CHAPTER 7:

INTRODUCTION TO FINANCIAL
STATEMENT AUDIT
 INDEPENDENT AUDITING DEFINED

Auditing is a systematic process by which a competent, Independent person objectively obtains 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.

Key words and phrases mentioned in the definition:

Systematic Process
Competent, Independent person
Objectively obtains and evaluates evidence
Assertions about economic actions and events
Degree of correspondence
Established criteria
Communicating the results
Interested users
 IFAC Education Committee defines auditing as follows:

“Auditing is a structured process that:

a) Involves the application of analytical skills, professional judgment, and professional

skepticism;
b) Is usually performed by a team of professionals, directed with managerial skills;
c) Uses appropriate forms of technology and adheres to a methodology;
d) Complies with all relevant technical standards, such as ISAs, ISQCs, IFRS, IPSAS, and
any applicable international, national or local equivalents as appropriate; and
e) Complies with required standards or professional ethics.”
OBJECTIVES OF AUDITING

The Philippine Standards on Auditing (PSA) 120 “Framework of the 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 aspects, in accordance
with an identified financial reporting framework the phrase used to express the auditor’s
opinion is “present fairly, in all material respects.” A similar objective applies to the audit of
financial or other information prepared in accordance with appropriate criteria.”
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.
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
WHY INDEPENDENT FINANCIAL AUDITING IS NECESSARY

FACTORS THAT CONTRIBUTE TO INFORMATION RISK:

a) Remoteness of information users from information providers

b) Potential bias and motives of information provider
c) Voluminous data
d) Complex exchange transactions
e) Consequences
HOW INFORMATION RISK MAY BE REDUCED:

1. Allow users to verify information.

2. User shares information risk with management.

3. Have the financial statements audited

ADVANTAGES AND PRACTICAL BENEFITS OF INDEPENDET AUDIT

A. To the auditee or clients

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.
ADVANTAGES AND PRACTICAL BENEFITS OF INDEPENDENT AUDIT

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 in making 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
a more confident basis for aiming at a decision as to the terms and conditions of the
arrangement.
ADVANTAGES AND PRACTICAL BENEFITS OF INDEPENDENT
AUDIT

C. To Government Agencies and Legal Community

1) BIR has more assurance concerning and dependability of tax return if they
have been based on audited financial statements.
2) Government institutions like GSIS, SSS,DBP will have better basis 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.
MANAGEMENT ASSETIONS AND FINANCIAL STAEMENTS

Financial statements assertions are management’s expressed or

implied claims about information reflected in the financial statements.
Assertions are central to auditing because they are the focus of the
auditor’s evidence collection effort. In other words, much of what auditors
do revolves around collecting and evaluating evidence about
management’s financial statement assertions.

One of the main tasks of the auditor is to collect sufficient

appropriate evidence that management’s assertions regarding the financial
statements are correct.
CORE CONCEPTS IN FINANCIAL STATEMENT AUDIT
Fundamental Concepts in Conducting a Financial Statement Audit

• Materiality – refers to the amount by which a set of financial statements could be

misstated without affecting the judgment of reasonable person. The concept of
materiality is important because it simply isn’t practical or cost beneficial for auditors to
ensure that financial statements are completely free of any small misstatements.
• 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.
• Audit Evidence Regarding Management Assertions – The third concept involved in
auditing is evidence regarding management 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.
GENERAL PRINCIPLES OF AN 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
GENERAL PRINCIPLES OF AN AUDIT
Reasonable Assurance

An audit in accordance with PSAs is designed to provide reasonable assurance that the
financial statement 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.

Limitations result from factors such as:

• The use of testing

• The inherent limitations of any accounting and internal control system
• The fact that most audit evidence is persuasive rather than conclusive.
GENERAL PRINCIPLES OF AN AUDIT
Reasonable Assurance

Also, the work undertaken by the auditor to form an opinion is permeated by judgment,
in particular regarding:

a) The gathering of audit evidence

b) The drawing of conclusions based on the audit evidence gathered

Further, other limitations may affect the persuasiveness of evidence available to draw
conclusions on particular financial statement assertions.

c) Unusual circumstances which increase the risk of material misstatements beyond that
which would ordinarily be expected; or
d) Any indication that a material misstatement has occurred.
GENERAL PRINCIPLES OF AN AUDIT
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.
GENERAL PRINCIPLES OF AN AUDIT
Skills and Knowledge Needed in Financial Statement Audit

Auditors 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 presentation 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.
GENERAL PRINCIPLES OF AN AUDIT
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 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
GENERAL PRINCIPLES OF AN AUDIT
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 conducted.
GENERAL PRINCIPLES OF AN AUDIT
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.
GENERAL PRINCIPLES OF AN AUDIT
Relating the Audit Process Components to the Business Model

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
GENERAL PRINCIPLES OF AN AUDIT
Relating the Audit Process Components to the Business Model

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.

Auditors often rely on this process model to divide the audit of a business’s
financial statements into manageable pieces.