued Interest Receivable account and a credit of P 400 in the Unearned
Interest Income account. The P 118,000 debit in the Notes Receivable account consisted the following three notes:
a. Robinson note of 8/13/2012 payable in annual installment of P 10,000 principal plus accrued interest at 6% each August 31,
P 70,000.
b. Tripper note discounted to Merlyn Inc. at 6% 11/1/2018 due 11/1/2019, P 8,000.
c. Pepper note for P 40,000 plus 6% interest dated 12/31/2018 due on 9/1/2019, P 40,000.
2. No entries were made during 2019 to the Accrued Interest Receivable or the Unearned Interest Income account and only one entry for
a credit of P 1,200 on December 31 appeared in the interest income account.
3. All notes were from the trade customers unless otherwise indicated.
4. Debits and credits affecting Notes Receivables were correctly recorded unless the facts indicate otherwise.

Required: Determine the following as of and for the year ended December 31, 2019:
5. Notes receivable – trade
6. Interest income

PROBLEM 3: Wizards Enterprises loaned P 1,000,000 to Washington Inc. on January 1, 2017. The terms of the loan require principal payments
of P 200,000 each year for 5 years plus interest at 8%. The first principal and interest payment is due on January 1, 2018. Washington made the
required payments during 2018 and 2019. However, during 2006 Washington began to experience financial difficulties, requiring Wizards to
reassess the collectibility of the loan. On December 31, 2019, Wizards determines that the remaining principal payments will be collected, but
the collection of interest is unlikely. The prevailing interest rate for similar type of note as of December 31, 2019 is 10%.

Required: Compute for the following:

7. The present value of the expected future cash flows as of December 31, 2019
8. The loan impairment for the year 2019
9. Interest income for the year 2020, assuming that Wizards' assessment of the collectibility of the loan has not changed.
10. Carrying value of the loan receivable for the year 2019.

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