Universidad de Manila

Atty. Maria Milagros R Lisaca BSA 31

Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

Auditor’ Responsibility
The fair presentation of the financial statements in accordance with the applicable
financial reporting standards is the responsibility of the client’s management. The
auditor’s responsibility is to design the audit to provide reasonable assurance of
detecting material misstatements in the financial statements. These
misstatements may emanate from:
1. Error
2. Fraud, and
3. Noncompliance with laws and regulations

Error
The term “error” refers to unintentional misstatements in the financial statements
including the omission of an amount or a disclosure, such as:
 Mathematical or clerical mistakes in the underlying records and accounting
data
 An incorrect accounting estimate arising from oversight or misinterpretation
of facts
 Mistake in the application of accounting policies

Fraud
Fraud refers to intentional act by one or more individuals among management,
those charged with governance, employees, or third parties, involving the use of
deception to obtain an unjust or illegal advantage. Although fraud is a broad legal
concept, the auditor is primarily concerned with fraudulent acts that cause a
material misstatement in the financial statements.

Types of fraud
1. Fraudulent financial reporting – involves intentional misstatements or
omissions of amounts or disclosure in the financial statements to deceive
financial statement users. This type of fraud is also known as management
fraud because it usually involves members of management or those charged
with governance. This may involve
 Manipulation, falsification or alteration of records or documents
 Misrepresentation in or intentional omission of the effects of
transactions from records or documents
 Recording of transactions without substance
 Intentional misapplications of accounting policies

2. Misappropriation of assets or employee fraud – involves theft of an

entity’s assets committed by the entity’s employees. This may include
 Embezzling receipts
 Stealing entity’s assets such as cash, marketable securities, and
inventory
 Lapping of accounts receivable
This type of fraud is often accompanied by false or misleading records or
documents in order to conceal the fact that the assets are missing.

Fraud involves motivation to commit it and a perceived opportunity to do so. A

perceived opportunity to commit fraud may exist when there is no proper
segregation of duties among employees or when management believes that internal
control can be easily circumvented.

The primary factor that distinguishes fraud from error is whether the underlying
cause of misstatement in the financial statements is intentional or unintentional.
Consequently, the auditor’s responsibility for the detection of fraud and error is
essentially the same.
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

Responsibility of Management and those charged with Governance

The responsibility for the prevention and detection of fraud and error rests with
both management and those charged with the governance of the entity. PSA 240
requires
 Management to establish a control environment and to implement internal
control policies and procedures designed to ensure, among others, the
detection and prevention of fraud and error
 Individuals charged with governance of an entity to ensure the integrity of an
entity’s accounting and financial reporting systems and that appropriate
controls are in place.

Auditor’s responsibility
Although the annual audit of financial statements may act as deterrent to fraud and
error, the auditor is not and cannot be held responsible for the prevention of fraud
and error. The auditor’s responsibility is to design the audit to obtain reasonable
assurance that the financial statements are free from material misstatements,
whether caused by error or fraud.

 Planning Phase
1. When planning an audit, the auditor should make inquiries of
management about the possibility of misstatements due to fraud and
error. Such inquiries may include:
o Management’s assessment of risks due to fraud
o Controls established to address the risks
o Any material error or fraud that has affected the entity or
suspected fraud that the entity is investigating
The auditor should also inquire of those individual in charge of
governance to seek their views on the adequacy of accounting and
internal control systems in place, the risk of fraud and error, and the
integrity of management.

2. The auditor should assess the risk that fraud or error may cause the
financial statements to contain material misstatements. PSA 240 requires
the auditor to specifically “assess the risk of material misstatements due
to fraud and consider that assessment in designing the audit procedures
to be performed.” The fact that fraud is usually concealed can make it
very difficult to detect. Nevertheless, using auditor’s knowledge of the
business, the auditor may identify events or conditions that provide an
opportunity, a motive, or a means to commit fraud, or indicate that fraud
may already have occurred. Such events or conditions are referred to as
“fraud risk factors”.
Judgments about the increased risk of material misstatements due to
fraud may influence the auditor’s professional judgments in the following
ways:
o The auditor may approach the audit with a heightened level of
professional skepticism
o The auditor’s ability to assess control risk at less than high level
may be reduced and the auditor should be sensitive to the ability of
the management to override controls.
o The audit team may be selected in ways that ensure that the
knowledge, skill and ability of personnel assigned significant
responsibilities are commensurate with the auditor’s assessment of
risk.
o The auditor may decide to consider management selection and
application of significant accounting policies, particularly those
related to income determination and asset valuation.
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

 Testing Phase
3. During the course of the audit, the auditor may encounter circumstances
that may indicate the possibility of fraud or error. For ex.: discrepancies
in the accounting records, missing documents, lack of cooperation from
management

4. After identifying material misstatement in the financial statements, the

auditor should consider whether such a misstatement resulted from a
fraud or an error. If the auditor believes that the misstatement is, or may
be the result of fraud, but the effect on the financial statements is not
material, the auditor should:
o Refer the matter to appropriate level of management at least one
level above those involved, and
o Be satisfied that, given the position of the likely perpetrator, the
fraud has no other implications for other aspects of the audit or
that those implications have been adequately considered.
However, if the auditor detects a material fraud or has been unable to
evaluate whether the effect on the financial statement is material or
immaterial, the auditor should:
o Consider implication for other aspect of the audit particularly the
reliability of management representations.
o Discuss the matter and then further investigation with an appropriate
level with at least one level above those involved
o Attempt to obtain evidence to determine whether a material fraud in
fact exists and if so, their effects, and
o Suggest that the client consult with legal counsel about question of law

 Completion Phase
5. The auditor should obtain a written representation from the client’s
management that:
o It acknowledges its responsibility for the implementation and
operations of accounting and internal control systems that are
designed to prevent and detect fraud and error,
o It believes the effects of those uncorrected financial statement
misstatements aggregated by the auditor during the audit are
immaterial, both individually and in the aggregate, to the financial
statements taken as a whole.
o It has disclosed to the auditor all significant facts relating to any
frauds or suspected frauds known to management that may have
affected the entity; and
o It has disclosed to the auditor the results of its assessment of the
risk that the financial statements may be materially misstated as a
result of the fraud.

 Consider the effect on the auditor’s report

6. Whether the auditor believes that material error or fraud exists, he should
request the management to revise the financial statements. Otherwise,
the auditor will express a qualified or adverse opinion.

7. If the auditor is unable to evaluate the effect of fraud on the financial

statements because of a limitation on the scope of the auditor’s
examination, the auditor should either qualify or disclaim his opinion on
the financial statements.

The risk of not detecting a material misstatement resulting from fraud is

higher than the risk of not detecting misstatement resulting from error.
This is due to the fact that fraud may involve sophisticated and carefully
organized schemes designed to conceal it, such as forgery, deliberate
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

failure to record transactions, or intentional misrepresentation being made

to the auditor .

The risk of the auditor not detecting a material misstatement resulting

from management fraud is greater than for employee fraud because those
charged with governance and management are often in a position that
assumes their integrity and enables them to override the formally
established control procedures.

Non Compliance with Laws and Regulations

Non compliance refers to acts or omission or commission by the entity being
audited, either intentional or unintentional, which are contrary to the prevailing
laws or regulations. Such acts include transactions entered by, or in the name of,
the entity or on its behalf by its management or employees. Common examples
include:
 Tax evasion
 Violation of environment protection laws
 Inside trading of securities

Management responsibility
It is management’s responsibility to ensure that the entity’s operations are
conducted in accordance with laws and regulations. The responsibility for the
prevention and detection of noncompliance rests with management. (PSA250)
The following policies and procedures, among others, may assist management in
discharging its responsibilities for the prevention and detection of noncompliance:
 Monitoring legal requirements and ensuring that operating procedures are
designed to meet these requirements
 Instituting and operating appropriate systems of internal control
 Developing, publicizing and following a Code of Conduct
 Ensuring employees are properly trained and understand the code of conduct
 Monitoring compliance with the Code of Conduct and acting appropriately to
discipline employees who fail to comply with it
 Engaging legal advisors to assist in monitoring legal requirement
 Maintaining a register of significant laws with which the entity has to comply
within its particular industry and a record of complaints.

Auditor’s responsibility
The auditor should recognize that noncompliance by the entity with laws and
regulations may materially affect the financial statements.
 Planning Phase
1. In order to plan the audit, the auditor should obtain a general
understanding of the legal and regulatory framework applicable to the
entity and the industry and how the entity is complying with that
framework.
To obtain the general understanding of the laws and regulations, the
auditor would ordinarily:
o Use the existing knowledge of the entity’s industry and business
o Inquire of management concerning the entity’s policies and
procedures regarding compliance with laws and regulations
o Inquire of management as to the laws and regulations that may be
expected to have a fundamental effect on the operations of the
entity
o Discuss with management the policies or procedures adopted for
identifying, evaluating, and accounting for litigation claims and
assessments
o Discuss the legal and regulatory framework with auditors of
subsidiaries in other countries (for example, if the subsidiary is
required to adhere to the securities regulations of the parent
company)
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

2. After obtaining the general understanding, the auditor should design

procedures to help identify instances of noncompliance with those laws
and regulations where noncompliance should be considered when
preparing financial statements, such as:
o Inquiring of management as to whether the entity is in compliance
with such laws and regulations
o Inspecting correspondence with the relevant licensing or regulatory
authorities

3. The auditor should also design audit procedure to obtain sufficient

appropriate audit evidence about compliance with those laws and
regulations generally recognized by the auditor to have an effect on the
determination of material amounts and disclosures in financial
statements.

 Testing phase
4. When the auditor becomes aware of information concerning a possible
instance of noncompliance, the auditor should obtain an understanding of
the nature of the act and the circumstance in which it has occurred, and
sufficient other information to evaluate the possible effect on the financial
statements. When evaluating the possible effect on the financial
statements, the auditor considers:
o The potential financial consequences, such as fines, penalties,
damages, threat of expropriation of assets, enforced
discontinuation of operations and litigation
o Whether the potential financial consequences require disclosure
o Whether the potential financial consequences are so serious as to
call into question the fair presentation given by the financial
statements

5. When the auditor believes there may be noncompliance, the auditor

should document the findings, discuss them with management, and
consider the implication on other aspects of the audit.

 Completion phase
6. The auditor should obtain written representations that management has
disclosed to the auditor all known actual or possible noncompliance with
laws and regulations that could materially affect the financial statements.

 Consider the effect on the auditor’s report

7. When the auditor believes that there is noncompliance with laws and
regulations that materially affects the financial statements, he should
request the management to revise the financial. Otherwise, a qualified or
adverse opinion will be issued.
8. If a scope limitation has precluded the auditor from obtaining sufficient
appropriate evidence to evaluate the effect on noncompliance with laws
and regulations, the auditor should express a qualified opinion or a
disclaimer or opinion.

An audit is subject to the unavoidable risk that some material misstatements in the
financial statements will not be detected, even though the audit is properly planned
and performed in accordance with PSAs. This risk is higher with regard to material
misstatements resulting from noncompliance with laws and regulations because:
 There are many laws and regulations relating principally to the operating
aspects of the entity that typically do not have a material effect on the
financial statements and are not captured by the accounting and internal
control systems. Auditors are primarily concerned with the noncompliance
that will have a direct and material effect in the financial statements.
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

 Noncompliance may involve conduct designed to conceal it, such as collusion,

forgery, deliberate failure to record transactions, senior management
override of controls or intentional misrepresentations being made to the
auditor

Fraud risk factors Relating to Misstatements Resulting from Fraudulent Financial

Reporting
Categories:
A. Fraud risk factors relating to Management’s Characteristics and Influence
over the Control Environment. These fraud risk factors pertain to
management’s abilities, pressures, style and attitude relating to internal
control and the financial reporting process
 There is motivation for management to engage in fraudulent financial
reporting. Specific indicators might include the following:
o A significant portion of management’s compensation is
represented by bonuses, stock options or other incentives, the
value of which is contingent upon the entity achieving unduly
aggressive targets for operating results, financial position or
cash flow
o There is excessive interest by management in maintaining or
increasing the entity’s stock price or earnings trend through the
use of unusually aggressive accounting practices
o Management commits to analysts, creditors and other third
parties to achieving what appear to be unduly aggressive or
clearly unrealistic forecasts
o Management has an interest in pursuing inappropriate means to
minimize reported earnings for tax-motivated reasons

 There is a failure by management to display and communicate an

appropriate attitude regarding internal control and the financial
reporting process. Specific indicators might include the ff:
o Management does not effectively communicate and support the
entity’s values or ethics, or management communicates
inappropriate values or ethics
o Management is dominated by a single person or a small group
without compensating controls such as effective oversight by
those charged with governance.
o Management does not monitor significant controls adequately
o Management fails to correct known material weaknesses in
internal control on a timely basis
o Management sets unduly aggressive financial targets and
expectations for operating personnel
o Management displays a significant disregard for regulatory
authorities
o Management continues to employ ineffective accounting
information technology or internal auditing staff

 Non financial management participates excessively in or is preoccupied

with, the selection of accounting principles or the determination of
significant estimates

 There is a high turnover of management, counsel or board members

 There is a strained relationship between management and the current

or predecessor auditor. Specific indicators might include the following:
o Frequent disputes with the current or a predecessor auditor on
accounting, auditing or reporting matters
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

o Unreasonable demands on the auditor, including unreasonable

time constraints regarding the completion of the audit or the
issuance of the auditor’s report
o Formal or informal restrictions on the auditor hat inappropriately
limit the auditor’s access to people or information, or limit the
auditor’s ability to communicate effectively with those charged
with governance.
o Domineering management behavior in dealing with the auditor,
especially involving attempts to influene the scope of the
auditor’s work

 There is a history of securities law violations, or claims against the

entity or its management alleging fraud or violations of securities laws

 The corporate governance structure is weak or ineffective, which may

be evidenced by, for example:
o A lack of members who are independent of management
o Little attention being paid to financial reporting matters and to
the accounting and internal control systems by those charged
with governance

B. Fraud risk factors relating to Industry Conditions

These fraud risk factors involve the economic and regulatory environment in
which the entity operates
 New accounting, statutory or regulatory requirements that could
impair the financial stability or profitability of the entity
 A high degree of competition or market saturation, accompanied by
declining margins
 A declining industry with increasing business failures and significant
declines in customer demand
 Rapid changes in the industry, such as high vulnerability to rapidly
changing technology or rapid product obsolescence.

C. Risk factors relating to Operating Characteristics and Financial Stability

These fraud risk factors pertain to the nature and complexity of the entity
and its transactions, the entity’s financial condition, and its profitability.
 Inability to generate cash flows from operations while reporting
earnings and earnings growth.
 Significant pressure to obtain additional capital necessary to stay
competitive, considering the financial position of the entity (including a
need for funds to finance major research and development or capital
expenditures)
 Assets, liabilities, revenues or expenses based on significant estimates
that involve unusually subjective judgment or uncertainties, or that
are subject to potential significant change in the near term in a
manner that may have a financially disruptive effect on the entity (for
example, the ultimate collectability of receivables, the timing of
revenue recognition, the reliability of financial instruments based on
highly subjective valuation of collateral or difficult to assess repayment
sources, or a significant deferral of costs).
 Significant related party transactions which are not in the ordinary
course of business
 Significant related party transactions which are not audited or are
audited by another firm
 Significant, unusual or highly complex transactions (especially those
close to year-end) that pose difficult questions concerning substance
over form.
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

 Significant bank accounts or subsidiary or branch operations in tax-

haven jurisdictions for which there appears to be no clear business
justification
 An overly complex organizational structure involving numerous or
unusual legal entities, managerial lines of authority or contractual
arrangements without apparent business purpose
 Difficulty in determining the organization or person (or persons)
controlling the entity
 Unusually rapid growth or profitability, especially compared with that
of other companies in the same industry
 Especially high vulnerability to changes in interest rates
 Unusually high dependence on debt, a marginal ability to meet debt
repayment requirements, or debt covenants that are difficult to
maintain
 Unrealistically aggressive sales or profitability incentive programs
 A threat of imminent bankruptcy, foreclosure or hostile takeover
 Adverse consequences on significant pending transactions (such as a
business combination or contract award) if poor financial results are
reported
 A poor or deteriorating financial position when management has
personally guaranteed significant debts of the entity.

Fraud risk factors Relating to Misstatement Resulting from

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

B. Fraud risk factors Relating to Controls

These fraud risk factors involve the lack of controls designed to prevent or
detect misappropriation of assets
 Lack of appropriate management oversight (for example, inadequate
supervision or inadequate monitoring of remote locations)
 Lack of procedures to screen job applicants for positions where
employees have access to assets susceptible to misappropriations
 Inadequate record keeping for assets susceptible to misappropriations
 Lack of an appropriate segregation of duties or independent checks
 Lack of an appropriate system of authorization and approval of
transactions (for example, in purchasing)
 Poor physical safeguards over cash, investments, inventory or fixed
assets
 Lack of timely and appropriate documentation for transactions (for
example, credits for merchandise returns)
 Lack of mandatory vacations for employees performing key control
functions.
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

THE AUDIT PROCESS – Accepting an Engagement

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

General approach when auditing financial statements

Financial statement assertions:

Existence or occurrence
FS Rights and obligations
Competence audit procedures
Valuation and allocation
Presentation and disclosure
Audit evidence

Audit opinion
FS – financial statements

Financial Statement assertions

Management is responsible for the fair presentation of financial statements that
reflect the nature and operations of the entity. Management makes assertions
regarding the recognition, measurement, presentation and disclosure of the various
elements of financial statements and related disclosures. These assertions may fall
under the following categories:

A. Assertions about classes of transactions and events for the period under
audit
 Occurrence – transactions and events that have been recorded have
occurred and pertain to the entity
 Completeness – all transactions and event that should have been
recorded have been recorded
 Accuracy – amounts and other data relating to recorded transactions
and events have been recorded appropriately
 Cut off – transactions and events have been recorded in the correct
accounting period
 Classification – transactions and events have been recorded in the
proper accounts

B. Assertions about account balances at the period end:

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

C. Assertions about presentation and disclosure

 Occurrence and rights and obligations – disclosed events, transactions,
and other matters have occurred and pertain to the entity
 Completeness – all disclosures that should have been included in the
financial statements have been included
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

 Classification and understandability – financial information is

appropriately presented and described, and disclosures are clearly
expressed
 Accuracy and valuation – financial and other information are disclosed
fairly and at appropriate amounts

Audit Procedures
The auditor should use assertions for classes of transactions, account balances, and
presentation and disclosures in sufficient detail to form a basis for the assessment
of risks of material misstatement and the design and performance of further audit
procedures.

Some of the audit procedures used by the auditor to gather sufficient appropriate
evidence include:
 Inspection – involves examining of records, documents or tangible assets
 Observation – consists of looking at a process or procedure being performed
by others
 Inquiry – consists of seeking information from knowledgeable persons inside
or outside the entity
 Confirmation – consist 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 procedure – consists of 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

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 underlying the financial
statements and corroborating information from other sources. At the conclusion of
the audit, the auditor should carefully evaluate the audit evidence obtained in order
to come up with an appropriate opinion.

Overview of the Audit Process

The audit process is the sequence of different activities involved in an audit.
The audit process:
 Accepting an engagement
 Audit planning
 Considering internal control
 Performing substantive tests
 Completing the audit
 Issuing a report

Accepting an engagement
The first step in the audit process is to make a decision of whether to accept or
reject an audit engagement. This process would require evaluation of the auditor’s
qualification as well as the auditability of the prospective client’s financial
statements. The procedures performed at this stage of the audit are referred to in
PSA 300 as “preliminary planning activities”. These procedures involve:
a. Performing procedures regarding the continuance of the client relationship
and the specific audit engagement
b. Evaluating compliance with ethical requirements, including independence
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

c. Establishing an understanding of the terms of the engagement

Audit Planning
In planning an audit, the auditor obtains more detailed knowledge about the client’s
business and industry in order to understand the transactions and events affecting
the financial statements, and to identify potential problems that might encountered
during the audit.

Considering the internal control

The auditor should give adequate consideration to the entity’s internal control
because the condition of the entity’s internal control directly affects the reliability of
the financial statements. The stronger the internal control, the more assurance it
provides about the reliability of accounting data and financial statements.
Consideration of the 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.

Performing Substantive Tests

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

Completing the audit

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

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

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

 Competence
One of the primary considerations before accepting an audit engagement is
to determine whether the auditor has the necessary skills and competence to
handle the engagement. According to the Code of Ethics, professional
accountants should not portray themselves as having expertise which they
do not possess. Before accepting the engagement, the auditor should obtain
a preliminary knowledge of the client’s business and industry to determine
whether the auditor has the degree of competence required by the
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

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 suggests that audit work
should be assigned to personnel who have the appropriate capabilities,
competence and time to perform the audit engagement in accordance with
professional standards. In addition, there should be sufficient direction,
supervision and review of work at all levels in order to provide reasonable
assurance that the firm’s standard of quality is maintained in the
performance of the engagement.

 Integrity of Management
The recent wave of litigation involving auditors has made pre-acceptance
investigation procedures very important. PSA 220 requires the firm to
conduct a background investigation of the prospective client in order to
minimize the likelihood of association with clients whose management lacks
integrity. This task would involve:

o 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
o Communicating with the predecessor auditor
Communication with predecessor auditor is not only a matter of
courtesy to the predecessor auditor. This communication allows the
incoming auditor to obtain information about the client that will be
useful in determining whether the engagement will be accepted. Once
permission of the client is obtained, the incoming auditor should
inquire into matters that may affect the decision to accept the
engagement. This includes questions regarding:
a. The predecessor auditor’s understanding as to the reasons for the
change of auditors
b. Any disagreement between the predecessor auditor and the client
c. Any facts that might have a bearing on the integrity of the
prospective client’s management

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, ownerships, nature of client’s business, or other
changes that may affect the scope of examination. In general, conditions which
would have caused an accounting firm to reject a prospective client may also result
or lead to a decision of terminating an audit engagement.

Engagement Letter
After accepting the audit engagement, an engagement letter should be prepared.
This serves as the written contract between the auditor and the client. This letter
sets forth:
1. The objective of the audit of financial statements which is to express an
opinion on the financial statements
Universidad de Manila
Atty. Maria Milagros R Lisaca BSA 31
Sources: Salosagcol, Auditing Theory / Cabrera, Auditing & Assurance Services

2. The management’s responsibility for the fair presentation of the financial

statements
3. The scope of the audit
4. The forms or any reports or other communication that the auditor expects to
issue
5. The fact that because of the limitations of the audit, there is an unavoidable
risk that material misstatement may remain undiscovered.
6. 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:
1. Billing arrangements
2. Expectations of receiving management representation letter
3. Arrangements concerning the involvement of others (experts, other auditors,
internal auditors and other client personnel)
4. 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:
o Avoid misunderstandings with respect to the engagement
o Document and confirm the auditor’s acceptance of the appointment

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

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
 Degree of independence of the component’s management