AT.

3001a Lecture Notes

Assurance Engagements & Other Services of a Practitioner

Introduction to Practitioners’ Engagements

  Public practitioners offer a wide array of professional services to various clients, profit or non-profit,
private or public, mainly dealing with its financial aspects.  These may include the traditional audit and
review of FSs, tax compliance and consulting, transaction and financial advisory services, etc. 
Categorically, these services can be classified into two: assurance and non-assurance.

Assurance Engagement: Definition and Objective

  In an assurance engagement, a practitioner expresses a conclusion designed to enhance the  degree
of confidence of the intended users other than the responsible party about the outcome of the
evaluation or measurement of a subject matter against criteria.  Hence, an assurance engagement is
an independent professional service that improves the quality (credibility) of information for decision
makers.

  Assurance services are very broad, and can be done by CPAs or by a variety of other professionals.

Types of Assurance Engagements

  As to structure of engagement:

o Assertion-based (Attestation) engagement. In this type of engagement, the evaluation or

measurement of the subject matter is performed by the responsible party, and the subject
matter information is in the form of assertion by the responsible party that is made available
to the intended users.  Independent financial statements audit normally falls under this type.

o Direct reporting engagement. In this type of engagements, the practitioner either directly
performs the evaluation or measurement of the subject matter, or obtains a representation
from the responsible party that has performed the evaluation or measurement that is not
available to the intended users.  The subject matter information is provided to the intended
users in the assurance report.

Elements of an Assurance Engagement

 The five elements of an assurance engagement are:

1. A three party relationship involving a practitioner, a responsible party, and intended users;

2. An appropriate subject matter;

3. Suitable criteria;

4. Sufficient appropriate evidence; and

5. A written assurance report in the form appropriate to a reasonable assurance engagement or a

limited assurance engagement.

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Three-party Relationship

Assurance engagements involve three separate parties:

1. Practitioner – the person, who performs the engagement, and is broader than the term “auditor”
which relates only to practitioners performing audit or review engagements with respect to historical
financial information.

2. Responsible party – is the person responsible for

 Direct reporting engagement – subject matter; or

 Assertion-based engagement – a subject matter information (the assertion), and may be the
subject matter. The responsible party may or may not be the party who engages the
practitioner (the engaging party).

3. Intended users – for whom the assurance report is prepared. The responsible party can be one of the
intended users, but not the only one.

Appropriate Subject Matter

  The subject matter, and subject matter information, of an assurance engagement can take many
forms, such as:

1.

1. Financial performance or conditions (for example, historical or prospective financial

statements)

2. Non-financial performance or conditions (for example, performance key indicators of

efficiency and effectiveness of an entity)

3. Physical characteristics (for example, capacity of a facility)

4. Systems and processes (for example, an entity’s internal control or IT system)

5. Behavior (for example, corporate governance, compliance with regulation, human resource
practices)

Suitable Criteria

  Benchmarks used to evaluate or measure the subject matter.

  Examples of formal criteria are the following:

o In the preparation of financial statements, the criteria may be Philippine Financial Reporting
Standards;

o When reporting on internal control, the criteria may be an established internal control
framework; and

o When reporting on compliance, the criteria may be the applicable law, regulation or
contract.

  Suitable criteria are required for reasonably consistent evaluation or measurement of a subject
matter within the context of professional judgment. Without the frame of reference provided by
suitable criteria, any conclusion is open to individual interpretation and misunderstanding.

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   The criteria must have the following characteristics to be considered suitable:

1. Relevance – relevant criteria contribute to conclusions that assist decision- making by the intended
users.

2. Completeness – criteria are sufficiently complete when relevant factors that could affect the
conclusions in the context of the engagement circumstances are not omitted. Complete criteria
include, where relevant, benchmarks for presentation and disclosure.

3. Reliability – reliable criteria allow reasonably consistent evaluation or measurement of the subject
matter including, where relevant, presentation and disclosure, when used in similar circumstances by
similarly qualified practitioners.

4. Neutrality – neutral criteria contribute to conclusions that are free from bias.

5. Understandability – understandable criteria contribute to conclusions that are clear, comprehensive,

and not subject to significantly different interpretations.

  The criteria need to be available to the intended users to allow them to understand how the subject
matter has been evaluated or measured.

Sufficient Appropriate Evidence

  Evidence is the information obtained by the practitioner in arriving at the conclusions on which the
opinion is based.

  The practitioner plans and performs an assurance engagement with an attitude of professional
skepticism.

  In addition, the practitioner recognizes the existence of assurance engagement risk (synonymous to
audit risk) – the risk that the practitioner expresses an inappropriate conclusion when the subject
matter information is materially misstated.

Written Assurance Report

   The practitioner provides a written report containing a conclusion that conveys the assurance
obtained about the subject matter information.

Non-assurance Engagements

  Engagements are considered non-assurance engagements if they lack one or more of the five
elements of an assurance engagement.

  Common examples of non-assurance engagements are:

1. Agreed-upon procedures engagement;

2. Compilations engagements;

3. Preparation of tax returns where no conclusion conveying assurance is expressed;

4. Consulting (or advisory) engagements such as management and tax consulting;

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AT.3002a Lecture Notes

Introduction to Audit & Audit Standard Setting Process

Auditing in General

  An audit is a 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.

Types of Audits

  As to objective, criteria and subject matter:

o Financial statements (FSs) audits.

o   Operational or performance audits. This type of audit can be divided into two types:

 Economy and efficiency (Management) audit—The appraisal of management

performance from the most efficient point of view, i.e., cost-benefit analysis.

 Effectiveness (Program results) audit—The evaluation of programs, projects and

activities to determine the extent of achievement of previously set goals and
objectives.

o  Compliance audits.

 As to auditor:

o External (Independent) audits—These are audits performed by CPAs who are independent of
the organizations whose assertions is the subject matter of the audit. External auditors
usually performs FS audits, but may also perform operational and compliance audits.

o  Internal audits—An internal audit is an independent appraisal function established within an

organization to examine and evaluate its activities as a service to the organization. Internal
auditors normally report the results of their examination to those charged with governance. 
Although internal audit is an “independent appraisal function”, internal auditors, being
employees of the auditee-organization, cannot be as independent as external auditors as
long as the employer-employee relationship exists.  Internal audits mainly comprise
operational and compliance audits.

o  Governmental (State) audits—Government auditing involves the determination of whether

government funds are being handled properly and in compliance with the applicable laws
and regulations, and whether the government programs of a particular agency are
conducted effectively and efficiently. Governmental auditors can perform FSs audit,
operational audit and compliance audit.

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  The following table compares the different types of audits as to their objective, subject matter and
criteria:

Subject
Types Examples Objectives Criteria
Matter

Annual audit of Applicable

Financial PLDT financial Conducted to determine whether financial
Financial
Statements statements the FSs are stated in accordance reporting
statements
Audit with specified criteria. framework
  (GAAP)

Evaluates the efficiency and

Evaluate
effectiveness of any part of an
Operational whether the
organization’s operating Operation of Company
or computerized
procedures and methods. At the computerized standards for
payroll system is
Performance completion of an operational audit, payroll efficiency and
operating
Audit management normally expects system effectiveness.
effectively and
recommendations from the auditor
efficiently
for improving operations.

Determine
whether bank Conducted to determine whether Loan agreement
Bank loan
Compliance requirements for the auditee is following specific provisions
continuation
Audit loan procedures, rules, or regulations
requirement  
continuation set by some higher authority.
have been met

Nature of Independent FSs Audit

  Audit engagement of financial statements is a reasonable assurance engagement in which a

professional accountant in public practice expresses an opinion whether financial statements are
prepared, in all material respects, in accordance with an applicable financial reporting framework,
such as an engagement conducted in accordance with PSAs

 Financial statements audit is an assurance engagement as it enhances the degree of confidence that
intended users can place in the FSs.  Also, it is an example of assertion-based assurance engagement
since the financial statements are assertions by management that these are fairly stated in all
material respects.

Assertions of Financial Statements

  Assertions are representations by management, explicit or otherwise, that are embodied in the
financial statements.

 The three categories of assertions are as follows:

o Classes of transactions and events (COCAC)

1. Occurrence—transactions and events that have been recorded have occurred and
pertain to the entity.

2. Completeness—all transactions and events that should have been recorded have
been recorded.

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 3. Accuracy—amounts and other data relating to recorded transactions and events
have been recorded appropriately.

4. Cutoff—transactions and events have been recorded in the correct accounting

period.

5. Classification—transactions and events have been recorded in the proper accounts.

o Account balances (RCEV)

1. Existence—assets, liabilities, and equity interests exist.

2. Rights and obligations—the entity holds or controls the rights to assets, and
liabilities are the obligations of the entity.

3. Completeness—all assets, liabilities and equity interests that should have been
recorded have been recorded.

4. 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.

o Presentation and disclosure (COCA)

1. Occurrence and rights and obligations—disclosed events, transactions, and other

matters have occurred and pertain to the entity.

2. Completeness—all disclosures that should have been included in the financial

statements have been included.

3. Classification and understandability—financial information is appropriately

presented and described, and disclosures are clearly expressed.

4. Accuracy and valuation—financial and other information are disclosed fairly and at
appropriate amounts.

Scope of Independent FSs Audit

 The auditor shall exercise professional judgment in determining the scope of the audit and consider
the requirements of the relevant legislations, regulations and professional standards.

 Under PSA 200, the auditor’s opinion on the FSs deals with whether the FSs are prepared, in all
material respects, in accordance with the applicable financial reporting framework.  The auditor’s
opinion therefore does not assure, for example, the future viability of the entity nor the efficiency or
effectiveness with which management has conducted the affairs of the entity.

Demand for Independent FSs Audit

 The need for independent FSs audit arises from the importance of reducing information risk.   Users
depend on reliable information in making important decisions. Decisions made based on unreliable
information could have adverse financial consequences.  Users, therefore, turn to the expertise of the
auditor who provides an unbiased opinion on the fair presentation of financial statements through
the auditor’s report.

 Causes of information risk are the following:

o Conflict of interest between management and users of financial statements (potential bias)

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 o Remoteness between a user and the organization

o Voluminous data

o Complexity of the transactions, information, or processing systems

Theoretical Framework of FSs Auditing

 Financial Statements audit, to be effective, should work based on the following basic assumptions:

o Data to be audited can be verified

o Independence

o No long-term conflict between the auditor and the management

o Effective internal control system reduces risk of material misstatement of the FSs

o Consistent application of GAAP results to fair presentation

o What was held true in the past will continue to hold true in the future in the absence of
known conditions to the contrary

o An audit benefits the public

The Auditor’s Overall Objectives—Obtaining Reasonable Assurance, Reducing Audit Risk

 To easily grasp the concept of the audit process, as required by PSAs, let us discuss first the overall
objectives of the auditor in the audit of financial statements.  It is advised that students should spend
time fully understanding these objectives because all the work of the auditor is geared towards the
achievement of the said objectives.

 In the audit of financial statements, the overall objectives of the auditor are:

o  To obtain reasonable assurance whether the F/S are free from material misstatement,
whether due to fraud or error, to enable the auditor to express an opinion on whether the
financial statements are prepared, in all material respects, in accordance with an applicable
financial reporting framework (FRF); and

o  To report on the financial statements, and communicate as required by the Philippine
Standards on Auditing (PSAs), in accordance with the auditor’s findings.

 The audit is conducted only with an aim to obtain reasonable assurance, which is a high, but not
absolute, level of assurance.  The auditor cannot provide absolute assurance because of certain
inherent limitations of audit.  Therefore, there is always some audit risk in any audit engagement. 

 To achieve the above objectives, the auditor shall perform audit procedures to gather sufficient
appropriate audit evidence about assertions embodied in the financial statements; and thereby,
reduce audit risk to an acceptably low level that enables the auditor to draw reasonable conclusions
on which to base the auditor’s opinion.

 Audit risk is the risk (or likelihood) that the auditor gives an inappropriate audit opinion when the
financial statements are materially misstated.  It should be noted that audit risk does not include the
risk that the auditor might express an opinion that the financial statements are materially misstated
when they are not.  This risk is ordinarily insignificant.  Further, audit risk is a technical term related to
the process of auditing; it does not refer to the auditor’s business risks such as loss from litigation,

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 adverse publicity, or other events arising in connection with the audit of financial statements.  These
other risks are simply called engagement risks.

   Audit risk is a function of the risks of material misstatement and detection risk [AR = f(ROMM x DR)]. 
The risk of material misstatement refers to the likelihood that the financial statements are materiality
misstated prior to the audit; while, detection risk is the risk that the procedures performed by the
auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and
that could be material, either individually or when aggregated with other misstatements.  Therefore,
risks of material misstatement are the function of the entity, its environment, and its internal control;
while, detection risk is therefore the function of the effectiveness of auditor’s audit procedures.

 In other words, audit risk may occur when the auditor expresses an inappropriate opinion stating that
the financial statements are fairly stated when in fact they are not.  This could occur when the
financial statements already are materially misstated even before the auditor begins the audit, and
the auditor fails to detect these material misstatements leading the auditor to express an
inappropriate opinion.  For this reason, the auditor must focus on—as a risk-based audit approach—
addressing these risks of material misstatement of the financial statements to effectively conduct the
audit and avoid audit risk from occurrence.

 For a given level of audit risk, the acceptable level of detection risk bears an inverse relationship to
the assessed level of risk of material misstatement.  The higher the assessed level of risk of material
misstatement, the lower the detection risk the auditor sets, and vice versa.

 Therefore, from the given relationship above, detection risk cannot be set to zero (given that there is
always risk of material misstatement).

AASC Pronouncements

  The Auditing and Assurance Standards Council’s (AASC’s) mission is “the promulgation of auditing
standards, practices and procedures which shall be generally accepted by the accounting profession in
the Philippines.”  The AASC replaced the Auditing Standards and Practices Council (ASPC), which was
established by the PICPA and ACPAPP.  It has 15 regular members coming from the following:

   The AASC pronouncements are listed below together with the particular engagements they are
applicable to:

 PHILIPPINE STANDARDS ON QUALITY CONTROL (PSQCs)

 PSQC 1, Quality Control for Firms that Perform Audits and Reviews of Financial Statements, and Other
Assurance and Related Services Engagements

 AUDITS OF HISTORICAL FINANCIAL INFORMATION

200–299 General Principles and Responsibilities

 PSA 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance
with PSA

 PSA 210, Agreeing the Terms of Audit Engagements

 PSA 220, Quality Control for an Audit of Financial Statements

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  PSA 230, Audit Documentation

 PSA 240, The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements

 PSA 250, Consideration of Laws and Regulations in an Audit of Financial Statements

 PSA 260, Communication with Those Charged with Governance

 PSA 265, Communicating Deficiencies in Internal Control to Those Charged with Governance and
Management

300–499 Risk Assessment and Response to Assessed Risks

 PSA 300, Planning an Audit of Financial Statements

 PSA 315 (Revised), Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and Its Environment

 PSA 320, Materiality in Planning and Performing an Audit

 PSA 330, The Auditor’s Responses to Assessed Risks

 PSA 402, Audit Considerations Relating to an Entity Using a Service Organization

 PSA 450, Evaluation of Misstatements Identified during the Audit

500-599 Audit Evidence

 PSA 500, Audit Evidence

 PSA 501, Audit Evidence—Specific Considerations for Selected Items

 PSA 505, External Confirmations

 PSA 510, Initial Audit Engagements—Opening Balances

 PSA 520, Analytical Procedures

 PSA 530, Audit Sampling

 PSA 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related
Disclosures

 PSA 550, Related Parties

 PSA 560, Subsequent Events

 PSA 570, Going Concern

 PSA 580, Written Representations

600–699 Using the Work of Others

 PSA 600, Special Considerations—Audits of Group Financial Statements (Including the Work of
Component Auditors)

 PSA 610, Using the Work of Internal Auditors

 PSA 620, Using the Work of an Auditor’s Expert

700-799 Audit Conclusions and Reporting

 PSA 700, Forming an Opinion and Reporting on Financial Statements

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  PSA 701, Communicating Key Audit Matters in the Independent Auditor’s Report

 PSA 705, Modifications to the Opinion in the Independent Auditor’s Report

 PSA 706, Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s
Report

 PSA 710, Comparative Information—Corresponding Figures and Comparative Financial Statements

 PSA 720, The Auditor’s Responsibilities Relating to Other Information in Documents Containing
Audited Financial Statements

800–899 Specialized Areas

 PSA 800, Special Considerations—Audits of Financial Statements Prepared in Accordance with Special
Purpose Frameworks

 PSA 805, Special Considerations—Audits of Single FSs and Specific Elements, Accounts or Items of a FS

 PSA 810, Engagements to Report on Summary Financial Statements

 AUDITS AND REVIEWS OF HISTORICAL FINANCIAL INFORMATION

2000–2699 Philippine Standards on Review Engagements (PSREs)

 PSRE 2400 Engagements to Review Historical Financial Statements

 PSRE 2410 Review of Interim Financial Information Performed by the Independent Auditor of the
Entity

 ASSURANCE ENGAGEMENTS OTHER THAN AUDITS OR REVIEWS OF HISTORICAL FINANCIAL INFORMATION

3000–3699 Philippine Standards on Assurance Engagements (PSAEs)

 PSAE 3000 Assurance Engagements Other than Audits or Reviews of Historical Financial Information

 PSAE 3400 The Examination of Prospective Financial Information

 PSAE 3402 Assurance Reports on Controls at a Service Organization

 PSAE 3410 Assurance Engagements on Greenhouse Gas Statements

 PSAE 3420 Assurance Engagements to Report on the Compilation of Pro Forma Financial Information
Included in a Prospectus

 RELATED SERVICES

4000–4699 Philippine Standards on Related Services (PSRSs)

 PSRS 4400 Engagements to Perform Agreed-Upon Procedures Regarding Financial Information

 PSRS 4410 Compilation Engagements

 The AASC’s Standards contain basic principles and essential procedures.

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 The Authority Attaching to Philippine Standards

  As set forth in the AASC’s Rules of Procedures, “pronouncements on generally accepted auditing
standards, interpretations, and opinions issued by the AASC apply whenever an independent
examination of financial statements of any entity, whether profit-oriented or not, and irrespective of
size or legal form, when such examination is conducted for the purpose of expressing an opinion
thereon. They may also have application, as appropriate, to other related activities of auditors.”

  The nature of the Philippine Standards issued by the AASC requires professional accountants to
exercise professional judgment in applying them. In exceptional circumstances, a professional
accountant may judge it necessary to depart from a basic principle or essential procedure of an
Engagement Standard to achieve more effectively the objective of the engagement. When such a
situation arises, the professional accountant should be prepared to justify the departure.

 Any limitation of the applicability of a specific Philippine Standard is made clear in the standard.

The Authority Attaching to Practice Statements

  Philippine Auditing Practice Statements (PAPSs) are issued to provide interpretive guidance and
practical assistance to professional accountants in implementing PSAs and to promote good practice.
Philippine Review Engagement Practice Statements (PREPSs), Philippine Assurance Engagement
Practice Statements (PAEPSs), and Philippine Related Services Practice Statements (PRSPSs) are issued
to serve the same purpose for implementation of PSREs, PSAEs and PSRSs, respectively.

 Professional accountants should be aware of and consider Practice Statements applicable to the
engagement. A professional accountant who does not consider and apply the guidance included in a
relevant Practice Statement should be prepared to explain how the basic principles and essential
procedures in the Engagement Standard(s) addressed by the Practice Statement have been complied
with.

Adoption of Auditing Standards and Statements

  It is the stated policy of the AASC to make the International Standards and Practice Statements issued
by the International Auditing and Assurance Standards Board (IAASB) the applicable standards and
practice statements in the Philippines.  Other PSAs or PAPSs may be issued when deemed necessary
by the AASC to address any unique requirements imposed by Philippine law or practice.

 An exposure draft (ED) is widely distributed to interested organizations and persons for comment
generally within 90 days. Issuance of ED requires approval by a majority of the members of the
Council.  The comments and suggestions received are considered and the ED is revised as appropriate.

 Issuance of final Philippine Standards and Practice Statements, as well as interpretations, requires
approval of at least ten members and submitted to the PRC through the BOA for approval after which
the pronouncements shall be published in the Official Gazette. After publication, the AASC
pronouncement becomes operative from the effective date stated therein.

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AT.3003 Lecture Notes

Risk-Based Financial Statements Audit, Responsibilities & Objectives

The Risk-Based Audit Process

 In accordance with professional and ethical standards, the auditor shall perform a quality audit.  In
achieving such quality audit, the auditor shall conduct the audit with the exercise professional
judgment and maintain professional skepticism throughout the planning and performance of the
audit and, among other things:

o  Identify and assess 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.

o  Obtain sufficient appropriate audit evidence about whether material misstatements exist,
through designing and implementing appropriate responses to the assessed risks.

o  Form an opinion on the financial statements based on conclusions drawn from the audit
evidence obtained.

 The audit process, described above, is presented in the following three audit phases:

1.  Risk Assessment

2.   Risk Response

3.   Concluding and Reporting

Phase 1—Risk Assessment

Preliminary Engagement Activities

  In this phase, the auditor makes a critical decision about whether to accept an audit engagement of a
new client or to continue an audit of an existing client.  In the case of initial audit, the auditor
communicates with the previous auditor to aid in making the said decision.  If the auditor determines
that the client is acceptable, the auditor agrees the terms of engagement and documents the same in
an audit engagement letter.

 Planning and Assessing Risks

 To effectively (and efficiently) perform an audit, the auditor should plan the audit.  As part of this
planning process, the auditor obtains understanding of the entity (client), its environment and its
internal control.  This understanding serves as the very frame of reference how the audit is conducted
and upon which the auditor exercises professional judgment and maintains professional skepticism.

 The auditor also, in this phase, determines materiality applicable to the financial statements,
identifies material accounts and disclosures in the financial statements, and assesses the risks of
material misstatement of the financial statements.

 The auditor then uses the results of this phase as a basis when designing and performing responses in
the next phase to obtain sufficient appropriate audit evidence.

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Phase 2—Risk Response

 Once the risks of material misstatement of financial statements have been identified and assessed,
the auditor then designs and implements appropriate responses to those risks in order to obtain
sufficient appropriate audit evidence about the assessed risks of material misstatement to reduce
audit risk to an acceptably low level.

 The auditor’s responses include overall responses and further audit procedures to address risks at the
financial statement level and assertion level, respectively.  This phase is the main audit evidence
gathering and evaluation.

Phase 3—Conclusion and Reporting

 This phase of the audit demands careful and thorough review of the auditor.  The judgments made
during this phase of the audit are often crucial to the ultimate outcome of the engagement.  The
procedures covered in this stage of audit often bring to light matters that are of major concern in
forming an opinion on the financial statements. 

 After the planned audit procedures have been performed, an evaluation of the results will take place. 
The auditor shall:

1.  Form an opinion on the F/S based on an evaluation of the conclusions drawn from the audit
evidence obtained; and

2.  Express clearly that opinion through a written report that also describes the basis for the
opinion.

 The auditor’s report shall be in writing (hard copy format or an electronic medium).  That report
contains the following opinions depending on the outcome of engagement:

o  Unmodified (Unqualified or Clean) opinion—The opinion expressed when the financial

statements are prepared, in all material respects, in accordance with the applicable financial
reporting framework.

o  Modified opinion—The three types of are:

1. Qualified opinion—The auditor is satisfied that the financial statements are

presented fairly, except for a specific aspect of them.

2. Adverse opinion—The auditor does not believe the financial statements are fairly
presented.

3. Disclaimer of opinion—The auditor does not know if the financial statements are
presented fairly.

Gathering Audit Evidence and Documentation

 From the start to end of the audit, the auditor gathers and accumulates audit evidence and
documentation that supports the opinion to be expressed.

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Maintaining Audit Quality

 Quality audit means that the audit is performed in accordance with relevant ethical, professional,
legal, and regulatory requirements.

Relevant Ethical Requirements

 Relevant ethical requirements ordinarily comprise Parts A and B of the Code of Professional Ethics. 
The fundamental principles, in accordance with the code of ethics, applicable to audit of financial
statements are:

1. Integrity

2. Objectivity

3. Professional competence and due care

4. Confidentiality

5. Professional behavior

 In addition to fundamental principles, the code also requires professional accountants to be

independent when performing audits, both of mind and in appearance.

Audit in Accordance with PSAs

 The auditor shall comply with all PSAs relevant to the audit.  A PSA is relevant to the audit when the
PSA is in effect and the circumstances addressed by the PSA exist.  The auditor shall not represent
compliance with PSAs in the auditor’s report unless the auditor has complied with the requirements
of this PSA and all other PSAs relevant to the audit.

 If an objective in a relevant PSA cannot be achieved, the auditor shall evaluate whether this prevents
the auditor from achieving the overall objectives of the auditor and thereby requires the auditor, in
accordance with the PSAs, to modify the auditor’s opinion or withdraw from the engagement. Failure
to achieve an objective represents a significant matter requiring documentation

Professional Judgment

 The ability of the auditor to exercise judgment that is professionally made is often described as the
hallmark or trademark of auditing.  Professional accountants are engaged to audit of financial
statements because of their ability to exercise professional judgment.

 Professional judgment is the application of relevant training, knowledge, and experience, within the
context provided by auditing, accounting and ethical standards, in making informed decisions about
the courses of action that are appropriate in the circumstances of the audit engagement.

 The auditor shall exercise professional judgment in planning and performing an audit of financial
statements.  It is essential to the proper conduct of an audit because it enables the proper
interpretation of:

o Relevant ethical requirements

o PSAs

o Informed decisions

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  Professional judgment is necessary in particular regarding decisions about:

o Materiality and audit risk

o Nature, timing, and extent of audit procedures

o Evaluating whether sufficient appropriate audit evidence has been obtained

o Evaluating management’s judgments in applying the applicable financial reporting

framework

o Drawing of conclusions, for example, assessing the reasonableness of the management’s

estimates

Professional Skepticism

 It is believed that professional skepticism is the auditor’s best method to detect fraud in the financial
statements.

 Professional skepticism is an attitude that includes a questioning mind, being alert to conditions which
may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence. 
The auditor shall plan and perform an audit with professional skepticism recognizing that
circumstances may exist that cause the financial statements to be materially misstated.

 Professional skepticism includes being alert to, for example:

o Audit evidence that contradicts other audit evidence obtained

o Information that brings into question the reliability of documents and responses to inquiries
to be used as audit evidence

o Conditions that may indicate possible fraud

o Circumstances that suggest the need for audit procedures in addition to requirements of
PSAs

 Maintaining professional skepticism throughout the audit is necessary if the auditor is, for example, to
reduce the risks of:

o Overlooking unusual circumstances.

o Over generalizing when drawing conclusions from audit observations.

o Using inappropriate assumptions in determining the nature, timing, and extent of the audit
procedures and evaluating the results thereof.

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AT.3004 Lecture Notes

Nature and Type of Audit Evidence

Definition of Audit Evidence

 Audit evidence is all information used by the auditor on which the audit opinion is based. The gathering and
evaluation of audit evidence is a cumulative and iterative process.

Types of Audit Evidence

 The auditor obtains two types of audit evidence such as:

1. Underlying accounting records - The records of initial accounting entries and supporting records, such
as checks and records of electronic fund transfers; invoices; contracts; the general and subsidiary
ledgers, journal entries and other adjustments to the financial statements that are not reflected in
journal entries; and records such as work sheets and spreadsheets supporting cost allocations,
computations, reconciliations and disclosures.

2. Other information – All other evidence obtained by the auditor such as minutes of meetings,
confirmation from third parties and information obtained from such audit procedures as inquiry,
observation, and inspection.

The auditor must obtain the two types of audit evidence above, which must be consistent with each other and
not doubtful as to its reliability.  Underlying accounting records alone cannot constitute sufficient audit
evidence.

  

Sources of Audit Evidence

 The following are the list of sources of audit evidence:

 Performance of audit procedures. (Primary source)

 Previous audits.

 Firm’s quality control procedures for client acceptance and continuance

 Work of a management’s expert.

 Management representations.

 Other sources inside and outside the entity.

  

Primary Source of Audit Evidence: Audit Procedures

 Audit procedures as to purpose:

1. Risk assessment procedures (RAP)—are the audit procedures performed to obtain an understanding
of the entity and its environment, including the entity’s internal control, to identify and assess the
risks of material misstatement, whether due to fraud or error, at the financial statement and

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 assertion levels, thereby providing a basis for designing and implementing responses to the assessed
risks of material misstatement; and

2. Further audit procedures (FAP) which comprise:

 Tests of controls (ToC)—an audit procedure designed to evaluate the operating effectiveness of
controls in preventing, or detecting and correcting, material misstatements at the assertion level; and

 Substantive procedures (SP), comprising tests of details and substantive analytical procedures—an
audit procedure designed to detect material misstatements at the assertion level.

 Audit procedures as to type:

1. Inspection—involves examining records or documents, whether internal or external, in paper form,

electronic form, or other media, or a physical examination of an asset.

2. Observation—consists of looking at a process or procedure being performed by others, for example,

the auditor’s observation of inventory counting by the entity’s personnel, or of the performance of
control activities.

3. External Confirmation—a direct written response to the auditor from a third party (the confirming
party), in paper form, or by electronic or other medium.

4. Recalculation—consists of checking the mathematical accuracy of documents or records.

5. Reperformance—involves the auditor’s independent execution of procedures or controls that were

originally performed as part of the entity’s internal control.

6. Analytical Procedures—consist of evaluations of financial information made by a study of plausible

relationships among both financial and non-financial data. Analytical procedures also encompass the
investigation of identified fluctuations and relationships that are inconsistent with other relevant
information or deviate significantly from predicted amounts.

7. Inquiry—consists of seeking information of knowledgeable persons, both financial and nonfinancial,

within the entity or outside the entity.

 Types of Audit Procedures Linked According to Purpose

Purpose

Types FAP
RAP
ToC SP

Inspection ✓ ✓ ✓

Observation ✓ ✓ ✓

External confirmation     ✓

Recalculation     ✓

Reperformance   ✓  

Analytical procedures ✓   ✓

Inquiry ✓ ✓ ✓

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Reliability and Cost of Audit Procedures

 The most reliable evidence gathering techniques (audit procedures) should be used whenever they are cost
effective. The quality of internal controls has a significant effect on reliability. Furthermore, a specific
substantive audit procedure is rarely sufficient by itself to provide competent evidence to satisfy the audit
objective. However, assuming good internal controls and the ability to choose a specific method, a list of the
most reliable to the least reliable evidence-gathering techniques are in general:

 recalculation,

 inspection,

 reperformance,

 observation,

 confirmation,

 analytical procedures,

The evidence-gathering procedures in order of cost from most costly to least costly are in general:

 confirmation (most costly),

 inspection,

 recalculation,

 reperformance,

 observation,

 analytical procedures,

 inquiry (least costly).

Inquiry is the most extensively used audit procedures. Although inquiry may provide important audit evidence,
and may even produce evidence of a misstatement, inquiry alone ordinarily does not provide sufficient audit
evidence of the absence of a material misstatement at the assertion level, nor of the operating effectiveness of
controls.

  

Sufficiency and Appropriateness of Audit Evidence

 The auditor shall design and perform audit procedures to enable the auditor to obtain sufficient appropriate
audit evidence (SAAE) to be able to draw reasonable conclusions on which to base the auditor’s opinion.   The
sufficiency and appropriateness of audit evidence are interrelated.

Sufficiency

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 Sufficiency is the measure of the quantity of evidence. The quantity of audit evidence needed is affected by
the auditor’s assessment of the risks of misstatement (the higher the assessed risks, the more audit evidence is
likely to be required) and also by the quality of such audit evidence (the higher the quality, the less may be
required). Obtaining more audit evidence, however, may not compensate for its poor quality.

Extent of Testing to Obtain Sufficient Evidence

 An effective test provides appropriate audit evidence to an extent that, taken with other audit evidence
obtained or to be obtained, will be sufficient for the auditor’s purposes.

 In selecting items for testing, the auditor determines the relevance and reliability of information to be used as
audit evidence; the other aspect of effectiveness (sufficiency) is an important consideration in selecting items
to test. The means available to the auditor for selecting items for testing are:

 All items (100% examination)

 Specific items

 Audit sampling

 The application of any one or combination of these means may be appropriate depending on the particular
circumstances, for example, the risks of material misstatement related to the assertion being tested, and the
practicality and efficiency of the different means.

Appropriateness

 Appropriateness is the measure of the quality of audit evidence; that is, its relevance and its reliability in
providing support for the conclusions on which the auditor’s opinion is based.

 When designing and performing audit procedures, the auditor shall consider the relevance and reliability of
the information to be used as audit evidence. The quality of all audit evidence is affected by the relevance and
reliability of the information upon which it is based.

Relevance

 Relevance deals with the logical connection with, or bearing upon, the purpose of the audit procedure,
direction of testing and, where appropriate, the assertion under consideration.

 Purpose of Audit Procedure

 Audit procedures classified according to purpose are risks assessment procedures (RAP), test of controls (ToC)
and substantive procedures (SP).  These three procedures have different purposes such as, to obtain
understanding the entity and its environment, including internal control, to test the operating effectiveness of
entity’s internal control and to detect material misstatements in the financial statements, respectively.

 Assertion

 Audit evidence, to be relevant, must link directly to relevant assertions. The auditor uses assertions in
considering different types of potential misstatements that may occur in the financial statements. It is the
reason why audit objectives follow and are closely related to assertions. In other words, assertions guide the
auditor in the performance of auditor procedures as to what appropriate audit evidence to obtain.

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 A given set of audit procedures may provide audit evidence that is relevant to certain assertions, but not
others. For example, inspection of documents related to the collection of receivables after the period end may
provide audit evidence regarding existence and valuation, but not necessarily cutoff.

 Directional Testing

 The relevance of information to be used as audit evidence may be affected by the direction of testing. For
example, if the purpose of an audit procedure is to test for overstatement in the existence or valuation of
accounts payable, testing the recorded accounts payable may be a relevant audit procedure. On the other
hand, when testing for understatement in the existence or valuation of accounts payable, testing the recorded
accounts payable would not be relevant, but testing such information as subsequent disbursements, unpaid
invoices, suppliers’ statements, and unmatched receiving reports may be relevant.

Reliability

 The reliability of information to be used as audit evidence, and therefore of the audit evidence itself, is
influenced by its source and its nature, and the circumstances under which it is obtained, including the
controls over its preparation and maintenance where relevant.

 Evidence is general more reliable when:

1. Obtained from independent sources;

2. The related controls are effective;

3. Obtained directly than indirectly or by inference;

4. In documentary form than oral; and

5. In original state than by photocopies or facsimiles.

Inconsistency in, or Doubts over Reliability of, Audit Evidence

 Obtaining audit evidence from different sources or of a different nature may indicate that an individual item
of audit evidence is not reliable, such as when audit evidence obtained from one source is inconsistent with
that obtained from another. This may be the case when, for example, responses to inquiries of management,
internal audit, and others are inconsistent, or when responses to inquiries of those charged with governance
made to corroborate the responses to inquiries of management are inconsistent with the response by
management.  Specific documentation requirement if the auditor identified information that is inconsistent
with the auditor’s final conclusion regarding a significant matter.

Audit documentation

 Audit documentation (a.k.a. “working papers” or “workpapers”) is the record of audit procedures performed,
relevant audit evidence obtained, and conclusions the auditor reached.

 The auditor shall prepare documentation to provide:

1. A sufficient and appropriate record of the basis for the auditor’s report; and

2. Evidence that the audit was planned and performed in accordance with PSAs and applicable legal and
regulatory requirements.

 Audit documentation serves a number of additional purposes, including the following:

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  Assisting the audit team to plan and perform the audit.

 Assisting members of the audit team responsible for supervision to direct and supervise the audit
work, and to discharge their review responsibilities.

 Enabling the audit team to be accountable for its work.

 Retaining a record of matters of continuing significance to future audits.

 Enabling the conduct of quality control reviews and inspections.

 Enabling the conduct of external inspections in accordance with applicable legal, regulatory or other
requirements.

 Auditor’s documentation is normally stored in an audit file. Audit file refers to one or more folders or other
storage media, in physical or electronic form, containing the records that comprise the audit documentation
for a specific engagement.

Timely Preparation of Audit Documentation

 Preparing sufficient and appropriate audit documentation on a timely basis helps to enhance the quality of the
audit and facilitates the effective review and evaluation of the audit evidence obtained and conclusions
reached before the auditor’s report is finalized.

Form, Content and Extent of Audit Documentation

 The auditor shall prepare audit documentation that is sufficient to enable an experienced auditor, having no
previous connection with the audit, to understand:

1. The nature, timing, and extent of the audit procedures performed to comply with the PSAs and
applicable legal and regulatory requirements;

2. The results of the audit procedures performed, and the audit evidence obtained; and

3. Significant matters arising during the audit, the conclusions reached thereon, and significant
professional judgments made in reaching those conclusions.

 In documenting the nature, timing and extent of audit procedures performed, the auditor shall record:

1. The identifying characteristics of the specific items or matters tested;

2. Who performed the audit work and the date such work was completed; and

3. Who reviewed the audit work performed and the date and extent of such review.

 Audit documentation, however, is not a substitute for the entity’s accounting records.  Oral explanations by
the auditor, on their own, do not represent adequate support for the work the audit.

Types of Audit Documentation

  Auditors generally classify audit documentation into two types:

1. Current files—Relate specifically to the current period's audit. They often include

o Reconciliation of accounting records to FSs

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 o Lead schedules of major components of amounts in the FSs and supporting detailed
schedules

o Documentation of substantive procedures performed providing evidence corroborating or

contradicting management's assertions

o The attorney's letter and management's representation letter

o Audit programs

 2. Permanent (continuing) files—Relate to the company and contain information with long-term significance.
They are of ongoing interest in any period under audit and often include

o Debt agreements and pension contracts

o Articles of incorporation

o Flowcharts of internal control

o Bond indenture agreements and lease agreements

o Analyses of capital stock & owners’ equity accounts

Departure from a Relevant Requirement

 If, in exceptional circumstances, the auditor judges it necessary to depart from a relevant requirement in a
PSA, the auditor shall document how the alternative audit procedures performed achieve the aim of that
requirement, and the reasons for the departure.

Assembly and Retention of the Final Audit File

 The auditor shall assemble the audit documentation on a timely basis, ordinarily not more than 60 days after
the date of the auditor’s report.  After the assembly, the auditor shall not delete or discard audit
documentation before the end of its retention period, which ordinarily is no shorter than seven years from
auditor’s report date.

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AT.3007 Lecture Notes
Considering Materiality and Audit Risk
Introduction

 The auditor is expected to design and conduct an audit that provides reasonable assurance
that material misstatements will, whether due to fraud or error, be detected.  Hence, the auditor shall
determine materiality for the FSs as a whole when establishing the overall audit strategy, which is part of
planning an audit.

Concept of Materiality

 Information is material if it influences user’s economic decisions. In audit, materiality is considered in terms of
the smallest aggregate level of misstatements that could be considered material to any one of the
statements that comprise the FSs.  For any given client, materiality is not simply a function of specific amounts
in the FSs. An auditor must understand who the potential users are and the type of judgments made by those
users when relying on FSs.

Application of Materiality

 Materiality is applied both in planning, performing and concluding on the audit. In particular, when:

 Identifying material classes of transactions, account balances and disclosures

 Determining the nature, timing and extent of risk assessment procedures

 Identifying and assessing the risks of material misstatement

 Determining the nature, timing and extent of further audit procedures (testing of controls and
performing substantive procedures)

 Evaluating the effect of uncorrected misstatements, if any, on the FSs and in forming the auditor’s
opinion.

Materiality, Audit Procedures, Audit Evidence, and Audit Risk

 The level of materiality has an inverse relationship with audit procedures and audit evidence.  The lower the
materiality—specifically performance materiality (see discussion below)—the more extensive audit procedures
to be performed and the more audit evidence to be gathered.

 As stated above, materiality is used in forming an opinion.  However, there is a risk that if materiality is set too
high the auditor may conclude that a misstatement is immaterial when indeed material; the opposite could

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also occur.  Therefore, inappropriate materiality level may lead to inadvertent occurrence of audit risk.  
Because of this, the auditor takes the view that materiality and audit risk are inversely related—the higher the
audit risk, the lower the materiality, and vice versa.

Materiality Levels

 The auditor establishes the following levels of materiality in an audit of FSs:

1. Materiality for the FSs as a whole

2. Materiality for particular classes of transactions, account balances, or disclosures, if necessary

3. Performance materiality for (a) and (b) above

 In addition, the auditor also determines a threshold at which misstatements are considered clearly trivial or
inconsequential.

Materiality for the FSs as a whole

 The auditor’s determination of materiality is a matter of professional judgment, and is affected by the
auditor’s perception of the financial information needs of users of the FSs. The determination of materiality is
not a mechanical exercise, if fact, there is no specific methodologies prescribed in the standard. However, a
percentage is often applied to a chosen benchmark as a starting point to determine materiality. Qualitative
conditions should also be considered in determining materiality.

Benchmarks

 Factors that may affect the identification of an appropriate benchmark include:

 The elements of the FSs (e.g., assets, liabilities, equity, revenue, expenses)

 Whether there are items on which the attention of the users of the particular entity’s FSs tends to be
focused

 The nature of the entity, where the entity is in its life cycle, and the industry and economic
environment in which the entity operates

 The entity’s ownership structure and the way it is financed

 The relative volatility of the benchmark.

 Profit before tax from continuing operations is often used for profit-oriented entities.

Materiality for Particular Classes of Transactions, Account Balances, or Disclosures

 For certain entities, there may be one or more particular classes of transactions, account balances, or
disclosures for which misstatements of lesser amounts than materiality for the FSs as a whole could reasonably
be expected to influence the economic decisions of users taken on the basis of the FSs.

 Factors that may indicate such classes of transactions, account balances, or disclosures exist include the
following:

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  Whether law, regulation or the applicable financial reporting framework affect users’ expectations
regarding the measurement or disclosure of certain items (e.g., related party transactions, and the
remuneration of management and those charged with governance)

 The key disclosures in relation to the industry in which the entity operates (e.g., research and
development costs for a pharmaceutical company)

 Whether attention is focused on a particular aspect of the entity’s business that is separately
disclosed in the financial statements (e.g., a newly acquired business).

Performance Materiality (Tolerable Misstatement)

 Performance materiality is the amount or amounts set by the auditor at less than materiality for the FSs as a
whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and
undetected misstatements exceeds materiality for the FSs as a whole, i.e., to provide a cushion or margin, so
that if misstatements are detected, the auditor may nevertheless be able to conclude with reasonable
assurance that the total misstatement in the FSs does not exceed materiality.

 The auditor is required to determine performance materiality for purposes of:

 assessing the risks of material misstatement; and

 determining the nature, timing, and extent of further audit procedures.

 If materiality level(s) have been set for particular classes of transactions, account balances, or disclosures,
performance materiality also refers to amount(s) set at less than these levels

Clearly Trivial Misstatement

 Though technically not a materiality level, clearly trivial misstatement is the amount below which
misstatements would be considered inconsequential and need not to be accumulated because such amounts
clearly will not have material effect on the FSs.

Revision of Materiality

 Materiality levels are not cast in stone once determined. These may be adjusted, upward or downward, as
necessary as the audit progresses for example due to the following reasons:

 Changes in entity’s circumstances

 New information

 Change in understanding of entity and its operations

Documentation of Materiality

 The auditor shall document the following:

 Materiality for financial statements as a whole

 Materiality level(s) for particular items

 Performance materiality for the above

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  Revisions to the above as the audit progresses

Identifying Material Classes of Transactions, Account Balances and Disclosures

 The auditor, after determining materiality and gaining sufficient understanding of the entity and its
environment including internal control, identifies material classes of transactions, account balances and
disclosures from the entity’s trial balance, list of accounts and notes to FSs.

 By identifying these items, the auditor focuses the audit only on what is deemed material, thereby reduces its
work on what is determined not to be material.

 The auditor applies his professional judgment and should consider both the account’s nature and amount,
quantitatively and qualitatively, in deciding whether an account is material or not.  Quantitative consideration
may involve comparison of an account’s amount with the materiality. However, there are accounts that may
not be quantitatively material but may deemed material qualitatively, such as those accounts involving
accounting estimates (e.g., allowance for doubtful accounts, retirement obligations, etc.) or suspicious account
(miscellaneous accounts, related party transactions).

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