CHAPTER 7

INTRODUCTION TO
FINANCIAL STATEMENT AUDIT
INDEPENDENT AUDITING DEFINED

Auditing has been defined in different ways by different sources. The definition
given by the American Accounting Association provides an effective means of
introducing and initially exploring the topic

Auditing is a systematic process by which a competent, independent person

objectively 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.

This definition includes several key words and phrases briefly discussed in this
section.
Systematic process
This implies a structured, logical, and organized series of steps and
procedures. Auditing consists of a series of sequential steps that
include information testing system and testing of transactions and
balances.

Competent independent person

The auditor must be qualified to understand the criteria used and the
competence to know how and what evidence to accumulate to reach
the proper conclusion. The auditor must also have an independent
mental attitude which involves impartial and objective thinking.

Objectively obtains and evaluates evidence

This means examining the bases for the assertions (representations)
and judiciously evaluating the results without bias or prejudice either
for or against the individual (or entity) making the representations.

176 Chapter 7
 • Assertions about economic actions and events
These are the representations made by the individual or entity.
They comprise the subject matter of auditing. Assertions include
information contained in financial statements, internal operating
reports, and tax returns. In the audit of financial statements,
assertions are the representations of management as to the
fairness of the financial statements.

• Degree of correspondence
This refers to the closeness with which the assertions can be
identified with" established criteria. The expression of
correspondence may be quantified, such as the amount of a
shortage in a petty cash fund, or it may be qualitative, such as
the fairness (Or reasonableness) of financial statements.

• Established criteria
These are the standards against which the assertions or
representations are judged. Criteria may be specific rules prescribed
by a legislative body, budgets and other measures of performance

set by management, or financial reporting standards established by

the Financial Reporting Standards Council (FRSC) and other
authoritative bodies.

• Communicating the results

This is often referred to as attestation. The final stage in the audit
process is the audit report the communication of the findings to users.
By attesting to the degree of correspondence with established criteria,
the investigator enhances (or weakens) the credibility of the
representations or claims that have been made by another party.
The communication of findings is achieved through a written report.

• Interested users
These are individuals who use (rely on) the auditor's findings.
In a business environment, this includes stockholders, management'
creditors, governmental agencies, and the public.
 to Financial Statement Audit 177
The 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 International
Standards on Auditing (ISAs), International Standards on Quality Control
(ISQCs), International Financial Reporting Standards (IFRS), International Public
Sector Accounting Standards (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 Philippine

Standards on Auditing" states the objective of an audit as follows:

"The objective of an audit of financial statements is to enable the auditor to

express an opinion whether the financial statements are prepared, in all
material respects, in accordance with an identified financial reporting
framework The phrase 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.
The auditor's opinion helps establish the credibility of the financial statements.
The user, however, should assume that the auditor's opinion is an assurance as to
the future viability of the entity nor an opinion as to the efficiency or effectiveness
with which management has conducted the affairs of the entity.

In conducting an audit of financial statements, the overall responsibilities of the auditor

are:

(a) To obtain reasonable assurance about whether the financial statements as a

whole are free from material misstatement, whether due to fraud or error,
thereby enabling the auditor to express an opinion on whether the financial
statements are prepared, in all material respects, in accordance with an
applicable financial reporting framework; and

(b) To report on the financial statements, and communicate as required by

the Philippine Standards on Auditing (PSAs), in accordance with the
auditor's findings.
 In all cases when reasonable assurance cannot be obtained and qualified

opinion in the auditor's report is insufficient in the circumstances for

purposes of reporting to the intended users of the financial' statements, the
PSAs require that the auditor disclaim an opinion or withdraw from the
engagement, where withdrawal is legally permitted.

SCOPE OF INDEPENDENT AUDIT

The term "scope of an audit" refers to the audit procedures deemed necessary in
the circumstances to achieve the objective of the audit. The procedures required
to conduct an audit in accordance with PSAs, relevant professional bodies,
legislations, regulation and, where appropriate, the terms of the audit
engagement and reporting requirements.

Since the primary objective of an independent audit is to express an opinion on

the company's financial statement, the auditor will conduct a critical and
systematic examination of the statements and of the related documents, records,
procedures, and control. Audit evidences may be gathered to enable him to
substantive the representations in the financial statements. Internal controls will
be evaluated for effectiveness since they affect the reliability of the financial
records. By inquiry, observation, confirmation and inspection, the auditor can
test the existence and validity of assets, liabilities, overall reasonableness of other
account balances in the financial statements.

When sufficient and competent audit evidences have been gathered, the auditor
can then formulate his opinion n the fairness with which the financial statements
have been prepared. He then prepares the audit report containing the scope of his
examination and the opinion he has expressed on the financial statements for
submission to the client, who in turn furnishes copies of the report to various
interested parties.

WHY INDEPENDENT FINANCIAL AUDITING IS NECESSARY

Without wide public acceptance, professions cannot exist, and independent

auditing is no exception. Over the years, society has perceived a need for audits of
publicly held companies, which has developed as a result of the separation of
ownership and management. Auditing services are used extensively by business'
 to Financial Statement Audit 179
government, and other not-for-profit organizations. As society becomes more
complex, there is an increased likelihood that unreliable information will be
provided to decision makers.

This is referred to as "Information Risk". Some of the factors that contribute to

information risk are:

a. Remoteness of information users from information providers

Decision makers, almost always, do not get firsthand knowledge about the
business enterprise with which they do business for the reasons that in
many cases,
l. owners are divorced from management,
1. directors are not involved in day-to-day operations or decisions,
2. business may be dispersed among numerous geographic locations and
complex corporate structure.

b. Potential bias and motives of information provider

A conflict of interest may be assumed to exist between management and
owners regarding the. financial statements. Management usually desires to
present the results of its stewardship in the most favorable light.
Information may possibly be biased in favor of the provider when his goals
are inconsistent with the decision maker. This could be attributed to either
an international emphasis designed to influence users in a certain manner
or maybe an honest optimism about future events.

c. Voluminous data
As businesses grow, possibly millions of exchange transactions are
processed daily via manual or sophisticated computerized systems. This
increases therefore the likelihood that improperly recorded information may
be included or buried in the records.
d. Complex exchange transactions
New and changing business relationships may lead to innovative accounting
and reporting problems. Some transactions are so complex and hence more difficult
to record properly. Also, transactions not quantifiable will require increased
disclosures.

e. Consequences

During the past decade, many financial statement users — pension funds,
private investors, venture capitalists, and banks — lost billions of pesos
 because financial information had become unreliable. As an example, the
factors leading up to, and the consequences of, unreliable information can
be seen in the subprime mortgage crisis in the United States.

Many borrowers did not provide correct information on their loan

applications and lenders sometimes did not perform adequate due
diligence in making lending decisions.

Consequently, various financial statement users and others suffered

significant losses. When financial information is not reliable, investors -
and other users lose a significant source of information that they need to
make decisions that have important consequences.

HOW INFORMATION RISK MAY BE REDUCED

To reduce information risk or the risk that information upon which a business
decision is made is inaccurate, managements of businesses and the users of their
financial statements may adopt any or all of the following approaches:

I . Allow users to verify information

The user may go to the business establishment to examine records and
obtain information about the reliability of the statement. Although
impractical because of costs, this is usually adopted by BIR examiners or

a business intending to purchase another business. It is common for

a purchaser to use a special audit team to independently verify and
evaluate key information of the prospective business. This is also
known as "due diligence audit."

2. user shares information risk with management

It is important to emphasize the fact that management has the primary

responsibility of providing reliable information to users. If users rely on inaccurate
financial statements and as a consequence incurs a financial loss, a lawsuit may be
brought against management to recover part of such.

3. Have the financial statements audited

To obtain reliable information, the user can have an independent audit
performed. The audited information is then used in the decision-making
process on the assumption that it is reasonably complete, accurate, and
 to Financial Statement Audit 181
As an expert in the application of financial reporting standards, the
independent auditor further enhances the quality of financial reporting.

ADVANTAGES AND PRACTICAL BENEFITS OF

INDEPENDENT AUDIT

A. To the Auditee or Client

Independent audit makes the financial statements more credible and

reliable.

2. Management is the beneficiary of constructive suggestions in

improving business operations.

3. Commission of fraud by management and employee is minimized.

4. Audited financial statements provide a more credible basis for the
preparation of tax returns.
5. Better and sound management decisions may be made if financial
records and reports are accurately maintained and provided.

B. To Creditors, Prospective Investors, Employees

l . 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 more confident basis for aiming at a decision as to the
terms and conditions of the arrangement.
182
Chapter 7

C. To Government Agencies and Legal Community

I. BIR has more assurance concerning accuracy and dependability of tax

return if they have been based on audited financial statements.
2. Government institutions like GSIS, SSS, DBP will have better 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.

OVERVIEW OF THE AUDIT OPINION FORMULATION PROCESS

To be able to provide reasonable assurance, auditors go through a structured

process, referred to as the Audit Opinion Formulation Process. That process is
presented in Figure 4-1.

Figure 4-1: Audit Opinion Formulation Process

Phase I
Risk Assessment

• Performing Risk Assessment including Client Acceptance and

Continuance Decision

Phase Il Risk Response

• Obtaining Evidence about Internal Control Operating

Effectiveness
• Obtaining Substantive Evidence about Accounts, Disclosures and
Assertions
 Introduction to Financial Statement Audit 183

Phase Ill
Reporting

• Completing the Audit and Making Reporting Decisions

Discussion

Phase I Of the audit opinion formulation process concerns risk assessment

starting from client acceptance and continuance. Auditors are not required to
perform audits for any organization that asks, auditors choose whether or not to
perform each individual audit. Audit firms have procedures to help ensure that they
are not associated with clients where management integrity is in question or where a
company might otherwise present the audit firm with unnecessarily high risk (such
as client financial failure or regulatory action against the client).

Once a. client is accepted (or the audit firm decides to continue to audit the
client), the auditor needs to perform risk assessment procedures to understand the
client's business thoroughly (or update prior knowledge in the case of a continuing
client), its industry, its competition, and its management and governance processes
(including internal controls) to determine the likelihood that financial accounts might
be in error.

Phase II, the auditor will also obtain evidence about Internal control operating
effectiveness through testing those controls. Much of what most people think of as
auditing, the obtaining of substantive evidence about accounts, disclosures, and
assertions are also in this phase. The information gathered in Phase I through Il will
greatly influence the amount of testing to be performed.

Finally, in Phase Ill, the auditor Will complete the audit and make a decision about
what type of audit report to issue.

The final phase in the audit process is to evaluate results and choose the appropriate
audit report to issue. The auditor's report, also known as the audit opinion, is the main
product or output of the audit. Just as the report of a house inspector
communicates the inspector's findings to a prospective buyer, the audit report
communicates the auditor's findings to the users of the financial statements.
184

After completion of the audit work, the auditor determines if the preliminary
assessments of risks were appropriate in light of the evidence collected and whether
sufficient evidence was obtained. The auditor then aggregates the total known and
estimated uncorrected misstatements and determines whether they cause the financial
statements to be materially misstated. If the uncorrected misstatements are judged to
be material, the auditor will request that the client correct misstatements. If the client
refuses, the auditor issues an opinion that clearly indicates that the financial statements
are materially misstated and explains the nature of the misstatement. If the uncorrected
misstatements are insignificant enough that they do not cause the financial
statements to be materially misstated, or if the client is willing to correct the
misstatements, the auditor issues an unqualified (i.e., "clean") report.

ACTIVITIES OF EACH PHASE OF THE AUDIT

OPIN10N FORMULATION PROCESS
Within each of the phases the auditor performs various activities, most of which are the
same whether the auditor is performing a financial statement only or for an integrated
audit. Figure 4-2 lists these activities. These activities are influenced by the auditing
profession, regulation and professional liability. When performing each of these
activities in Figure 4-2, the auditor is expected to make quality professional judgment
and sound decision.

Figure 4-2: Activities in each Phase of the

Audit Opinion Formulation Process

 Introduction to Financial Statement Audit 185

Phase of the Audit Activities Within the Phase

Opinion Formulation Process
Phase I — Risk Assessment • Assess preconditions for an audit
Performing Risk Assessment including
Client Acceptance and Continuance
• Develop common understanding of the
audit engagement with the client

• Identify and assess risks of material

misstatement
• Respond to identify risks of material
misstatement

Phase II — Risk Response

Obtaining Evidence about Internal Control • Select controls to test, if applicable
Operating Effectiveness, if applicable • Perform tests of controls, if applicable
• Consider the results of tests of controls if
applicable

Obtaining Substantive Evidence about • Perform substantive tests

Accounts, Disclosures and Assertions

Phase III
Completing the Audit and Making Reporting • Complete review and communication
Decisions activities
• Determine the type(s) of opinion(s) to issue

MANAGEMENT ASSERTIONS AND FINANCIAL STATEMENTS

Financial statement 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.
 186
One of the main tasks of the auditor is to collect sufficient appropriate evidence that
management's assertions regarding the financial statements are correct. The process is
really quite logical and intuitive. First, you would carefully consider the most
important assertions the company is making about the account, and then you would
decide what evidence you would need to substantiate the truthfulness of each
important assertion.

Figure 4-3 lists the management assertions that auditors focus on in an audit. This
presentation divides management assertions into two aspects of information reflected in
the financial statements: transactions and related disclosure, and account balances and
related disclosure. Understanding the assertions in terms of transactions and account
balances helps the auditor focus on the different types of audit procedures needed to test
management's assertions in these two categories.

Figure 4-3: Summary of Management Assertions by Category

Assertions about classes of transactions and events (and related disclosures) for the
period:

• Occurrence: Transactions and events that have been recorded or disclosed have
occurred, and such transactions and events pertain to the entity.
• Completeness: All transactions and events that should have been recorded have
been recorded, and all related disclosures that should have been included in the
financial statements been included.
• Authorization: All transactions and events have been properly authorized.
• Accuracy: Amount and other data relating to recorded transactions and events
have been recorded appropriately, and related disclosures have been
appropriately measured and described.
• Cutoff: Transactions and events have been recorded in the correct accounting period.
 Introduction to Financial Statement Audit 187

• Classification: Transactions and events have been recorded in the proper accounts.

• Preparation: Transactions and events are appropriately aggregated or

disaggregated and clearly described and related disclosures are relevant and
understandable in the context of the requirements of the applicable financial
reporting framework.

Assertions about account balances (and related disclosures) 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 interest that should have
been recorded have been recorded, and all related disclosures that should
have been included in the financial statements have been included.
• Accuracy, valuation, and allocation: Assets, liabilities, and equity
interests have been included in the financial statements at appropriate
amounts, and any resulting valuation or allocation adjustments have been
appropriately recorded, and related disclosures have been appropriately
measured and described.
• Classification: Assets, liabilities, and equity interests have been recorded in the
proper accounts.
• Presentations: Assets, liabilities, and equity interests are appropriately
aggregated or disaggregated and clearly described, and related disclosures
are relevant and understandable in the context of the requirements of the
applicable financial reporting framework.
Once the auditor has finished auditing the important assertions relating to each account
included in the company's financial statements, the findings are reported to the
company's shareholders and to the investing public.

CORE CONCEPTS IN FINANCIAL STATEMENT AUDIT

Fundamental Concepts in Conducting a Financial Statement Audit

Figure 4-3 presents a simplified overview of the process for conducting a financial
statement audit from start to finish. The auditor gathers evidence about the business
transactions that have been accumulated and recorded. The auditor uses this evidence
to compare the assertions contained in the financial statements to the criteria used by
management in preparing them. Financial Report Standards communicate. to the
user the degree of correspondence between the assertions and the criteria.
188
Figure 4-3: An Overview of the Financial Statement Auditing Process
Terms of Engagement
Management Auditor

The conceptual and procedural details of a financial statement audit build on three
fundamental concepts: materiality, audit risk, and evidence relating to management's
financial statement assertions. The auditor's assessments of materiality and audit risk
influence the nature, timing and extent of the audit evidence to be gathered.
 Introduction to Financial Statement Audit 189

Auditors do not guarantee or ensure the fair presentation of financial statements. There
exists some risk that the financial statements are not fairly stated even when the opinion
is unqualified or unmodified.
Materiality

Materiality refers to the amount by which a set of financial statements could be misstated
without affecting the judgment of reasonable person. It also refers to the magnitude of an
omission or misstatement of accounting information that, in the light of surrounding
circumstances make is probable that the judgment of a reasonable person relying on that
information would have been changed or influenced by the omission or misstatement.

One of the auditor's first tasks in planning an audit is to make a judgment about just how
big a misstatement would have to be before it would significantly affect users' judgments.
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.

The focus of this definition is on the users of the financial statements. In planning the
engagement, the auditor assesses the magnitude of a misstatement that may affect users'
decisions. This materiality assessment helps the auditor determine the nature, timing, and
extent of audit procedures used to collect audit evidence.

Audit Risk

The second major concept involved in auditing is audit risk, which is the risk that the
auditor may mistakenly give a "clean" opinion on financial statements that are materially
misstated.

Audit risk is the risk that the auditor mistakenly expresses a clean audit opinion when the
financial statements are materially misstated.

Auditing standards make it clear that an audit provides "reasonable assurance " that the
financial statements do not contain material misstatements. The phrase "reasonable
assurance" implies that even when the auditor does a good job, there is some risk that a
material misstatement could be present in the financial statements and the auditor will fail
to detect it. The auditor plans and conducts the audit to achieve an acceptably low level of
audit risk. The auditor controls the level of audit risk through 'the effectiveness and extent
 190 7
of the audit work conducted. The more effective and extensive the audit work (and thus the
type and amount of audit evidence collected), the lower the risk that a misstatement will
go undetected and that the auditor will issue an inappropriate report.

Audit Evidence Regarding Management Assertions

The third concept involved in auditing is evidence regarding management's assertions, or,
more simply, audit evidence. Most of the auditor's work in arriving at an opinion on the
financial statements consists of obtaining and evaluating audit evidence relating to
management's assertions. Audit evidence consists of the underlying accounting data and
any additional information available to the auditor, whether originating from the client or
externally.

The assertions, in conjunction with assessment of materiality and audit risk, are used by
the auditor to determine the nature, timing, and extent of evidence to be gathered. Once the
auditor has obtained sufficient appropriate evidence that the management assertions can be
relied upon for each significant account and disclosure, the auditor has reasonable
assurance that the financial statements are fairly presented. Note the two key descriptors of
audit evidence: sufficient and appropriate.

The sufficiency of audit evidence simply refers to the quantity of evidence the auditor
obtains — does the auditor have enough evidence to justify a conclusion as to whether
management's assertions are fairly stated? The appropriateness of audit evidence refers to
whether the evidence is relevant and reliable. Relevance refers to whether the evidence
relates to the specific management assertion being tested. Reliability refers to the
diagnosticity of the evidence.

While the auditor has a professional responsibility to obtain "sufficient appropriate

evidence", the auditor seldom has the luxury of obtaining completely convincing evidence
about the true state of particular management assertion. In most situation, the auditor is
able to obtain only persuasive evidence that the assertion is fairly stated.

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:
 Introduction to Financial Statement Audit 191
(a) independence;
(b) integrity;
(c) objectivity;
(d) professional competence and due care;
(e) confidentiality;
(O professional behavior, and
(g) technical standards.

The auditor should conduct an audit in accordance with Philippine Standards on Auditing.
These contain basic principles and essential procedures together with related guidance in
the form of explanatory and other material.

The auditor should plan and perform the audit with an attitude of professional skepticism
recognizing that circumstances may exist which cause the financial statements to be
materially misstated. For example, the auditor would ordinarily expect to find evidence to
support management representations and not assume they are necessarily correct.

Reasonable Assurance

An audit in accordance with Philippine Standards on Auditing (PSAs) is designed to

provide reasonable assurance that the financial statements taken as a whole are free
from material misstatement. Reasonable assurance is a concept relating to the
accumulation of the audit evidence necessary for the auditor to conclude that there
are no material misstatements in the financial statements taken as a whole.
Reasonable assurance relates to the whole audit process.
However, there are inherent limitations in an audit that affect the auditor's ability to detect
material misstatements. These limitations result from factors such as:

• The use of testing.

• The inherent limitations of any accounting and internal control system (for
example, the possibility of collusion).
• The fact that most audit evidence is persuasive rather than conclusive.
Also, the work undertaken by the auditor to form an opinion is permeated by judgment, in
particular regarding:
 192 7
(a) the gathering of audit evidence, for example, in deciding the nature. timing and
extent of audit procedures; and
(b) the drawing of conclusions based on the audit evidence gathered, for example
assessing the reasonableness of the estimates made by management in preparing
the financial statements.

Further, other limitations may affect the persuasiveness of evidence available to draw
conclusions on particular financial statement assertions (for example, transactions
between related parties). In these cases, certain PSAs identify specific procedures which
will, because of the nature of the particular assertions, provide sufficient appropriate audit
evidence in the absence of:

(a) unusual circumstances which increase the risk of material misstatements beyond
that which would ordinarily be expected; or
(b) any indication that a material misstatement has occurred.

Responsibility for the Financial Statements

While the auditor is responsible for forming and expressing an opinion on the financial
statements, the responsibility for preparing and presenting the financial statements is that
of the management of the entity. The audit of the financial statements does not relieve
management of its responsibilities.

Skills and Knowledge Needed in Financial Statement Audit

Audits are performed in teams where each auditor is expected to complete tasks requiring
considerable technical knowledge and expertise, along with leadership, teamwork, and
professional skills. In terms of technical knowledge and expertise, auditors must
understand accounting and auditing authoritative literature,
 Introduction to Financial Statement Audit 193

develop industry and client-specific knowledge. develop and apply computer skills.
evaluate internal controls, and assess and respond to fraud risk.

In terms of leadership, teamwork, and professional skills, auditors make

presentations to management and audit committee members, exercise logical
reasoning, communicate decisions to users, manage and supervise others by
providing meaningful feedback, act with integrity and ethics, interact in a team
environment, collaborate with others, and maintain a professional personal
presence. While external auditors at all types of audit firms need these skills, the
work environment at larger versus smaller audit firms differs.

Parties Involved In Preparing and Auditing Financial Statements

Various parties are involved in the preparation and audit of financial Statements
and related disclosures. Management has responsibilities for (a) preparing and
presenting financial statements in accordance with the applicable financial
reporting framework; (b) designing, implementing and maintaining internal
control over financial reporting; and (c) providing the auditors with information
relevant to the financial statements and internal controls. The internal audit
function provides management and the audit committee with assurance on internal
controls and repots. The audit committee, a subcommittee of the organization's
board of directors, oversees both management and the internal auditors, and they
also hire the external auditor.

The external auditor's job is to obtain reasonable assurance about whether

management's statements are materially accurate and to provide a publicly

available report. External auditors conduct their procedures and make judgments
in accordance with professional standards. The audited financial statements are
provided to users who have an interest in the organization.

The Context of Financial Statement Auditing

You have already learned about different kinds of auditors and audit services,
public accounting firms, and the auditor's role in society. Now let us turn our
attention to the primary context that shapes the external auditor's environment: the
business or entity being audited.
 194 Chapter 7

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.

Relating the Audit Process Components to the Business Model

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

In a simple business model, management, with guidance and direction from the board of
directors, decides on a mission, what can be translated into a set of objectives along with
the strategies designed to achieve those objectives. The organization must assess and
manage risks that may threaten the achievement of its objectives. The organization then
undertakes certain processes in order to implement its strategies.

Most businesses establish processes that fit in broad business process categories, also
known as business cycles. The five categories that characterize the processes of most
businesses are

l. Revenue and collection cycle

2. Purchases and disbursement cycle
3. Payroll

4. Inventory Warehousing Transaction

5. Financing Process

Each business process involves a variety of important transactions.

The enterprise designs and implements, accounting information system to capture the
details of those transactions. It also designs and implements a system of internal control to
ensure that the transactions are handled and recorded appropriately and that resources are
protected.
 Introduction to Financial Statement Audit 195

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.

REVIEW QUESTIONS

Questions

1. Define auditing. Explain the basic objective auditing as

provided for in PSA 120 "Framework of Philippine
Standards on Auditing".

2. In the conduct of audits of financial statements it would be a serious breach

of responsibility if the auditor did• not thoroughly understand accounting.
However, many competent accountants do not have an understanding of
the auditing process, What causes the difference?

3. Discuss the major factors in today's society that have made the need for
independent audits much greater than it was fifty years ago.

4. Identify the major causes of information risk and identify the three main
ways information risk can be reduced. What are the advantages and
disadvantages of each?

5. Explain what is meant by information risk and discuss the four causes Of
this risk.

6. Discuss the three primary ways users of information can reduce

information risk.

7. Discuss four factors that are likely to significantly reduce informati011 risk
in the next five to ten years.
 196 Chapter 7

8. Explain the relationship between accounting and auditing.

Multiple Choice Questions

1. Which of the following is a principle underlying an audit conducted in accordance

with generally accepted auditing standards?
a. The audit provides reasonable assurance the client will remain in
business for at least one year.
b. The audit report expresses an opinion on whether the financial statements are
free of material and immaterial misstatement.
c. Auditors are responsible for, among other things, maintaining
professional objectivism, exercising professional engagement, and
obtaining appropriate documentation.
d. An auditor's opinion enhances the degree of confidence that intended users
can place in the financial statements.

2. Audits of financial statements are designed to obtain reasonable assurance of

detecting misstatement due to:
Fraudulent Financial Reporting Misappropriation of Assets
A. Yes Yes
B. Yes No
C. No Yes
D. No No

a. Option A c. Option C
b. Option B d. Option D

3. An audit provides reasonable assurance of detecting which of the following

types of material illegal acts?
Direct Effect Without a Direct Effect
A. Yes Yes
B. Yes No
C. No Yes
D. No No

a. Option A c. Option C
b. Option B d. Option D
 Introduction to Financial Statement Audit 197

4. An attitude that includes a questioning mind, being alert to conditions that

may indicate possible misstatements, and a critical assessment of audit
evidence is referred to as:
a. Reasonable assurance. c. Audit neutralism.
b. Professional skepticism. d. Auditing mindset.

5. A set of criteria used to determine measurement, recognition, representation,

and disclosure of all material items appearing in the financial statements is
referred to as a(n)
a. Financial reporting framework.
b. Public Company Accounting Oversight Board Criteria.
c. Quality control presentation standard.
d. Special purpose audit standard.

6. An audit should be designed to obtain reasonable assurance of detecting material

misstatements due to:
a. Errors.
b. Errors and fraud.
c. Errors, fraud, and noncompliance with laws with a direct effect on
financial statement amounts and others.
d. Errors, fraud and noncompliance with all laws.

7. Which of the following is accurate, as indicated in the principles underlying an

audit?
a. Management is expected to provide the auditors with all needed
evidence prior to the beginning of audit work.
b. An auditor is unable to obtain absolute assurance that the financial
statements are free from material misstatement.
c. Auditors are responsible for having appropriate competence to perform
the audit without the assistance of outside specialists.
 198 Chapter 7

d. Management is responsible for preparing accurate financial

statement amounts, while auditors are responsible for auditing those
amounts and for preparing note disclosures related to those amounts.

8. Which of the following is not an underlying premise of an audit?

a. Management must provide the auditor with all information relevant to the
preparation and fair presentation of the financial statements.

b. Management and the auditors have responsibility for the preparation of

financial statements in accordance with the applicable financial
reporting framework.
c. Where appropriate, the auditor may obtain information from
those charged with governance.
d. The auditors should be provided unrestricted access to those within the
entity from whom the auditor determines it necessary to obtain audit
evidence.

9. By definition, proper professional skepticism on an audit requires:

Questioning mind Subjective assessment of audit evidence

A. No No
B. No Yes
C. Yes No
D. Yes Yes

a. Option A c. Option C
b. Option B d. Option D
Case
Case 1
Joe Ramos a college student majoring in accounting, helped finance his education with
a part-time job maintaining all accounting records for a small business, Red Company,
located near campus. Upon graduation, Ramos passed the CPA examination and joined
the audit staff of a CPA firm. However, he continued to perform all accounting work
for Red Company during his "leisure time." Two years later, Ramos received his CPA
certificate and decided to give up his part-time work with Red Company. He noticed
Red that he would no longer be available after preparing the year-end financial
statements.
 Introduction to Financial Statement Audit 199

On January 7, Ramos delivered the annual financial statements as his final act for Red
Company. The owner then made the following request: "Joe, I am applying for a
substantial bank loan, and the bank loan officer insists upon getting audited financial
statements to support my loan application. You are now a CPA, and you know
everything that's happened in this company and everything that's included in these
financial statements, and you know they give a fair picture. I would appreciate it if you
would write out the standard audit report and attach it to the financial statements. Then
I'll be able to get some fast action on my loan application."

Required:
a. Would Ramos be justified in complying with Red's request for an auditor's opinion?
Explain.
b. If you think Ramos should issue the audit report, do you think he should first
perform an audit of the company despite his detailed

knowledge of the company's affair? Explain.

c. If Red had reqeested an audit by the national CPA firm for which Ramos worked,
would it have been reasonable for that firm to accept and to assign Ramos to
perform the audit? Explain.