Chapter 4 THE AUDIT PROCESS - Accepting an Engagement An audit of firiancial statements generally begins with the financial statements prepared by the entity’s management. Without these financial statements, there can be no audit to perform. A general approach to auditing financial statements would require consideration of financial statement assertions, audit procedures, and audit evidence before forming an audit opinion. General Approach to Auditing Financial Statements Financial Statement Assertions —» Existence or Occurrenc —» Rights and Obligations 2 Completeness \—> 5 Audit 5 [Ls Valuation and allocation Procedures 8 Presentation and Audit Evidence Audit Opinion 0]@ Financial statement assertions Management is responsible for the fair presentation of financial statements that reflect the nature and operations of the entity. In representing that the financial statements are in accordance with the applicable financial reporting framework, management implicitly or explicitly makes assertions regarding recognition, measurement, and presentation of classes of transactions and events, account balances and disclosures, The auditor uses these assertions to consider the different types of potential misstatements that may occur in the financial statements. Financial statement assertions can be classified into: > Rights and obligation That the entity has rights over the reported assets and that it has valid obligation to settle the reported liabilities. An example of an audit procedure to test this assertion is to. examine ownership documents such as certificate of title for real property. Valuation and allocation . That assets and liabilities are properly valued and that revenues and expenses are properly measured. A typical audit procedure to test this assertion includes recalculation of financial statement values such as depreciation, accrued interest and amortized costs of financial assets and liabilities. Presentation and disclosure That assets and liabilities are properly classified and that disclosures in the notes to the financial statements are adequate. Testing this assertion will require the application of the relevant accounting standards. In addition, the auditor may review major contracts such as loan agreements to identify important information that needs to be disclosed in the notes to the financial statements. 112> Existence or occurrence ‘That assets and liabilities exist as of the financial statement date and that revenues and expenses occurred during the reporting period. One of the most effective audit procedures to test the mice of an asset is the physical examination or ocular inspection of the. asset. In circumstances where physical examination is not feasible, the auditor may obtain evidence about the existence of asset through external confirmation. Completeness That all items that should be reported in the financial statements are so included. A typical procedure to satisfy this assertion is to start with a source documents such as sales invoice and determine if itis recorded in the sales journal. v Existence and completeness emphasize two opposite audit concerns. Existence/occurrence assertion is concerned with the potential overstatement of accounts while completeness assertion is concemed with potential understatement of accourits. When designing audit procedures, the direction of test is a crucial step in satisfying the’ completeness or the existence/occurrence assertions. When the auditor traces items from the source documents to the accounting records, the auditor is obtaining evidence that all transactions (as represented by thé“source documents) have been completely recorded. On the other hand, when the auditor works from the accounting records back to the supporting documents, the auditor is obtaining evidence that,the recorded items exist and are supported by documents. Tracing forward from the source documents to the accounting records is periormed primarily to test for understatement. This procedure will satisfy the completeness: assertion. In contrast, éracing backwards ot vouching is. performed primarily in .ortler to satisfy the existence/ocgyrrence assertion. It is -pectormed' to test for possible overstatement of an account. 113:Test for Completeness qRAcNe Understatement Assertion Existence/ Completeness Assertion Test for Overstatement SOURCE DOCUMENTS Q a ° QO Fy o Z —_ B Zz. » o Q 0 < The PSA 500 classifies the financial statement assertions according to. the categories of the financial statements affected: Assertions about classes of transactions and events for the period under audit: > Occurrence - transactions and events that have.been recorded have occurred and pertain to the entity. > Completeness - all transactions and events that should have been recorded have been recorded. > Accuracy - amounts and other data relating to recorded transactions and events have been recorded appropriately.Cutoff - transactions and events have been recorded in the correct accounting period, Classification - transactions and events have been recorded in the proper accounts. Assettions about account balances at the period end: Existence - assets, liabilities, and equity interests exist. Rights and obligations - the entity holds or controls the rights to assets, and liabilities are the obligations of the entity. Completeness - all assets, liabilities and equity interests that should have been recorded are in fact recorded. Valuation and allocation - assets, liabilities, and equity interests are included in the financial statements; at appropriate amounts and any resulting valuation .or allocation adjustments are apptopriately recorded. Assertions about presentation and disclosure: > Occurrence and rights & obligations - disclosed events, transactions, and.other matters have occurred and pertain to the entity. Completeness - all disclosures that should have been included in the financial statements are in fact included. Classification and understandability - financial information is appropriately presented and described, and disclosures are clearly expressed... . Accuracy and valuation - financial and other information are disclosed fairly and at appropriate amounts. 11S -The auditor may use the above categories of assertions or may express them differently so long as all aspects described in the assertions have been’covered. Audit procedures The objective of the audit is to determine the validity of the financial statement assertions. To accomplish this, auditors normally develop specific audit objectives for each of the relevant assertions. These audit objectives serve as a guide to auditors in assessing the risks of material misstatement and in designing the appropriate audit procedures to be performed. The selection of the appropriate procedures, to satisfy a particular objective, is affected by a number of factors including the auditor’s assessment of materiality and risk. Regardless of the procedures selected, there is only one basic criterion. The procédures selected should enable the auditor to gather sufficient appropriate evidence about the validity of an assertion. Some of the common audit procedures used by the auditor to gather sufficient appropriate evidence include: 1. Inspection- involves examining of records, documents, or tangible assets. 2. Observation- consists of looking at a process.or procedure being performed by others. 3. Inquiry- consists of seeking information from knowledgeable petsons inside or outside the entity. 4. Confirmation- consists of the response to an inquiry to cottoborate information contained in the accounting records.+ 5. Computation- consists of checking the arithnetical accuracy of source documents and accounting records or performing independent calculatioris. 6. Analytical Procedures- consist of the analysis of significant ratios ad trends including the resulting investigation of fluctuations and relationships that are inconsistent with other relevant information ot deviate from:predicted amounts. Audit Evidence: Audit procedures are the means used by the auditor to obtain sufficient appropriate evidence. Audit evidence refers to the information obtained by the auditor in arriving at the conclusions on which the audit opinion is based. Audit evidence will comprise source documents and accounting records underlying the financial statements and corroborating information from other sources. This evidence will either ptove or disprove the validity of the assettions.made by management on the financial statements, Audit Opinion - The results of the procedures performed and the audit evidence, Obtained are carefully evaluated to atrive at the apptopriate opiniowt about the. fait presentation of the financial statements.THE AUDIT PROCESS The audit process is the sequence of different activities involved fn an audit. The emphasis and order of certain activities may vary depending upon a particular audit, but this process would basically include the following audit activities: Steps in the Audit Process Issuing a Report . | Completing the Audit Sea Performing Substantive Tests Considering Internal Control Audit Planning” Accepting an Engagement Accepting an Engagement The first step in the audit process is to make a decision of whether to accept or reject an audit engagement. This ptocess requires evaluation of the auditor’s qualification as well as the auditability 118of the prospective client’s financial statements. A preliminary understanding of the client's business and background investigation of a prospective client ate usually performed at this stage of the audit. The procedures performed at this stage of the audit are referred to in PSA 300 as the “preliminary planning activities” and would involve: a, Performing procedures regarding the continuance of the client relationship and the specific audit engagement, b. Evaluating compliance with ethical requirements, including independence; and c. Establishing an understanding of the terms of the engagement. 3 Audit Planning In planning an audit, the auditor obtains more detailed knowledge about the client’s business and industry. Knowledge of the client's business and industry is important because it helps the auditor in understanding the transactions and events affecting the financial statements. In addition, such knowledge also helps in the early identification of the potential problems that might be encountered in the audit. The auditor's understanding of the client, combined with the assessment of risk and materiality, should enable the auditor to develop an overall audit plan and a detailed approach for the expected conduct and scope of the audit. ry Se Considering the Internal Control The auditor. is required to give adequate consideration to the entity’s internal control ‘because the condition of the entity’s internal control directly affects the reliability of the financial 119statements. The stronger the internal control is, the more assurance it provides about the reliability of the accounting data and the financial statements. Consideration of internal control involves obtaining understanding of the entity’s internal control systems and assessing the level of control risk- that is, the risk that the client’s internal control may not prevent or detect material misstatements in the financial statements. If the auditor decides to assess control risk at less than high level, sufficient appropriate audit evidence must be obtained to prove that the intemal control is functioning effectively and that it can be relied on. This evidence can be obtained by performing tests of controls. £3 Performing Substantive Tests Based on the results of audit planning and the consideration of internal control, the auditor designs and performs substantive tests to obtain reasonable assurance that the financial statements are presented fairly in accordance with the applicable financial reporting framework.’ Substantive tests are audit procedures designed to detect material misstatements in the financial statements. The nature, timing and extent of the substantive tests are highly dependent on the results of the auditor’s consideration of internal control. If based on the evaluation of internal control, the auditor has obtained evidence that the intemal control is functioning effectively; the scope of the auditor’s substantive tests can be reduced. On the other hand, if the results of tests of control prove that the internal control’ is weak, the auditor. will have to compensate for this weakness by performing -mote effective and extensive substantive procedures, 120£3 Completing the Audit ‘The auditor must have sufficient appropriate evidence in order to reach.a conclusion on the fairness of the financial statements. ‘After the auditor has completed testing the account balances, the auditor performs additional audit procedures to complete the audit and become satisfied that the evidence gathered is consistent with the opinion to be expressed in auditor’s report. Some of the common procedures performed at this stage of the audit include review of subsequent events and contingencies, assessing the appropriateness of the use of the going concern assumption, performing overall analytical review procedures, and obtaining ~ written representations from the client’s management. Issuing a Report a On the basis of audit evidence gathered and evaluated, the auditor forms a conclusion about the financial statements. This conclusion (in’the form-of an opinion) is communicated to various interested users through an audit report. @ Accepting an Engagement An important element of the firm’s quality control policies and procedures is a system for deciding whether to accept or reject an audit engagement. In making this decision, the firm should consider: D Its competence; > Itsindependence; % Its ability to serve the client properly; > The integrity of the prospective client's management; and > The adequacy of the accounting records 12k§3 Competence One of the primary considerations before accepting an audit engagement is to determine whether the auditor has the necessary skills and competence to handle the engagement. According to the Code of Ethics, professional accountants should not portray themselves as having expertise which they do not possess. Competence is acquired through a combination of education, training and experience. Before accepting an audit engagement, the auditor should obtain a preliminary knowledge of the client’s business and industry to determine whether the auditor has the degree of competence required by the engagement or whether such competence can be obtained before the completion of the audit. £2 Independence Essential to the credibility of the auditor’s report is the concept of independence. Before accepting an audit engagement, the auditor should consider whether there are any threats to the audit team’s independence. and objectivity and, if so, whether, adequate safeguards can be established. fa Ability to serve the client properly Closely related to competence is the auditor’s ability to serve the client properly. An engagement should not be accepted if there are no enough qualified personnel to perform the audit. PSA 220 requires that audit work be assigned to personnel who have the appropriate capabilities, competence and time to perform the audit engagement in accordance with the professional standards. In addition, there should be sufficient direction, supervision and review of work at all levels in order to provide reasonable assurance that the firm’s standard of quality is maintained in the performance of the engagement. i22$3 Integrity of management The recent wave of litigation involving auditors has made pre- acceptance investigation procedures very important. PSA 220 requires the firm to conduct a background investigation of the prospective client in order to minimize the likelihood of association with clients whose management lacks integrity. This task would involve: 1. Making inquiries of appropriate parties in the business community such as prospective client’s banker, legal counsel, or underwriter to obtain infotmation about the reputation of the client. 2. Communicating with the predecessor auditor Communication with predecessor auditor is not only a matter of courtesy to the predecessor auditor. This communication allows the successor auditor to obtain information about the client that will be useful in determining whether the engagement will be accepted. But before the successor auditor contacts the predecessor auditor, the*successot auditor should obtain the client’s permission to communicate with the predecessor auditor. This is a necessary procedure because the Code of Ethics for Professional Accountants prevents an auditor from disclosing any information obtained about the client without the client’s explicit permission. Refusal of the prospective client’s management to permit this will raise serious questions as to whether the engagement will be accepted. Once permission of the client is obtained, the successor auditor should inquire into matters that may affect the 123decision to accept the engagement. ‘This includes questions regarding: > The predecessor auditor's understanding as to the reasons for the change of auditors; > Any disagreement between the predecessor auditor and the client; or > Any facts that might have a bearing on the integrity of the prospective client’s management. The predecessor auditor should respond fully to the successor auditor's inquiry and advise the successor auditor if there are any professional reasons why the engagement should not be accepted. Adequacy of the Accounting Records The audit of the financial statements is performed on the assumption that the financial statements are verifiable. Therefore, the client's accounting records and documents supporting the amounts. and disclosures -in the financial statements must be adequate enough to permit examination of the accounts. Inadequacy of the accounting records is sufficient season for the auditor to decline an audit engagement. Retention of Existing Clients The auditor's evaluation of clients is not a one-time consideration. Clients should be evaluated at least once a year or upon occurrence of major events, such as changes in management, directors, ownership, nature of client’s business, or other changes that may affect the scope of the examination.In general, conditions which would have caused the auditor to feject a prospective client may also result ot lead to a decision of terminating an audit engagement. + Engagement letter According to PSA 210, the auditor and the client should agree on the terms of the engagement and the agreed terms will have to be recorded in an engagement letter. The engagement letter serves as the written contract between the auditor and the client. This letter sets forth: > The objective of the audit of financial statements which is to express an opinion on the financial statements; > The management's responsibility for the fair presentation of the financial statement; > The scope of the audit; > The forms or any reports or other communication that the auditor expects to issue; > The fact that because of the limitations of the audit, there is an unavoidable risk “that material’ misstatements may remain undiscovered; and >. The responsibility of the client to’ allow the auditor to have unrestricted access to whatever records, documentation and other information requested in connection with the audit. In addition, the aiditor may also include the following items in the engagement letter: > Billing arrangements, > Expectations of receiving management representation letter; > Arrangements concerning the involvement of others (experts, other auditors, internal auditors and other client personnel); and > Request for the client to confiem the tegms of the engagement, A sample format of an audit engagement letter is presented a the ena of this Chapter. 125£3 Importance of the engagement letter It is in the interest of both the auditor and the client that the auditor sends engagement letter in order to: 1. Avoid misunderstandings with respect to the engagement; and 2. Document and confirm the auditor’s acceptance of the appointment. Recurring audits For recurring audit engagements, an auditor does not normally send new engagement letter every year. However, the following factors that may cause the auditor to send a new engagement letter: > Any indication that the client misunderstands the objective and scope of the audit; ; > Any revised or special’terms of the engagement; > A recent change of senior management, board of directors or ownership; > A significant change in the nature ot size of the client’s business; or > Legal requirements and other government agencies’ pronouncements. ; : In cases where the auditor decides not to send a new engagement letter, the auditor should remind the client of the terms of the original arrangement to reiterate the objectives of the engagement as well as the responsibilities of both the auditor and the client.yy £3 Audits of Components When the auditor of a parent entity is also the auditor of its subsidiary, branch or division (component), the auditor should consider the following factors in making a decision of whether to send a separate letter to the component: > > YvVvev Who appoints the auditor of the component; Whether a separate audit report is to be issued on the component; Legal requirements; The extent of any work performed by other auditor; Degree of ownership by: parent; or Degree of independence of the component’s management.Engagement Letter for the Conduct of an Audit of Financial Statements To the Board of Directors of ABC Company: Objective and scope of the audit You have requested that we audit the financial statements of ABC Company, which comprise the statement of financial position as at December 31, 20X1, and the statement of comprehensive income, statement of changes in equity and statement of cash flow for the year then ended, and a summary of significant accounting policies and other explanatory information. We are pleased to confirm our acceptance and our understanding of this audit engagement by means of this letter. Our audit will be conducted with the objective of our expressing an opinion on the financial statements. Our responsibilities We_will conduct our audit in accordance with Philippine Standards on Auditing (PSAs). Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor's judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error, An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. Because of the inherent limitations of an audit, together with the inherent limitations of internal control, there is an unavoidable risk that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with PSAs. In making our risk assessments, we consider internal control relevant to the entity's preparation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion ‘on the effectiveness of the entity’s internal control. However, we will communicate 128to you in writing concerning any significant deficiencies in internal control relevant to the audit of the financial statements that we have identified during the audit. Responsibilities of Management and Those Charged with Governance Our audit will be conducted on the basis that management and, where appropriate, those charged with governance acknowledge and understand that they have responsibility: (a) For the preparation and fair presentation of the financial statements in accordance with Philippine Financial Reporting Standards (PFRS); (b) For such internal control as [management] determines is necessary to enable the, preparation of financial. statements that are free from material ___ misstatement, whether due to fraud or error; and (c)_ To provide us with: (i) Access to all information of which management is aware that is relevant to the preparation of the financial statements such as records, documentation and other matters; (ii) Additional information that we may request from management for the purpose of the audit; and (iil) Unrestricted access to persons within the, entity from whom we determine it necessary to obtain audit evidence. As part of our audit process, we will request from management and, where appropriate, those charged with governance, written confirmation concerning representations made to us in connection with the audit. We look forward to full cooperation from your staff during our aucit. Biling Arrangements Our fees, which will be billed as work progresses, are based on the time required by the individuals assigned to the engagement plus out-of-pocket expenses. Individual hourly rates vary according to the degree of responsibility involved and the experience and skill required. 129Reporting ‘Atthe conclusion of the audit, we shall issue a report that contains our opinion about whether the financial statements are fairly presented in accordance with the PFRS. In addition to our report on the financial statements, we expect to provide you with a separate letter concerning any material weaknesses in accounting and internal control systems which come to our notice., The form and content of our report may need to be amended in the light of our audit findings. This letter will be effective for future years unless it is terminated, amended or superseded. Please sign and: return the attached copy of this letter to indicate your acknowledgement of, and agreement with, the arrangements for our audit of the financial statements including our respective responsibilities. PSV & Co, Acknowledged and agreed on behalf of ABC Company by (signed) Name and Title Date