Auditing and Assurance Prin

BSA 3

ARLYN C. PASION 9/13/23 PRELIM

Course Code Auditing 1
Course Title AUDITING AND ASSURANCE PRINCIPLES
Course & Year BSA 3
Instructor Arlyn Castillo Pasion, CPA

MODULE- PRELIM

TOPIC OUTLINE

LESSON 1- AUDIT – An Overview

1. AUDITING DEFINED
2. Types of Audits
3. Types of auditors
4. Comparison among the Different Types of Audit
5. Inherent limitations of audit
6. Role of Management and Independent Auditor
7. General Principles Governing the Audit of Financial Statements
8. Need for an Independent Financial Statement Audit
9. Theoretical Framework of Auditing
10. EXERCISE #1

LESSON 2: AUDITOR’S RESPONSIBILITY

1. Error
2. Fraud
3. Responsibility of Management and Those Charged with Governance
4. Auditor’s Responsibility
a. Planning Phase
b. Testing Phase
c. Completion Phase
d. Consider the Effect on The Auditor’s Report
5. Noncompliance with Laws and Regulations
a. Management’s Responsibility
b. Auditor’s Responsibility
6. Exercise # 2
LESSON 1- AUDIT – An Overview

AUDITING DEFINED
“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 assertion and established criteria and communicating the
result to users.”

This definition conveys the following thoughts.

1. Auditing is a systematic process

Auditing proceeds by means of an ordered and structured series of steps.

2. An audit involves obtaining and evaluating evidence about assertions regarding

economic actions and events

Assertions are representations made by an auditee about economic actions and

events. The auditor’s objective is to determine whether these assertions are valid. To
satisfy this objective, the auditor performs audit procedures and gathers evidence
that corroborates or refutes the assertions.

3. An audit is conducted objectively

The auditor should conduct the audit without bias. Impartial attitude must be
maintained by the auditor when evaluating evidence and formulating his conclusion.

4. Auditors ascertain the degree of correspondence between assertion and established

criteria

Established criteria are needed to judge the validity of the assertions. These criteria
are important because they establish and inform the user of the basis against which
the assertions have been evaluated or measured. In an audit, the auditor determines
the degree by which the assertions conform to the established criteria. For example,
when auditing financial statements, the auditor judges the fair presentation of the
financial statements(assertions) by comparing the statement with the applicable
financial reporting framework (criteria).

5. Auditors communicate the audit results to various interested users.

The communication of audit findings is the ultimate objective of any audit. For the
audit to be useful, the result must be communicated to users on a timely basis.

Figure 1.1- Illustrative Definition of Auditing

independent auditor

following a systematic process

objectively obtains and evaluates evidence

establishes the degree of corresondence between

assertions established criteria

communicates the results to interested users

♦ Types of Audits
Base on primary audit objectives, there are three major types of audit-financial,
compliance and operational audits.

◙ Financial statement audit

This is an audit conducted to determine whether the financial statements of an

entity are fairly presented in accordance with the applicable financial reporting
framework. This type of audit will be the focus of the discussion in this text.

◙ Compliance audit

Compliance audit involves a review of an organization’s procedures to determines

whether the organization has adhered to specific procedures, rules or regulations.
The performance of compliance audit is dependent upon the existence of verifiable
data and recognized criteria established by an authoritative body. A common
example of this type of audit is the examination conducted by BIR examiner to
determine whether entities comply with tax rules and regulations.

◙ Operational audit

An operational audit is a study of a specific unit of an organization for the purpose of

measuring its performance. The main objective of this type of audit is to assess
entity’s performance, identify areas for improvements and make recommendations
to improve performance. This type of audit is also known as performance audit or
management audit.

It should be noted that, although there are different types of audit, all audits possess
the same general characteristics. They all involve:

1. Systematic examination and evaluation of evidence which are undertaken to

ascertain whether assertion comply with establish criteria; and

2. Communication of the results of the examination, usually in a written report, to a

party by whom, or on whose behalf, the auditor was appointed.

Unlike compliance and financial statement audits, where the criteria are usually defined,
criteria used in operational audit to evaluate the effectiveness and efficiency of
operations are not clearly established.

Types of auditors
Auditors can be classified according to their affiliation with the entity being
examined.

◙ External auditors

These are independent CPAs who offer their professional services to different client
on a contractual basis. External auditors are the one who generally conduct financial
statement audits.

o Internal auditors

Internal audits are entity’s own employees who investigate and appraise the
effectiveness and efficiency of operations and internal controls. The main function of
internal auditors is to assist the members of the organization in the effective
 discharge of their responsibilities. Internal auditors usually perform operational
audits.

◙ Government Auditors
This are government employees whose main concern is to determine whether
persons or entities comply with government laws and regulations. Government
audits usually conduct compliance audits.

Figure 2. Comparison among the Different Types of Audit

Financial audit Compliance audit Operational audit

Assertions That the financial That the That the
made by the statements are fairly organization has organization’s
auditee presented complied with laws, activities are
regulations or conducted
contracts effectively and
efficiently

Established Financial reporting Laws, regulations Objectives set by

criteria standards or other and contracts the board of
financial reporting directors
framework
Content of the An opinion about whether Reports on the Recommendations
auditor’s the financial statements degree of or suggestions on
report are fairly presented in compliance with how to improve
conformity with the applicable laws, operations
applicable financial regulations and
accounting framework contracts

 The Independent Financial Statement Audit

The purpose of an independent financial statement audit is to enhance the degree of

confident of intended users in the financial statements. This is achieved by the
expression of an opinion by the auditor on the fair presentation of the financial
statement. An audit conducted in accordance to form that opinion.

◙ Responsibility for the financial statements

An audit in accordance with CPAs is conducted on the premise that management,

and where appropriate, those charge with governance have the responsibility for the
preparation and presentation of financial statement in accordance with the
applicable financial reporting framework. This responsibility includes the design,
implementation and maintenance of internal control relevant to the preparation and
presentation of financial statement that are free from material misstatement,
whether due to fraud or error and to provide the auditor with unrestricted access to
all information, records and documents relevant to the financial statements.

◙ Assurance provided by the auditor

The auditor’s opinion on the financial statement is not a guarantee that the financial
statements are dependable. An audit conducted in accordance with Philippine
Standards on Auditing (PSAs) is designed to provide only reasonable assurance (not
absolute assurance) that the financial statements taken as a whole are free from
material misstatement. The auditor is not and cannot obtain absolute assurance
 because there are inherent limitations of audit that affect the auditor’s ability to
detect material misstatements. These limitations result from such factors as:

1. The use of testing/ sampling risk

For practical reasons, auditors do not examine all evidence available. Many audit
conclusions are made by examining only sample of evidence. Whenever a sample is
taken, there is always a possibility that the auditor’s conclusion, based on the sample,
may be different from the conclusion that would have been reached if the auditor
examines the entire population

2. Error in application of judgement / non-sampling risk

The work undertaken by the auditor to form an opinion is permeated by judgment.
Human weakness can cause auditors to commit mistakes in the application of audit
procedures and evaluation of evidence.

3. Reliance on management’s representation

Some evidence supporting the financial statements must be obtained by obtaining oral
or written representations from management. For example, it is difficult for the auditor
to determine the proper valuation of accounts receivable without management’s honest
assessment. If the management lacks integrity, management may provide the auditor
with false representations causing the auditor to reply on unreliable evidence

4. Inherent limitations of the client’s accounting and internal control systems.

Although the auditor performs procedures to detect material misstatements when
auditing financial statements, such procedures may not be effective in detecting
misstatements resulting from collusion among employees or management’s
circumvention of internal control.

5. Nature of evidence
Evidence obtained by the auditor dot not consist of “hard facts” which prove or disprove
the accuracy of the financial statements. Instead, it comprises pieces of information and
impressions which gradually accumulated during the course of an audit and which, when
taken together, persuade the auditor about the fairness of the financial statements.
Thus, audit evidence is generally persuasive rather than conclusive in nature.

Because of the inherent limitations of an audit, there is an unavoidable risk that some
material misstatements of the financial statements may not be detected, even though the
audit is properly planned and performed in accordance with PSAs.
Figure 3: Role of Management and Independent Auditor

Users of financial statements

GENERAL PRINCIPLES GOVERNING THE AUDIT OF FINANCIAL STATEMENTS

1. The auditor should comply with relevant ethical requirements, including those
relating to independence, relating to financial statement audit engagements. Auditor
must adhere to standard of ethical conduct that embody and demonstrate integrity,
objectivity, and concern for the public rather than self-interest.

2. The auditor should conduct an audit in accordance with Philippine Standards on

Auditing.
These standards contain the basic principles and essential procedures which the
auditor should follow.

3. The auditor should exercise professional judgment in planning and performing an

audit of financial statements.
Professional judgement is the hallmark of auditing. The distinguishing feature of the
professional judgment expected of an auditor is that is is exercised by an auditor
whose training, knowledge and experience have assisted in making competent and
reasonable judgment.

4. The auditor should obtain sufficient appropriate audit evidence to reduce audit risk
to an acceptable low level to enable the auditor express an opinion on the financial
statements.
Audit evidence is necessary to support the auditor’s opinion and report. It is
cumulative in nature and is primarily obtained from audit procedures performed
during the audit.

5. The auditor should plan and perform the audit with an attitude of professional
skepticism recognizing that circumstances may exist which may cause the financial
statements to be materially misstated.
An attitude of professional skepticism means an auditor makes a critical assessment,
with a questioning mind, of the validity of audit evidence obtained and is alert to
audit evidence that contradicts or bring into questions the reliability of documents or
management representations.

Need for an Independent Financial Statement Audit

1. Conflict of interest between management and users of financial statements.

In a sense, financial statements may be viewed as the report by management as to
how the entity performed under their direction and supervision. Managers are
 frequently placed in position where they can benefit by providing outside parties
with overly optimistic or even false financial information. Outside parties, however,
want unbiased, realistic financial statements. Recognizing this inherent conflict of
interest, users of financial statements have become skeptical of unaudited financial
statements.

2. Expertise
The complexity of accounting and auditing requires expertise in verifying the quality
of the financial information. Since most of the users of financial information are not
equipped with the necessary skills and competence to determine whether the
financial statements are reliable, a qualified person is hired by users to verify the
reliability of the financial statements on their behalf.

3. Remoteness
Users of financial information are usually precluded from directly assessing the
reliability of the information. Most of the users do not have access to the entity’s
records to personally verify the reliability of the financial statements. As a result, an
independent auditor is needed to assist them in verifying the reliability of the
financial information.

4. Financial consequences
Misleading financial information could have substantial economic consequences for a
decision maker. It is therefore important that financial statements be audited before
these statements are used for making important decisions.

Theoretical Framework of Auditing

1. Audit functions operates on the assumption that all financial data are verifiable
All balances reported in the financial statements must have supporting documents or
evidence to prove their validity. If no evidence exists in relation to the financial
statements on which an auditor is to express an opinion, then there can be no audit
to perform.

2. The auditor should always maintain independence with respect to the financial
statements under audit.
Independence is essential for ensuring the credibility of the auditor’s report. The
report of the auditor will be of little or no value to the readers of the financial
statements if the readers are aware that the auditor is not independent with respect
to the client.

3. There should be no long-term conflict between the auditor and the client
management.
Short-term conflicts may exist regarding the application of auditing procedures and
accounting policies, but in the end, both the auditor and the management must be
interested in the fair presentation of the financial statements

4. Effective internal control system reduces the possibility of errors and fraud affecting
the financial statements.
The condition of the entity’s internal control system directly affects the reliability of
the financial statements. The stronger the internal control is, the more assurance it
provides about the reliability of the accounting data and financial statements.

5. Consistent compliance with applicable financial reporting framework results in fair

presentation of financial statements.
 We often use different criteria to verify the validity of an assertion. In the case of an
independent audit of financial statements, the criteria are usually the PFRS or PFRS
for SMEs.

6. What was held true in the past will continue to hold true in the future in the absence
of known conditions to the contrary.
Experience and knowledge accumulated from auditing a client in prior years can be
used to determine the appropriate audit procedures that need to be performed.

7. An audit benefits the public

Financial statements are ordinarily prepared and presented in order to meet the
common information needs of a wide range of users. These users who rely on the
financial statements as their major source of information are the primary beneficiary
of the financial statement audit.

Name:_________________________________________
Course and Year_________________________________
Date:__________________________________________

Exercises # 1. MULTIPLE CHOICE

1. Broadly defined, the subject matter of any audit consists of

a. financial statements c. assertions
b. economic data d. operating data

2. The criteria for evaluating quantitative information vary. For example, in the case of
an independent audit of financial statements by CPA firms, the criteria are usually
the
a. PFRS or PFRS for SMEs
b. Philippine Standards of Auditing
c. National Internal Revenue Code
d. Regulations of the Securities and Exchange Commission

3. An audit of financial statements is conducted to determine if the

a. organization is operating efficiently and effectively
b. auditee is following specific procedures or rules set doen by some higher authority
c. overall financial statements are stated in accordance with the applicable financial
reporting framework
d. client’s internal control is functioning as intended
4. An audit involves ascertaining the degree of correspondence between assertions and
established criteria. In the case of an audit of financial statements, which of the
following would not be a valid criterion?
a. international Accounting Standards
b. Philippine Financial Reporting Standards
c. Philippine Standard on Auditing
d. Philippine Accounting Standards

5. An audit that involves obtaining and evaluating evidence about the efficiency and
effectiveness of an entity’s operating activities in relation to specified objectives is
a(n):
a. external audit c. operational audit
b. compliance audit d. financial statement audit

6. In financial statements audits, the audit process should be conducted in accordance

with
a. the audit program
b. Philippine Standard of Auditing
c. Philippine Accounting Standard
d. Philippine Financial Reporting Standards

7. Which of the following types of audit uses laws and regulations as its criteria?
a. performance audit c. operational audit
b. compliance audit d. financial statement audit

8. A typical objective of an operational audit is to determine whether an entity’s

a. internal control structure is adequately operating as designed
b. operational information is in accordance with generally accepted accounting
principles
c. specific operating units are functioning efficiently and effectively
d. financial statements present fairly the results of operations

9. The auditor communicates the results of his or her work through the medium of the
a. engagement letter c. management letter
b. audit report d. financial statements
10. Independent auditing can best describe as a
a. professional activity that measures and communicates financial accounting data
b. subset of accounting
c. professional activity that attests to the fair presentation of financial statements
d. regulatory activity that prevents the issuance of improper financial information

11. Which of the following has the primary responsibility for the fairness of the
representations made in the financial statements?
a. client’s management c. independent auditor
b. audit committee d. board of accountancy

12. An audit of the financial statements of KIA Corporation is being conducted by an

external auditor. The external auditor is expected to
a. expresses an opinion as to the fairness of KIA’s financial statements
b. expresses an opinion as to the attractiveness of KIA for investment purposes
c. certifies the correctness of KIA’s financial statements
d. examines all evidence supporting KIA’s financial statements.

13. The primary purpose of an independent financial statement audit is to

a. provides a basis for assessing management’s performance
b. complies with government regulatory requirements
c. assure management that the financial statements are unbiased and free from
material error
 d. provides users with an un biased opinion about the fairness of information
reported in the financial statements.

14. The reason an independent auditor gathers evidence is to

a. forms an opinion on the financial statements
b. detect fraud
c. evaluate management
d. evaluates internal controls

15. An attitude that includes a questioning mind and a critical assessment of audit
evidence is referred to as
a. due professional care
b. professional skepticism
c. reasonable assurance
d. supervision

LESSON 2: AUDITOR’S RESPONSIBILITY

The fair presentation of financial statements in accordance with 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 statements may emanate from
1. Error
2. Fraud
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 rh 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.

1. Fraudulent financial reporting involves intentional misstatements or omissions of

amounts or disclosures 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 misapplication 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 asset 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. For

example, an employee might be motivated to steal company’s assets because this
employee lives beyond his means. Also, a member of management may be forced to
manipulate the financial statements in order to meet an overly optimistic projection. 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
circumvented

The primary facto that distinguished fraud from errors is whether the underlying cause
of misstatement in the financial statements is intentional or unintentional. Although the
auditor may be able to identify opportunities for fraud to be perpetrated, it is often
difficult, if not impossible, for the auditor to determine intent, particularly in matters
involving management judgment, such as accounting estimates and the appropriate
application of accounting principles. Consequently, the auditor’s responsibility for the
detection of fraud and error is essentially the same.

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. In this regard, 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
 Management’s assessment of risk due to fraud
 Controls established to address the risks
  Any material error or fraud that has affected the entity or suspected fraud
that the entity is investigating
The auditor’s inquiries of management may provide useful information concerning the
risk of material misstatements in the financial statements resulting from employee fraud.
However, such inquiries are unlikely to provide useful information regarding the risk of
material misstatements in the financial statements resulting from management fraud.
Accordingly, the auditor should also inquire of those charged with 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. In this regard, PSA 240 requires the
auditor to specifically “assess the risk of material misstatement 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 the 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”. Fraud risk factor do not necessarily been
present in circumstances when fraud have occurred.

Judgments about the increased risk of material misstatements due to fraud may
influence the auditor’s professional judgments in the following ways:
 The auditor may approach the audit with a heightened level of professional
skepticism
 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.
 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.
 The auditor may decide to consider management selection and application of
significant accounting policies, particularly those related to income
determination and asset valuation.

TESTING PHASE

3. During the course of the audit, the auditor may encounter circumstances that may
indicate the possibility of fraud or error. For example, there are discrepancies found
in the accounting records, conflicting or missing documents or lack of cooperation
from management. In these circumstances, the auditor should perform procedures
necessary to determine whether material misstatement exist.

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

should consider whether such a misstatement resulted from a fraud or an error. This
is important because errors will only result to an adjustment of financial statements
but fraud may have other implications on an audit.

If the auditor believes that the misstatements is, or may be the result of fraud, but
the effect on the financial statements are not material, the auditor should
 Refer the matter to the appropriate level of management at least on level
above those involved, and
 Be satisfied that, given the position of the likely perpetrator, the fraud has no
other implication for other aspects of the audit or that those implication have
been adequately considered.

However, if the auditor detects a material fraud or has been unable to evaluate whether
the effect on financial statement is material or immaterial, the auditor should
  Consider implication for other aspects of the audit particularly of management
representation.

 Discuss the matter and the approach to further investigation with an appropriate
level of that is at least one level above those involve,

 Attempt to obtain evidence to determine whether a material fraud in fact exist

and, their effect, and

 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

 it acknowledges its responsibility for the implementation and operations of

accounting and internal control system that are designed to prevent and detect
fraud and error;

 it believes the effects of those uncorrected financial statement misstatement

aggregated by the auditor during the audit are immaterial, both individually and
in the aggregate, to the financial statements taken as a whole. A summary of
such items should be included in or attached to the written representation;

 it has disclosed to the audits all significant facts relating to any fraud or
suspected fraud known to management that may have affected the entity; and

 it has disclosed to the audit the result of its assessment of the risk that the
financial statement may be material misstated as a result of fraud.

 CONSIDER THE EFFECT ON THE AUDITOR’S REPORT

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

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

Because of the inherent limitation of an audit there is an unavoidable risk that material
misstatement in the financial statement resulting from fraud and error may not be
detected. Therefore, the subsequent discovery of material misstatement in the financial
statement resulting from fraud or error does not, in and of itself, indicate that the
auditor has failed to adhere to the basic principle and essential procedure of an audit.

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 act that fraud
may involve sophisticated and carefully organized schemes designed to conceal it, such
as forgery, deliberate failure to record transactions, or intentional misrepresentation
being made to the auditor. Hence, audit procedures that are effective for detecting
material errors may be ineffective for detecting material fraud, especially those
concealed though collusion.

Furthermore, 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. Certain levels of
management mat be in a position to override control procedures designed to prevent
similar fraud by other employees, for example, by directing subordinates to record
transactions incorrectly or to conceal them. Given its position of authority within an
entity, management has the ability to either direct employees to do something or solicit
their help to assist management in carrying out a fraud, with or without the employees’
knowledge.

NONCOMPLIANCE WITH LAWS AND REGULATIONS

Noncompliance refers to act of 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 into by, or in the name of, the entity
or in its behalf by its management or employees. Common examples include:

 Tax evasion
 Violation of environmental protection laws
 Inside trading of securities

MANAGEMENT’S 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. (PSA 250)

The following policies and procedures, among other, may assist management in
discharging its responsibility 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 requirements.

  Maintaining a register of significant laws with which the entity has to comply within
its particular industry and record of complaints.

In larger entities, these policies and procedures may be supplemented by assigning

appropriate responsibility to an internal audit function an audit committee.

AUDITOR’S RESPONSIBILITY

An audit cannot be expected to detect noncompliance with all laws and regulations.
Nevertheless, 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 the 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 laws and regulations, the auditor would
ordinarily:

 Use the existing knowledge of the entity’s industry and business.

 Inquire of management concerning the entity’s policies and procedure

regarding compliance with laws and regulations.

 Inquire of management as to the laws or regulations that may be expected

to have a fundamental effect on the operations of the entity.

 Discuss with management the policies or procedures adopted for identifying,

evaluating and accounting for litigation claims and assessments.

 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).

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:

 Inquiring of management as to whether the entity is in compliance

with such laws and regulations.

 Inspecting correcting correspondence with the relevant licensing or

regulatory authorities.

3. The auditor should also design audit procedures to obtain sufficient appropriate
audit evidence about compliance with those laws and regulations generally
recognized by the auditors 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 circumstances in which it has occurred, and sufficient other information to
evaluate the possible effect in the financial statements. When evaluating the possible
effect on the financial statement, the auditor considers:

 The potential financial consequences, such as fines, penalties, damage,

threat of expropriation of assets, enforce discontinuation of operations and
litigation.

 Whether the potential financial consequences require disclosure.

 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 the with management, and consider the implication
on other aspects of the audit

 COMPLETION PHASE

6. The auditor should obtain written representations that management has disclose 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 statements. 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 of noncompliance with laws and regulations, the
auditor should express a qualified opinion or a disclaimer of 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.
 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.
Name:_________________________________________
Course and Year_________________________________
Date:__________________________________________

Exercises # 2. MULTIPLE CHOICE

1. Material misstatements may emanate from all of the following except

a. fraud b. error
b. limitations of the audit d. noncompliance with laws & regulations

2. An intentional act by one or more individuals among management employees, or

third parties which results in misrepresentation of financial statements refers to
a. fraud b. error
b. noncompliance d. illegal acts

3. The management responsibility to detect and prevent fraud and error is

accomplished by
a. implementing adequate quality control system
b. having an annual audit of financial statements
c. implementing adequate accounting and internal control system
d. issuing a representation letter to the auditor.

4. The auditor’s best defense when material misstatements in the financial statements
are not uncovered in the audit is that
a. The audit was conducted in accordance with generally accepted accounting
principles
 b. Client is guilty of contributory negligence
c. The audit was conducted in accordance with PSAs
d. The financial statements are client’s responsibility

5. The risk that the audit will fail to uncover a material misstatement is eliminated
a. If client has good internal control
b. If client follows generally accepted accounting principles
c. When the auditor has complied with PSAs
d. Under no circumstances
6. What primarily differentiates fraud from an error?
a. materiality c. intent
b. effect on misstatements d. frequency of occurrence

7. Which of the following is an example of an error?

a. Defalcation
b. Suppression or omission of the effects of transaction from the records or
documents.
c. Recording of transaction without substance
d. Misapplication of accounting policies
8. Fraudulent financial reporting is often called
a. management fraud c. defalcation
b. misappropriation of assets d. employee fraud

9. The term used to refer to acts of omission or commission by the entity being
audited, which are contrary to the prevailing laws and regulations is
a. fraud c. misappropriation
b. noncompliance d. defalcation
10. Generally, the decision to notify parties outside the client’s organization regarding an
noncompliance with laws and regulations is the responsibility of the
a. independent auditor c. management
b. client legal counsel d. internal auditors