The Financial

Statements Audit –Client

Acceptance, Audit
Planning, Supervision and
Monitoring

Module 2
Title Contents

• The FS Audit • Overview of the audit

process
• Client Acceptance • Pre-engagement
• Audit Planning procedures
• Scope & purposes of audit
• Supervision and planning
Monitoring • Direction, supervision, and
review
Overview of the FS Audit
Phases of the Audit Process

Post audit responsibilities

Issuance of the audit report

Completing the audit

Substantive testing

Study and evaluation of internal controls

Audit planning

Pre-engagement
Pre-engagement
1. Client acceptance
2. Client continuance
3. Terms of engagement
4. Changes in the terms of engagement
Client acceptance
• Identify potential client
• Evaluate relationship between auditor and potential
client
• Evaluate auditability
• Consider:
• Adequacy of accounting records
• Quality of internal control
• Evaluate management’s integrity
• Procedures would include the following:
• Review the company’s financial statements
• Discuss the company’s management with the predecessor auditor
• Discuss the company’s management with the members of the
financial community
• Consider engaging professionals/investigators to evaluate the
principals associated with the prospective client
• Obtain credit reports when deemed necessary
• Prepare engagement letter
• A conference between the client and the auditor
must be called to agree on certain issues, including:
• Specific services to be rendered
• Cooperation and work expected to be performed by
the client’s personnel
• Expected starting and completion dates of the
engagement
• Possibility that the completion dates may be changed if
unforeseen audit problems arise
• Nature and limitations of the audit engagement
• Estimate of the fee
Client Continuance

• Reasons for discontinuing clients might

include:
• Evidence indicating a client’s management may
lack integrity
• Difficulty in working with client personnel
• Inability to negotiate an acceptable increase in
the audit fee
• Client need for specialized services the current
audit firm is unable or unwilling to provide
Terms of engagement

• After a decision is made to accept or

continue an engagement, an agreement
should be reached with the client, preferably
through the auditor, about the professional
services desired, and an engagement letter
is prepared.
The Engagement letter

• Engagement letter
• To be sent preferably before the commencement of the
engagement
• A formal written agreement between the CPA firm and the
client for the conduct of the audit and related services
• A written contract between the auditor and the client which
generally serves
• To minimize misunderstandings
• To alert the client as to the purpose of the engagement and role
of the external auditor
• To help minimize legal liability for services neither contracted
for nor performed
Contents of an engagement
letter
• The objective of the audit of FS
• Arrangements regarding planning
• Management’s responsibility for the and performance of the audit
FS
• Expectation of receiving from
• The financial reporting framework management written confirmation of
adopted by management in representations made
preparing the FS
• Request for the client to confirm the
• Scope of the audit terms of engagement by
acknowledging receipt of the
• The form of any reports or other engagement letter
communication of results of the
engagement • Description of any other letters or
reports the auditor expects to issue
• The fact that there is an unavoidable to the client
risk that even some material
misstatement may remain • Basis on which fees are computed
undiscovered and any billing arrangements
• Unrestricted access to records,
documentation, etc
• Management’s responsibility for
internal control
Audit of components

• Component
• Subsidiary, branch, or division
• Factors that influence the decision whether to send a separate
engagement letter to the component include:
• Who appoints the auditor of the component
• Whether a separate audit report is to be issued on the component
• Legal requirements
• Extent of any work performed by other auditors
• Degree of ownership by parent
• Degree of independence of the component’s management
Recurring audits

• When to send a new engagement letter:

• Any indication that the client misunderstands the
objective and scope of the audit
• Any revised special terms of the engagement
• A recent change in senior management, board of
directors, or ownership
• A significant change in nature or size of the client’s
business
• Legal requirements
• A change in the financial reporting framework adopted
by management in preparing the FS
Changes in the terms of
engagement
• Some reasons that may prompt for a change in the engagement
• Change in circumstances affecting the need for the service
• A misunderstanding as to the nature of an audit or related service
originally requested
• Restriction on the scope of the engagement whether imposed by
management or caused by circumstances
• The auditor should carefully consider the reason given for the request,
particularly the implication of a restriction on the scope of the
engagement.
• If auditor is unable to agree, or is not permitted to continue the
original engagement, he should withdraw and consider whether there
is any obligation to report to other parties.
Audit planning
1. Knowledge of the business
2. Preliminary analytical procedures
3. Materiality
4. Assessing and managing risks
5. Audit plan and audit program
6. Considering the work of others
Benefits of Planning

• To help ensure that

• Appropriate attention is devoted to important areas of the audit
• Potential problems are identified and resolved on a timely basis
• The audit engagement is properly organized and managed in
order to be performed in an effective and efficient manner.
• To
• Assist in proper assignment of work to engagement team
members
• Facilitate the direction and supervision of engagement team
members and the review of their work
• Assist in coordination of work done by auditors of components
and experts
Knowledge of the business

PSA 315: The auditor should obtain a knowledge of the

business sufficient to enable the auditor to identify and
understand the events, transactions, and practice that may
have a significant effect on the financial statements or on
the examination or audit report.
Knowledge of the business
• Obtaining the knowledge
• Previous experience with the entity and its industry
• Discussion with
• people within the entity
• internal audit personnel and review of internal audit reports
• other auditors and with legal and other advisors
• knowledgeable people outside the entity
• Publications, legislation, regulations
• Visits to the entity’s premises and plant facilities
• Documents produced
• Using the knowledge
• Establishing and evaluating materiality judgments
• Considering the appropriateness of the selection and application of
accounting policies, and the adequacy of FS disclosures
• Identifying areas of special audit consideration
• Developing expectations for use in analytical procedures
• Designing and performing further audit procedures to reduce audit risk
• Evaluating sufficiency and appropriateness of audit evidence obtained
Understanding the accounting
and internal control system
• How to obtain? • What to understand?
• Inquiries of appropriate • Major classes of
management, supervisory, transactions
and other personnel with
various organizational • How such transactions are
levels within the entity initiated
• Inspection of documents • Significant accounting
and records records, supporting
documents, and accounts
• Observation of the entity’s
activities and operations • Accounting and financial
reporting process
• Evaluation of internal
controls
• Type of internal controls
involved
Preliminary analytical
procedures
Analytical Procedures
…consist of evaluations of financial information made by a study of
plausible relationships among both financial and non-financial data.

Purposes:
•To assist the auditor in planning the nature, timing, and extent
of other auditing procedures
•As a substantive test to obtain evidential matter about particular
assertions related to account balances or classes of transactions
•As an overall review of the financial information in the final review
stage of the audit
Analytics in the Planning Stage

• Purpose: To assist in understanding the

business and in identifying areas of potential
risk
• PSA 520: Requires the auditors to perform
analytical procedures as a part of the
planning process for every audit.

• Sample preliminary analytics

Risks
Audit risk
Business risk
RISK

• BUSINESS RISK
• Risk that auditor will suffer a loss or injury to
professional practice due to litigation or adverse
publicity in connection with an audit.
• Always present whether or not the auditor conducts
the audit in accordance with PSA hence cannot be
directly controlled by auditor.
• AUDIT RISK
• Risk that the auditor gives an inappropriate audit
opinion when the FS are materially misstated.
Risk assessment and the
auditor’s response

• Risk assessment procedures

• Audit procedures performed to obtain an
understanding of the entity and its
environment, including its internal control, to
assess the risks of material misstatement at the
FS and assertion levels.
Audit plan and audit
programs
AUDIT STRATEGY VS AUDIT PLAN VS AUDIT PROGRAM
The audit strategy

• Establishing audit strategy involves

designing optimized approaches that seek
to achieve the necessary audit assurance at
the lowest cost within the constraints of the
information available.
• The overall audit strategy sets the scope,
timing, and direction of the audit, and
guides the development of the more
detailed audit plan.
Audit Plan
• Contains the overview of the • Information typically included
engagement, outlining the are:
nature and characteristics of the • Description of the client
client’s business operations and company
the overall audit strategy.
• Audit objectives
• Prepared before the starting
work at the client’s office but • Description of the nature and
may be modified throughout the extent of other services
engagement. • Timetable of the audit work
• Work to be done by the client
• Assignment of audit staff
• Target completion dates
• Preliminary evaluation and
judgment about materiality level
• Any special problems to be
resolved
• Conditions that may require
changes in audit test
Complete the Initial Audit
Program
• Audit program
• A set of audit procedures specifically designed for each audit.
• A list of audit procedures to be performed so that the auditor will
have evidence as basis for expressing his opinion.
• Includes both substantive tests and tests of controls.
• Serves as a set of instructions to assistants involved in the audit
and as a means to control and record the proper execution of the
work.
• May also contain:
• Audit objectives for each area
• Time budget
Developing audit programs

• On initial engagements, the audit program

typically will develop in three stages:
• The broad phases of the program can be
outlined at the time of engagement.
• Other details of the program can be identified
after the review of the internal control structure
and accounting procedures has begun
• Procedures on specific phases of the audit can
be further challenged and revised as the work
progresses
Considering the work of
others
Work of others
• Predecessor Auditor
• Other CPAs
• Experts
• Auditor should evaluate
• Expert’s competence
• Expert’s objectivity
• Use of Client’s Staff
• Working papers prepared by the client should never be accepted at face
value.
• Internal Auditors
• Affects the audit in two ways
• Enhance internal control
• Assists external auditors in performing specific audit procedures
Study and Evaluation of
Internal Controls
Audit approaches

Control risk assessment Approach Implications for the engagement

HIGH control risk No reliance approach No reliance on the clients internal
(controls are ineffective) controls
No test of controls
More evidence to accumulate
More extensive substantive tests are
required
LESS THAN HIGH control Reliance approach Possible reliance on the client’s
risk (controls may be internal controls
effective) Test of controls must be performed to
justify reliance on controls.
If test of controls confirm that
controls can be relied on, less
evidence will be accumulated or less
extensive substantive testing.
Substantive testing
Evidence gathering
Description of substantive tests
Audit procedure Description
Tests of details Test of details involve the examination of items or
details that comprise an account balance (tests of
balances) or class of transactions (tests of
transactions). Every audit involves the performance
of tests of details.
Substantive analytical Analytical procedures applied specifically for the
procedures purpose of testing the reasonableness of account
balances and identifying significant fluctuations or
differences which may require further audit
investigation.

Substantive analytical procedures require less time

and effort, but are also less reliable compared to
tests of details.
Completing the audit
Completing the audit

• After all the previous steps, the auditor performs

• FINAL analytical procedures, and
• Other audit procedures, such as
• reading minutes of recent board and committee meetings
• obtaining management representation letters.

• In addition, the auditor:

• Makes final materiality judgments
• Summarizes and evaluates the audit findings
• Reviews the working papers
• Reviews the FS presentation and disclosures for adequacy, and
• Considers subsequent events
Issuance of the audit report
Types of audit reports
Audit report Description
Unmodified opinion Communicates a favorable signal about
financial position, results of operations, and
cash flows.
Qualified opinion Communicates a favorable signal about
financial statements, but with modifications.
For example, an auditor may wish to alert
users that the FS are presented fairly “except
for” the effects of misapplying an accounting
principle.
Adverse opinion Communicates an unfavorable signal.
Usually, this is issued when the conditions are
appropriate for a qualified opinion, yet the
issue leading to qualification is so material
and pervasive.
Disclaimer of opinion Signals that an auditor does not express an
opinion.
Post audit responsibilities
Debriefing
Post audit responsibilities

• Debriefing usually involves:

• Considering events during the audit.
• Analyzing the activities within the audit.
• Producing recommendations.
Basic concepts underlying a
financial statement audit
• Auditor independence
• Professional skepticism
• Conduct and scope of audit in accordance with PSAs
• Audit evidence and financial statement assertions
• Audit materiality
• Audit risk
• Professional judgment
• Inherent limitations of an audit
 Audit evidence and FS
assertions
• AUDIT
EVIDENCE Accounting records Other information
• All the Records of initial entries Minutes of meetings
information
used by the Supporting records Confirmations from 3rd parties
auditor in Checks and records of electronic fund Analysts’ reports
arriving at the transfers
conclusions on
which the audit Invoices Comparable data about competitors
opinion is (benchmarking)

based, and Contracts Controls manuals

includes the General and subsidiary ledgers Information obtained by auditor from
information audit procedures
contained in
the accounting Journal entries Other information developed by, or
records Other adjustments to the FS that are not
available to, the auditor
underlying the reflected in formal journal entries
financial
statements and Records such as worksheets
other Spreadsheets
information.
Audit evidence and FS
assertions

• Audit procedures according to purpose

Category Description / Purpose

Risk assessment procedures Used for obtaining an understanding of

the client entity and its environment,
including internal control. Risk
assessment procedures are performed
during the audit planning and internal
control phases of the audit.
Tests of controls Used to test the operating effectiveness
of controls in preventing, or detecting
and correcting, material misstatements.
Substantive tests Used to detect material misstatements
in account balances, classes of
transactions and disclosures.
Audit evidence and FS assertions
Assertions about Assertions about Assertions about
classes of account balances presentation and
transactions and at period end disclosure
events for the Existence Occurrence and
period under audit rights and
Rights and
Occurrence obligations obligations
Completeness Completeness Completeness
Accuracy Valuation and Classification and
Cut off allocation understandability
Classification Accuracy and
valuation
Audit materiality
 MATERIALITY, defined
AUDIT: ACCOUNTING:
The magnitude or an Information is material if
omission or misstatement omitting, misstating or
of accounting information obscuring it could
that, in the judgment of a reasonably be expected
reasonable person relying to influence decisions that
on the information, would the primary users of
have been changed or general purpose
influenced by the financial reports make
omission or misstatement. on the basis of those
reports, which provide
financial information
about a specific reporting
entity
Importance of materiality:

• Helps establish the extent of substantive

tests
• Evaluate potential and actual misstatements
• Defines the threshold at which the auditor
would require the client to make an
adjustment to the financial statements.
Different types of materiality
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When does the auditor
consider materiality?
STAGE STEPS

• Planning 1. Establish a preliminary

Stage judgment about
materiality
2. Determine tolerable
misstatement
• Audit 3. Estimate likely
Completion misstatements and
Stage compare the totals to the
preliminary judgment
about materiality
Step 1: Establish a preliminary
judgment about materiality

• The preliminary judgment about materiality

• Is also known as OVERALL MATERIALITY or
MATERIALITY AT THE FS LEVEL or PLANNING
MATERIALITY.
• Represents the maximum amount by which a set of
financial statements could be misstated and still
not cause the auditor to believe that the decisions
of reasonable users would be affected.
• Considered as the smallest aggregate level of
misstatement that could distort any one of the FS.
Step 1: Establish a preliminary
judgment about materiality

• Considerations in determining acceptable

materiality levels:
• Elements of FS and FS measures
• Whether there are FS items where users
attention tends to be focused
• Nature of the entity and industry in which it
operates
• Size, nature of ownership, financing of the client
• Consider that FS are interrelated
Step 1: Establish a preliminary
judgment about materiality
Quantitative factors: Qualitative factors
• Total assets • Probability of illegal
• Total revenues payments
• Net income before • Probability of fraud
taxes • Small amounts that
• Gross profit may violate
• Average of three covenants in
years’ net income contracts
before taxes • Interruption in a
trend in earnings
sample
Step 2: Determine tolerable
misstatement

• Tolerable misstatement is
• Also known as materiality at the account
balance level
• The amount of planning materiality that is
allocated to an account balance or class of
transactions (i.e. allocated materiality is the
tolerable misstatement for that account or
class of transactions)
Step 2: Determine tolerable
misstatement
• The process of allocation may be done judgmentally or using
formal quantitative approaches.
• Example: During the audit of the 2019 FS of ABC Company, the
audit partner determined that planning materiality is set at 1% of
the total assets of P25,000,000. For simplicity, assume that there
are no other assets except as presented below:
Account Balance % Tolerable
misstatement
Cash P 1,000,000 4 P 2,500
Trading securities 5,000,000 20 1,250
Accounts receivable 7,000,000 28 95,000
Inventories 12,000,000 48 151,000
Total P25,000,000 100 P250,000
Step 3: Estimate likely misstatements and
compare totals to the preliminary judgment
about materiality

• The aggregate of uncorrected misstatements (also known as

likely misstatements) comprises:
• Specific misstatements identified by the auditor including the
net effect of uncorrected misstatements identified during the
audit of previous periods;
• The auditor’s best estimate of other misstatements which
cannot be specifically identified (i.e. projected errors)
• If the aggregate of the uncorrected misstatements that the
auditor has identified approaches the materiality level, the
auditor would consider whether it is likely that undetected
misstatements could exceed materiality level.
• If aggregate uncorrected misstatements approach the
materiality level, the auditor would consider reducing audit
risk by performing additional audit procedures or by
requesting management to adjust the financial statements
for identified misstatements.
Audit risk
Audit risk

• Audit risk
• Is the risk (or the likelihood) that the auditor expresses
an inappropriate audit opinion when the FS are
materially misstated.
• Can be assessed quantitatively or non-quantitatively.
• Is composed of:
• Risk of material misstatement
• Inherent risk
• Control risk
• Detection risk
The audit risk model: AR =
IRxCRxDR
STEPS IN ASSESSING RMM:
1. Identify relevant FS assertions.
2. Understand the entity and its environment, including
its internal controls.
► Procedures:
• Inquiries of management and others within the entity
• Analytical procedures
• Observation and inspection
► (PSA 315) RMM may be greater for significant non routine
transactions from matters such as:
► Greater mgt intervention to specify acctg treatment
► Greater manual intervention for data collection and processing
► Complex calculations or accounting principles
► Nature of non routine transactions
► RMM may be greater for significant judgment matters that
require use of estimates, such as:
► Accounting principles for acctg estimates or revenue recognition may
be subject to differing interpretation.
► Required judgment may be subjective, complex, or require
assumptions.
The audit risk model: AR =
IRxCRxDR
3. Make decisions about materiality.
► PSA 320

4. Perform analytical procedures.

5. Identify risks that may result in material
misstatements, including risk of fraud.
• PSA 250: Consideration of laws and regulations.
• PSA 240: Auditor’s responsibility to consider fraud.
• PSA 330: Auditor’s Procedures in Response to Assessed
Risks
6. Develop preliminary audit strategies.
The audit risk model:
AR = IRxCRxDR
STEPS IN USING THE AUDIT RISK
MODEL
• Design substantive tests.
• Set the desired level of audit risk.
• Level of assurance provided is the
complement of DR.
• Assess the level of inherent risk.
• E.g. LOWER acceptable DR, greater
• Knowledge of the client’s business and assurance by:
industry, preliminary analytical
procedures. • More effective substantive procedures
(nature)
• Assess the level of control risk. • Performing year-end procedures
(timing)
• Studying and evaluating the
effectiveness of the client’s accounting • Using larger sample size (extent)
and internal control systems.
• E.g. HIGHER acceptable DR, lower
• Determine the acceptable level of assurance by:
detection risk.
• Less effective substantive procedures
• DR = AR / (IR x CR) (nature)
• Performing interim procedures (timing)
• Using smaller sample size (extent)
Acceptable detection risk
matrix
Auditor’s assessment of control risk
High Medium Low

High Lowest Lower Medium

Auditor’s
assessment
of inherent Medium Lower Medium Higher
risk

Low Medium Higher Highest

Relationships
• The greater the risk of material misstatement the auditor believes exists,
the less the detection risk can be accepted.
• The lower the acceptable detection risk, the greater the amount of audit
procedures to be performed in order to reduce the chances of not
detecting misstatements.
• There is an inverse relationship between materiality and audit effort.
• There is an inverse relationship between materiality and the level of audit
risk, that is, the higher materiality, the lower the audit risk and vice versa.
• E.g. If after planning for specific audit procedures, the auditor determines that
the acceptable materiality is lower, audit risk is increased. The auditor would
compensate for this by either:
• Reducing the assessed level of material misstatement, where this is possible, and
supporting the reduced level by carrying out extended additional tests of controls;
or
• Reducing detection risk by modifying the nature, timing, and extent of planned
substantive procedures.
Relationships, continued…

• As the desired level of audit risk decreases, the auditor

should design more effective substantive procedures.
• As the assessed level of inherent risk increases, the auditor
should design more effective substantive procedures.
• As the assessed level of control risk increases, the auditor
should design more effective substantive procedures.
• As the acceptable level of detection risk decreases, the
assurance directly provided from substantive tests increases.
Thus, the auditor should design more effective audit
procedures in order to achieve the desired level of
assurance.
Direction, supervision, and
review
Direction

• Involves informing assistants

• of their responsibilities and the objectives of
the procedures they are to perform.
• of matters, such as the nature of the entity’s
business and possible accounting or auditing
problems that may affect the nature, timing,
and extent of audit procedures with which they
are involved
Supervision

• Involves directing the efforts of assistants who are

involved in accomplishing the objectives of the audit and
determining whether those objectives were accomplished.
• Elements include:
• Instructing assistants
• Keeping informed of significant problems encountered
• Reviewing the work
• Dealing with differences in opinion
• Closely related to both direction and review and may
involve elements of both.
 Review
• Is done to consider whether • What needs to be reviewed on
a timely basis?
• Work has been performed in
accordance with the audit • Overall audit plan and audit
program program
• Work performed and results • Assessment of inherent and
obtained have been control risks, including results of
adequately documented tests of controls
• All significant audit matters • Documentation of audit
have been resolved evidence obtained from
substantive tests
• Objectives of the audit
procedures have been • The financial statements,
achieved proposed audit adjustments,
and proposed auditor’s report
• Conclusions expressed are
consistent with results of
work performed and support
the audit opinion