Introduction to Financial Statements Audit
assertions can be identified with established criteria.
Independent Auditing Defined
Auditing has been defined in different ways by
different sources. The definition given by the
American Accounting Association provides an
effective means of Introducing and initially exploring
the topic
Auditing is a systematic process by which a
competent, Independent person objectively bruins
and evaluates evidence regarding assertions about
economic actions and events to ascertain the degree
of correspondence between those assertions and
established criteria and communicating the results to
interested users.
This definition includes several key words and
phrases briefly discussed in this section.
Systematic process
This implies a structured, logical, and
organized series of steps and procedures. Auditing
consists of a series of sequential steps that include
formation testing system and testing of transactions
and balances.
Competent, independent person
The auditor must be qualified to understand
the criteria used and the competence to know how
and what evidence to accumulate to reach the proper
conclusion. The auditor must also have an
independent mental attitude which involves impartial
and objective thinking.
Objectively obtaining and evaluates evidence
This means examining the bases for the
assertions (representations) and judiciously
evaluating the results without bias or prejudice either
for or against the individual or entity was he
representations.  adheres to a methodology;
Assertions about economic actions and events
These are the representations made by the
individual or entity. T comprise the subject matter of
auditing Assertions include information contained in
financial statements, internal operating reports, and
tax returns. In the audit of financial statement
assertions are the representations of management as
to the fairness of the financial statements.
Degree of correspondence
This refers to the closeness with which the
The expression of correspondence may be quantified,
such as the amount of a shortage in a petty cash fund,
or it may be qualitative, such as the fairness for
reasonableness) of financial statements.
Established criteria
These are the standards against which the
assertions or representations are judged. Criteria may
be specific rules prescribed by a legislative body,
budgets and other measures of performance set by
management, or financial reporting standards
established by the Financial Reporting Standards
Council (FRSC) and other authoritative bodies.
Communicating the results
This is often referred to as attestation. The
final stage in the audit process is the audit report the
communication of the findings to users. By attesting
to the degree of correspondence with established
criteria, the investigator enhances (or weakens) the
credibility of the representations or claims that have
been made by another party. The communication of
findings is achieved through a written report.
Interested users
These are individuals who use rely on the
auditor’s findings le a business environment, this
includes stockholders, management creditors,
governmental agencies, and the public.
The IFAC Education Committees defines auditing
as follows:
a) “Auditing is a structured process that:
b) Involves the application of analytical skills,
professional judgment, and professional
skepticism
c) is sully performed by a team of
professionals, directed with managerial
skills;
d) uses appropriate forms of technology and
e) complies with all relevant technical
standards such as International Standards
on Auditing (ISA), International Standards
on Quality Control ISOC). International
Financial Reporting Standards (FRS),
International Public Sector Accounting
Standards (IPSAS), and any applicable
international, national or local equivalents
as appropriate; and
f) complies with required standards or
professional ethics.”
Objectives of Auditing
The Philippine Standards on Auditing (PSA) 120
“Framework of Philippine Standards on Auditing
states the objective of an audit as follows:
“The objective of an audit of financial statements is
to enable the auditor to express an opinion whether
the financial statements are prepared, in all material
respects in accordance with an identified financial
reporting framework The phrase sed to express the
auditor’s opinion is present fairly, in all material
respects similar objective applies to the credit of
financial or other information prepared in accordance
with appropriate criteria.”
In conducting an audit of financial statements, the
overall responsibilities of the auditor are:
a) To obtain reasonable assurance about
whether the financial statements as a whole
are free from material misstatement,
whether due to fraud or error, thereby
enabling 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; and
b) To report on the financial statements, and
communicate as required by the Philippine
Standards on Auditing (PSA), in
accordance with the auditor’s findings.
In all cases when reasonable assurance cannot be
obtained and qualified opinion in the auditor’s report
is insufficient in the circumstances for purposes of
reporting to the intended users of the financial
statements, the PSAS require that the auditor
disclaim an opinion or withdraw from the
engagement where withdrawal is legally permitted.
Scope of Independent Audit
The term “scope of an audit refers to the audit
procedures deemed necessary in the circumstances to
achieve the objective of the audit. The procedures
required to conduct an audit in accordance with PSAs
relevant professional bodies, legislation, regulation
and, where appropriate, the terms of the audit
engagement and reporting requirements.
Since the primary objective of an independent audit
is to express an opinion on the company’s financial
statement the auditor will conduct a critical and
systematic examination of the statements and of the
related documents, records, procedures, and control
Audit evidences may be gathered to enable him to
substantive the representations in the financial
statements. Internal controls will be evaluated for
effectiveness since they affect the reliability of the
financial records. By inquiry, observation,
confirmation and inspection, the auditor can test the
existence and validity of assets, liabilities, overall
reasonableness of other account balances in the
financial statements
When sufficient and competent audit evidences have
been gathered, the auditor can then formulate his
opinion n the fairness with which the financial
statements have been prepared. He then prepares the
audit report containing the scope of his examination
and the opinion he has expressed on the financial
statements for submission to the client who in turn
furnishes copies of the report to various interested
parties.
Why Independent Financial Auditing is
necessary?
Without wide public acceptance, professions cannot
exist, and independent auditing is no exception Over
the years, society has preserved a need for audits of
publicly held companies, which has developed as a
result of the separation of ownership and
management. Auditing services are used extensively
by business, government and other mot for profit
organizations. As society becomes more complex
there is an increased likelihood that unreliable
information will be provided to design makers.
“Information Risk”
a) Remoteness of information users from
information providers
Decision makers, almost always, do not get
firsthand knowledge about the business enterprise
with which they do business for the reasons that in
many cases:
1. owners are divorced from management,
2. directors are not involved in day-to-day
operations or decisions
3. business may be dispersed among
numerous geographic locations and
complex corporate structure.
b) Potential bias and motives of information
provider
A conflict of interest may be assumed to
exist between management and owners regarding the
financial statements Management usually desires to
present the results of its stewardship in the most
favorable light. Information may possibly be biased
in favor of the provider when his ghouls are
inconsistent with the decision maker. This could be
attributed to either an international emphasis
designed to influence users in a certain manner or
maybe an honest optimism about future events.
c) Voluminous data
As businesses grow, possibly millions of
exchange transactions are processed daily via manual
or sophisticated computerized systems. This
increases therefore the likelihood that improperly
recorded information may be included or buried in
the records.
d) Complex exchange transactions
New and changing business relationships
may lead to innovative accounting and reporting
problems. Some transactions are so complex and
hence more difficult to record properly. Also,
transactions not quantifiable will require increased
disclosures.
e) Consequences
During the past decade many financial
statement e pension funds private investors venture
capitalist and bunks-lost billions of pesos became
financial information had become unreliable. As an
example, the factors leading up to, and the
consequences of, unreliable information can be seen
in the subprime mortgage crisis in the United States.
How Information Risk may be reduced?
1. Allow me to verify information
The user may to the business establishment
to examine records and obtain information about the
reliability of the statement. Although impractical
because of costs, this is usually adopted by BIR
examiners or business intending to purchase another
business. It is common for a purchase to use a special
audit team to independently verify and evaluate key
information of the prospective business. This is also
known as “due diligence audit”.
2. Users shares information risk with
management
It is important to emphasize the fact that
management has the primary responsibility of
providing reliable information to users Of users rely
on inaccurate financial statements and I a
consequence incurs a financial loss, a lawsuit may be
brought against management to recover part of such.
3. Have the financial statements audited
To obtain reliable information, the user can
have an independent audit performed. The audited
information is then used in the decision making
process on the assumption that it is reasonably
complete, accurate, and unbiased.
As an expert in the application of financial
reporting standards, the independent auditor further
enhances the quality of financial reporting
Advantages and Practical Benefits of Independent
Audit
A. To the Auditee or Client
1. Independent audit makes the financial statements
more credible and reliable.
2. Management is the beneficiary of constructive
suggestions in improving business operations.
3. Commission of fraud by management and
employee is minimized
4. Audited financial statements provide a more
credible basis for the preparation of tax returns.
5. Better and sound management decisions may be
made if financial records and reports are accurately
maintained and provided.
B. To Creditors, Prospective Investors, Employees
1. Financial institutions have more credible basis in
deciding whether financial assistance will be
extended to the auditee.
2. Suppliers and other creditors will have reliable
basis decisions related to extension of credit.
3. Potential and current investors will have more
credible basis in evaluating managerial efficiency.
4. Employees will have a better and credible basis in
requesting for fringe benefits and wage adjustments.
5. In the event of sale, purchase, or merger of a
business, both buyer and seller will have more
confident basis for aiming at a decision as to the
terms and conditions of the arrangement.
C. To Government Agencies and Legal
Community
1. BIR has more assurance concerning accuracy and
dependability of tax return if they have been based on
audited financial statements.
2. Government institutions like GSIS, SSS, DBP will
have better bases in extending financial assistance to
business enterprises.
3. Audited statements provide the legal community
an independent basis for administering estates and
trust, setting action in bankruptcy and insolvency,
etc.
 opinion, is the main product or output of the audit.
Overview of the Audit Opinion Formulation Just as the report of a house inspector communicates
Process the inspector's findings to a prospective buyer, the
audit report communicates the auditor's findings to
Phase I Risk Assessment
the users of the financial statements.
Performing Risk Assessment including
Client Acceptance and Continuance
Decision
Activities of each phase of the Audit

Phase II Risk Response Opinion Formulation Process

Obtaining Evidence about Internal
Control Operating Effectiveness
Phase I-Risk ● Assess preconditions for an
Obtaining Substantive Evidence about
Assessment audit
Accounts, Disclosures and Assertions
  ● Develop common
understanding of the audit
Phase Reporting engagement with the client
III Completing the Audit and Making ● Identify and assess risks of
  Reporting Decisions material misstatement
● Respond to identify risks of
material misstatement
Phase I of the audit opinion formulation process
concerns risk assessment starting from client Phase II - Risk  
acceptance and continuance. Auditors are not Response ● Select controls to test, if
applicable
required to perform audits for any organization that
Obtaining ● Perform tests of controls, if
asks, auditors choose whether or not to perform each Evidence about applicable
individual audit. Audit firms have procedures to help Internal Control ● Consider the results of tests
ensure that they are not associated with clients where of controls, applicable
with clients where management integrity is in Operating  
question or where a company might otherwise Effectiveness, if ● Perform substantive tests
present the audit firm with unnecessarily high risk applicable
(such as client financial failure or regulatory action
Obtaining
against the client),
Substantive
Evidence about
Once a client is accepted (or the audit firm decides to Accounts,
continue to audit the client), the auditor needs to Disclosures and
perform risk assessment procedures to understand the Assertions
client's business thoroughly (or update prior
knowledge in the case of a continuing client), its
industry, its competition, and its management and Phase III ● Complete review and
governance processes (including internal controls) to Completing the communication activities
determine the likelihood that financial accounts Audit and Making Determine the type(s) of
might be in error. Reporting opinion(s) to issue
Decisions
Phase II, the auditor will also obtain evidence about
internal control operating effectiveness through Management Assertions and Financial Statements
testing those controls. Much of what most people
think of as auditing, the obtaining of substantive Assertions about classes of transactions and events
evidence about accounts, disclosures, and assertions (and related disclosures) for the period:
are also in this phase. The information gathered in  
Phase I through Il will greatly influence the amount  Occurrence: Transactions and events that
of testing to be performed. have been recorded or disclosed have
 Completeness: All transactions and events
Finally, in Phase III, the auditor will complete the that should have been recorded have
audit and make a decision about what type of audit financial statements been included.
report to issue.
 Authorization: All transactions and events
have been properly authorized.
The final phase in the audit process is to evaluate
 Accuracy: Amount and other data relating
results and choose the appropriate audit report to
to recorded transactions and events have
issue. The auditor's report, also known as the audit
 been recorded appropriately, and related
disclosures have been appropriately
measured and described.
 Cutoff: Transactions and events have been
recorded in the correct accounting period.
 Classification: Transactions and events
have been recorded in the proper accounts.
 Preparation: Transactions and events are
appropriately aggregated or disaggregated
and clearly described and related
disclosures are relevant and understandable
in the context of the requirements of the The conceptual and procedural details of a financial
applicable financial reporting framework. statement audit build on three fundamental concepts:
materiality, audit risk, and evidence relating to
Assertions about account balances and related management's financial statement assertions. The
disclosures) at the period end: auditor's assessments of materiality and audit risk
influence the nature, timing and extent of the audit
 Existence: Assets, liabilities, and equity evidence to be gathered.
interests exist.
 Rights and obligations: The entity holds Auditors do not guarantee or ensure the fair
or controls the rights to assets, and presentation of financial statements there exists some
liabilities are the obligations of the entity. risk that the financial statements are not fairly stated
 Completeness: All assets, liabilities, and even when the opinion is unqualified or unmodified.
equity interest that should have been Materiality
recorded, have been recorded, and all
related disclosures that should have been Materiality refers to the amount by which a set of
included in the financial statements have financial statements could be misstated without
been included. affecting the judgment of a reasonable person. It also
 Accuracy, valuation, and allocation: refers to the magnitude of an omission or
Assets, liabilities, and equity interests have misstatement of accounting information that in the
been included in the financial statements at light of surrounding circumstances make it probable
appropriate amounts, and any resulting that the judgment of a reasonable person relying on
valuation or allocation adjustments have that information would have been changed or
been appropriately recorded, and related influenced by the omission or misstatement.
disclosures have been appropriately
measured and described. One of the auditor's first tasks in planning an audit is
to make a judgment about just how big a
 Classification: Assets, liabilities, and
misstatement would have to be before it would
equity interests have been recorded in the
significantly affect users' judgments. The concept of
proper accounts.
materiality is important because it simply isn't
 Presentations: Assets, liabilities, and
practical or cost beneficial for auditors to ensure that
equity interests are appropriately
financial statements are completely free of any small
aggregated or disaggregated and clearly
misstatements.
described, and related disclosures are
relevant and understandable in the context
The focus of this definition is on the users of the
of the requirements of the applicable
financial statements. In planning the engagement, the
financial reporting framework.
auditor assesses the magnitude of a misstatement that
 
may affect users' decisions. This materiality
Core Concepts in Financial Statement Audit
assessment helps the auditor determine the nature,
timing, and extent of audit procedures used to collect
audit evidence.

Audit Risk

The second major concept involved in auditing is

audit risk, which is the risk that the auditor may
mistakenly give a "clean" opinion on financial
statements that are materially misstated.
Audit risk is the risk that the auditor mistakenly
expresses a clean audit opinion when the financial
statements are materially misstated.
Auditing standards make it clear that audit provides
“reasonable assurance that the financial statements do
not contain materials misstatements. The phase
“reasonable assurance" implies that even when the
auditor does a good job, there is some risk that a
material misstatement could be present in the
financial statements and the auditor will fail to detect
it. The auditor plans and conduits the audit to achieve
an acceptably low level of audit risk the auditor
controls the level of audit risk through the
effectiveness and extent of the audit work conducted.
The more effective and extensive the audit work (and
thus the type and amount of audit evidence
collected), the lower the risk that a misstatement will
go undetected and that the auditor will issue an
inappropriate report.
Audit Evidence Regarding Management
Assertions
The third concept involved in auditing is evidence
regarding management's assertions, or, more simply,
audit evidence. Most of the auditor's work in arriving
at an opinion on the financial statements consists of
obtaining and evaluating audit evidence relating to
management's assertions. Audit evidence consists of
the underlying accounting data and any additional
information available to the auditor, whether
originating from the client or externally.
The assertions, in conjunction with assessment of
materiality and audit risk, are used by the auditor to
determine the nature, timing, and extent of evidence
to be gathered. Once the auditor has obtained
sufficient appropriate evidence that the management
assertions can be relied upon for each significant
account and disclosure, the auditor has reasonable
assurance that the financial statements are fairly
presented. Note the two key descriptors of audit
evidence: sufficient and appropriate.
The sufficiency of audit evidence simply refers to the
quantity of evidence the auditor obtains - does the
auditor have enough evidence to justify a conclusion
as to whether management's assertions are fairly
stated? The appropriateness of audit evidence refers
to whether the evidence is relevant and reliable.
Relevance refers to whether the evidence relates to
the specific management assertion being tested.
Reliability refers to the diagnosticity of the evidence.
While the auditor has a professional responsibility to
obtain "sufficient appropriate evidence", the auditor
seldom has the luxury of obtaining completely
convincing evidence about the true state of particular
management assertion. In most situations, the auditor
is able to obtain only persuasive evidence that the
assertion is fairly stated.
General Principles of Audit
Compliance with Ethical Requirements
The auditor should comply with the
“Revised Code of Ethics for Professional
Accountants in the Philippines” promulgated by the
Board of Accountancy and approved by the
Philippine Professional Regulation Commission.
Ethical principles governing the auditor's professional
responsibilities are:
a) independence;
b) integrity;
c) objectivity;
d) professional competence and due care;
e) confidentiality;
f) professional behavior; and
g) technical standards.
Reasonable Assurance
An audit in accordance with Philippine Standards on
Auditing (PSAs) is designed to provide reasonable
assurance that the financial statements taken as a
whole are free from material misstatement.
Reasonable assurance is a concept relating to the
accumulation of the audit evidence necessary for the
auditor to conclude that there are no material
misstatements in the financial statements taken as a
whole. Reasonable assurance relates to the whole
audit process. However, there are inherent limitations
in an audit that affect the auditor's ability to detect
material misstatements. These limitations result from
factors such as:
 The use of testing.
 The inherent limitations of any accounting
and internal control system (for example,
the possibility of collusion).
 The fact that most audit evidence is
persuasive rather than conclusive.
 Also, the work undertaken by the auditor to
form an opinion is permeated by judgment,
in particular regarding:
a) the gathering of audit evidence, for
example, in deciding the nature.
 timing and extent of audit procedures;
and
b) the drawing of conclusions based on
the audit evidence gathered, for
example assessing the reasonableness
of the estimates made by management
in preparing the financial statements.
 Further, other limitations may affect the
persuasiveness of evidence available to
draw conclusions on particular financial
statement assertions (for example,
transactions between related parties). In
these cases, certain PSAs identify specific
procedures which will, because of the
nature of the particular assertions, provide
sufficient appropriate audit evidence in the
absence of:
a) unusual circumstances which increase
the risk of material misstatements
b) beyond that which would ordinarily be
expected; or any indication that a
material misstatement has occurred.
Responsibility for the Financial Statements
While the auditor is responsible for forming and
expressing an opinion on the financial statements, the
responsibility for preparing and presenting the
financial statements is that of the management of the
entity. The audit of the financial statements does not
relieve management of its responsibilities.
Skills and Knowledge Needed in Financial
Statement Audit
Audits are performed in teams where each auditor is
expected to complete tasks requiring considerable
technical knowledge and expertise, along with
leadership, teamwork, and professional skills. In
terms of technical knowledge and expertise, auditors
must understand accounting and auditing
authoritative literature, develop industry and client-
specific knowledge, develop and apply computer
skills, evaluate internal controls, and assess and
respond to fraud risk.
In terms of leadership, teamwork, and professional
skills, auditors make presentations to management
and audit committee members, exercise logical
reasoning, communicate decisions to users, manage
and supervise others by providing meaningful
feedback, act with integrity and ethics, interact in a
team environment, collaborate with others, and
maintain a professional personal presence. While
external auditors at all types of audit firms need these
skills, the work environment at larger versus smaller
audit firms differs.
Parties Involved in Preparing and Auditing
Financial Statements
Various parties are involved in the preparation and
audit of financial statements and related disclosures.
Management has responsibilities for:
a) preparing and presenting financial
statements in accordance with the
applicable financial reporting framework;
b) designing, implementing and
maintaining internal control over financial
reporting; and
c) providing the auditors with information
relevant to the financial statements and
internal controls.
The internal audit function provides management and
the audit committee with assurance on internal
controls and repots. The audit committee, a
subcommittee of the organization's board of directors,
oversees both management and the internal auditors,
and they also hire the external auditor.
The external auditor's job is to obtain reasonable
assurance about whether management's statements
are materially accurate and to provide a publicly
available report. External auditors conduct their
procedures and make judgments in accordance with
professional standards. The audited financial
statements are provided to users who have an interest
in the organization.
The Context of Financial Statement Auditing
You have already learned about different kinds of
auditors and audit services. public accounting firms,
and the auditor's role in society. Now let us turn our
attention to the primary context that shapes the
external auditor's environment the business or entity
being audited.
The Business Entity as the Primary Context of
Auditing
In studying the subsequent chapters, you will be
building your auditing tool kit. How you apply
auditing tools on any particular engagement will
depend greatly in the nature of the entity's business.
The point is that the context provided by the entity's
business greatly impacts the auditor and the nature of
the audit and is thus a primary aspect of the
environment in which financial statement auditing is Auditors often rely on this process model to divide
conducted. the audit of a business's financial statements into
manageable pieces.

\
Relating the Audit Process Components to the
Business Model

While businesses in different industries can have

different characteristics, most have some
fundamental conceptual characteristics in common.
These commonalities provide a way for auditors to
organize how they approach financial statement
audit, regardless, of the type of entity they are
auditing.

In a simple business model, management, with

guidance and direction from the board of directors,
decides on a mission, what can be translated into a set
of objectives along with the strategies designed to
achieve those objectives. The organization must
assess and manage risks that may threaten the
achievement of its objectives. The organization then
undertakes certain processes in order to implement its
strategies.
Most businesses establish processes that fit in broad
business process categories, also known as business
cycles. The five categories that characterize the
processes of most businesses are

1) Revenue and collection cycle

2) Purchases and disbursement cycle
3) Payroll
4) Inventory Warehousing Transaction
5) Financing Process

Each business process involves a variety of important

transactions.

The enterprise designs and implements, accounting

information system to capture the details of those
transactions. It also designs and implements a system
of internal control to ensure that the transactions are
handled and recorded appropriately and that
resources are protected.

The accounting information system must be capable

of producing reliable financial reports, which
summarize the effects of the organizations
transactions on its account balances and which are
used to establish management accountability to
outside owners.