Introduction to Audit and Audit Standard Setting Process

References:
a. Preface to the International Standards and Philippine Standards
b. PSA 200 (Revised and Redrafted), Overall Objectives of the Independent Auditor
and the Conduct of an Audit in Accordance with Philippine Standards on Auditing

Auditing Defined
• An audit is a systematic process of objectively obtaining and evaluating evidence
regarding assertions about economic actions and events to ascertain the degree of
correspondence between these assertions and established criteria, and communicating
the results to interested users.

Key Concepts from the Definition of Auditing

• An audit is a systematic process.
• An important element of auditing is objectivity (independence).
• An audit involves both an investigative and a reporting process.
§ Investigative wherein an auditor evaluates evidence to ascertain the degree of
correspondence between economic assertions and established criteria.
§ Reporting, because an audit involves communicating the results to interested users
through the audit report.

Distinctions
Audit vs. Assurance engagements
• Scope of service. Assurance engagements are broader than auditing. Assurance
engagements encompass assertion-based assurance engagements which encompass
audit engagements.

Audit vs. Accounting

• Accounting involves the process of recording financial transactions pertaining to an
entity and preparing the related financial statements while an audit involves examining
the financial reports produced by an entity’s accounting system to ascertain whether
those financial reports conform with the established criteria.

Types of Audits
• As to objective, criteria, and subject matter:
a. Financial statements audits.
b. Operational or performance audits. This type of audit can be divided into two types:
§ Economy and efficiency (Management) audit— The appraisal of management
performance from the most efficient point of view, i.e., cost benefit analysis.
§ Effectiveness (Program results) audit—The evaluation of programs, projects, and
activities to determine the extent of achievement of previously set goals and objectives.
c. Compliance audits.
• As to auditor:
a. External (Independent) audits—These are audits performed by CPAs who are
independent of the organizations whose assertions is the subject matter of the audit.
External auditors usually perform financial statement audits but may also perform
operational and compliance audits.
b. Internal audits—Internal auditing is an independent, objective assurance and
consulting activity designed to add value and improved an organization’s operations.
Internal auditors cannot achieve the same level of independence as with external auditors
because internal auditors are usually employed by the entity they audit.
 However, organizational independence by internal auditors can be maximized when they
have direct access to the audit committee or board of directors of the entity. Internal audits
mainly comprise operational and compliance audits.
c. Governmental (State) audits—Government auditing involves the determination of
whether government funds are being handled properly and in compliance with the
applicable laws and regulations, and whether the government programs of a particular
agency are conducted effectively and efficiently. Governmental auditors can perform
financial statements audit, operational audit and compliance audit.

Nature of Independent financial statements Audit

• Audit engagement of financial statements is a reasonable assurance engagement in
which a professional accountant in public practice expresses an opinion whether financial
statements are prepared, in all material respects, in accordance with an applicable
financial reporting framework, such as an engagement conducted in accordance with
PSAs.
• Financial statements audit is an assurance engagement as it enhances the degree of
confidence that intended users can place in the financial statements. Also, it is an
example of assertion-based assurance engagement since the financial statements are
assertions by management that these are fairly stated in all material respects.

The following table compares the different types of audits as to their objective, subject
matter and criteria:

Types Examples Objectives Subject Criteria

Matter
Financial Annual audit of Conducted to determine Financial Applicable
Statements SMC whether the financial statements financial
Audit financial statements are stated in reporting
statements accordance with specified framework
criteria (GAAP)

Operational Evaluate Evaluates the efficiency and Operation of Company

Or whether effectiveness of any part of an computerized standards
Performance the organization’s operating payroll for efficiency
Audit computerized procedures and system and
payroll system is methods. At the completion of effectiveness
operating an operational audit,
effectively management normally
and efficiently expects recommendations from
the auditor for improving
operations.

Compliance Determine Conducted to determine Bank loan Loan agreement

Audit whether whether the continuation provisions
bank auditee is following specific requirement
requirements procedures,
for loan rules, or regulations set by
continuation some higher
have been met authority.
Assertions of Financial Statements
• Assertions are representations by management, explicit or otherwise, that are embodied
in the financial statements.
• The three categories of assertions are as follows:
A. Classes of transactions and events (COCAC)
1. Occurrence—transactions and events that have been recorded have occurred and
pertain to the entity.
2. Completeness—all transactions and events that should have been recorded have been
recorded.
3. Accuracy—amounts and other data relating to recorded transactions and events have
been recorded appropriately.
4. Cutoff—transactions and events have been recorded in the correct accounting period.
5. Classification—transactions and events have been recorded in the proper accounts.

B. Account balances (RCEV)

1. Existence—assets, liabilities, and equity interests exist.
2. Rights and obligations—the entity holds or controls the rights to assets, and liabilities
are the obligations of the entity.
3. Completeness—all assets, liabilities and equity interests that should have been
recorded have been recorded.
4. 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 appropriately recorded.

C. Presentation and disclosure (COCA)

1. Occurrence and rights and obligations— disclosed events, transactions, and other
matters have occurred and pertain to the entity.
2. Completeness—all disclosures that should have been included in the financial
statements have been included.
3. Classification and understandability—financial information is appropriately presented
and described, and disclosures are clearly expressed.
4. Accuracy and valuation—financial and other information are disclosed fairly and at
appropriate amounts.

Scope of Independent Financial Statements Audit

• The auditor shall exercise professional judgment in determining the scope of the audit
and consider the requirements of the relevant legislations, regulations, and professional
standards.
• Under PSA 200, the auditor’s opinion on the financial statements deals with whether the
financial statements are prepared, in all material respects, in accordance with the
applicable financial reporting framework. The auditor’s opinion therefore does not assure,
for example, the future viability of the entity nor the efficiency or effectiveness with which
management has conducted the affairs of the entity.

Demand for Independent Financial Statements Audit

• The need for independent financial statements audit arises from the importance of
reducing information risk. Users depend on reliable information in making important
decisions. Decisions made based on unreliable information could have adverse financial
consequences. Users, therefore, turn to the expertise of the auditor who provides an
unbiased opinion on the fair presentation of financial statements through the auditor’s
report.
• Causes of information risk are the following:
§ Conflict of interest between management and users of financial statements (potential
bias)
§ Remoteness between a user and the organization
§ Voluminous data
§ Complexity of the transactions, information, or processing systems
Theoretical Framework of Financial Statements
Auditing
• Financial Statements audit, to be effective, should work based on the following basic
assumptions:
a. Data to be audited can be verified
b. Independence
c. No long-term conflict between the auditor and the management
d. Effective internal control system reduces risk of material misstatement of the financial
statements
e. Consistent application of GAAP results to fair presentation
f. What was held true in the past will continue to hold true in the future in the absence of
known conditions to the contrary
g. An audit benefits the public

The Auditor’s Overall Objectives—Obtaining

Reasonable Assurance, Reducing Audit Risk
• In the audit of financial statements, the overall objectives of the auditor are:
§ To obtain reasonable assurance whether the financial statements are free from material
misstatement, whether due to fraud or error, to enable 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 (FRF); and
§ To report on the financial statements and communicate as required by the Philippine
Standards on Auditing (PSAs), in accordance with the auditor’s findings.
• The audit is conducted to obtain reasonable assurance, which is a high, but not absolute,
level of assurance. The auditor cannot provide absolute assurance because of certain
inherent limitations of audit. Therefore, there is always some audit risk in any audit
engagement.
• To achieve the above objectives, the auditor shall perform audit procedures to gather
sufficient appropriate audit evidence about assertions embodied in the financial
statements; and thereby, reduce audit risk to an acceptably low level that enables the
auditor to draw reasonable conclusions on which to base the auditor’s opinion.
• Audit risk is the risk (or likelihood) that the auditor gives an inappropriate audit opinion
when the financial statements are materially misstated. It should be noted that audit risk
does not include the risk that the auditor might express an opinion that the financial
statements are materially misstated when they are not. This risk is ordinarily insignificant.
Further, audit risk is a technical term related to the process of auditing; it does not refer
to the auditor’s business risks such as loss from litigation, adverse publicity, or other
events arising in connection with the audit of financial statements. These other risks are
called engagement risks.

Audit Risk Model

• Audit risk is a function of the risks of material misstatement and detection risk [AR =
f(ROMM x DR)]. The risk of material misstatement refers to the likelihood that the financial
statements are materiality misstated prior to the audit; while detection risk is the risk that
the procedures performed by the auditor to reduce audit risk to an acceptably low level
will not detect a misstatement that exists and that could be material, either individually or
when aggregated with other misstatements. Therefore, risks of material misstatement are
the function of the entity, its environment, and its internal control, while detection risk is
therefore the function of the effectiveness of auditor’s audit procedures.
• In other words, audit risk may occur when the auditor expresses an inappropriate opinion
stating that the financial statements are fairly stated when in fact they are not.

This could occur when the financial statements already are materially misstated even
before the auditor begins the audit, and the auditor fails to detect these material
misstatements leading the auditor to express an inappropriate opinion. For this reason,
the auditor must focus on—as a risk-based audit approach— addressing these risks of
material misstatement of the financial statements to effectively conduct the audit and
avoid audit risk from occurrence.
• For a given level of audit risk, the acceptable level of detection risk bears an inverse
relationship to the assessed level of risk of material misstatement. The higher the
assessed level of risk of material misstatement, the lower the detection risk the auditor
sets, and vice versa.
• Therefore, from the given relationship above, detection risk cannot be set to zero (given
that there is always risk of material misstatement).

AASC Pronouncements
The Auditing and Assurance Standards Council’s (AASC’s) mission is “the promulgation
of auditing standards, practices and procedures which shall be generally accepted by the
accounting profession in the Philippines.” The AASC replaced the Auditing Standards and
Practices Council (ASPC), which was established by the PICPA and ACPAPP. It has 15
regular members coming from the following in accordance with the IRR to RA 9298 or the
Philippine Accountancy Act of 2004:

No. of Members
Chairman 1
Board of Accountancy 1
Securities and Exchange Commission 1
Bangko Sentral ng Pilipinas 1
Commission on Audit 1
Association of CPAs in Public Practice 1
PICPA
Public Practice 6
Commerce and Industry 1
Academe/Education 1
Government 1
Total 15

However, per PRC BOA Resolution No. 22 Series of 2020, the BOA unanimously agreed
that the membership in the AASC be increased from fifteen (15) to eighteen (18) to include
two (2) representatives from the small and medium sized practitioners, a representative
from the Insurance Commission, and remove the representative from government. The
PRC BOA Resolution was dated July 1, 2020 and was published in official gazette on
July 9, 2020. Hence, the updated structure of the AASC is as follows:

No. of Members
Chairman 1
Board of Accountancy 1
Securities and Exchange Commission 1
Bangko Sentral ng Pilipinas 1
Insurance Commission 1
Commission on Audit 1
Association of CPAs in Public Practice 1
PICPA
Public Practice 6 9
Commerce and Industry 1 1
Academe/Education 1 1
Total 18
The AASC pronouncements are listed below together with the particular engagements
they are applicable to:

PHILIPPINE STANDARDS ON QUALITY CONTROL (PSQCs)

• PSQC 1, Quality Control for Firms that Perform Audits and Reviews of Financial
Statements, and Other Assurance and Related Services Engagements

AUDITS OF HISTORICAL FINANCIAL INFORMATION

200–299 General Principles and Responsibilities
• PSA 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in
Accordance with PSA
• PSA 210, Agreeing the Terms of Audit Engagements
• PSA 220, Quality Control for an Audit of Financial Statements
• PSA 230, Audit Documentation
• PSA 240, The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial
Statements
• PSA 250, Consideration of Laws and Regulations in an Audit of Financial Statements
• PSA 260, Communication with Those Charged with Governance
• PSA 265, Communicating Deficiencies in Internal Control to Those Charged with
Governance and Management
300–499 Risk Assessment and Response to Assessed Risks
• PSA 300, Planning an Audit of Financial Statements
• PSA 315 (Revised), Identifying and Assessing the Risks of Material Misstatement
• PSA 320, Materiality in Planning and Performing an Audit
• PSA 330, The Auditor’s Responses to Assessed Risks
• PSA 402, Audit Considerations Relating to an Entity Using a Service Organization
• PSA 450, Evaluation of Misstatements Identified during the Audit
500-599 Audit Evidence
• PSA 500, Audit Evidence
• PSA 501, Audit Evidence—Specific Considerations for Selected Items
• PSA 505, External Confirmations
• PSA 510, Initial Audit Engagements—Opening Balances
• PSA 520, Analytical Procedures
• PSA 530, Audit Sampling
• PSA 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates,
and Related Disclosures
• PSA 550, Related Parties
• PSA 560, Subsequent Events
• PSA 570, Going Concern
• PSA 580, Written Representations
600–699 Using the Work of Others
• PSA 600, Special Considerations—Audits of Group Financial Statements (Including the
Work of Component Auditors)
• PSA 610, Using the Work of Internal Auditors
• PSA 620, Using the Work of an Auditor’s Expert
700-799 Audit Conclusions and Reporting
• PSA 700, Forming an Opinion and Reporting on Financial Statements
• PSA 701, Communicating Key Audit Matters in the Independent Auditor’s Report
• PSA 705, Modifications to the Opinion in the Independent Auditor’s Report
• PSA 706, Emphasis of Matter Paragraphs and Other Matter Paragraphs in the
Independent Auditor’s Report
• PSA 710, Comparative Information—Corresponding Figures and Comparative Financial
Statements
• PSA 720, The Auditor’s Responsibilities Relating to Other Information in Documents
Containing Audited Financial Statements

800–899 Specialized Areas

• PSA 800, Special Considerations—Audits of Financial Statements Prepared in
Accordance with Special Purpose Frameworks
• PSA 805, Special Considerations—Audits of Single financial statements and Specific
Elements, Accounts or Items of a financial statement
• PSA 810, Engagements to Report on Summary Financial Statements

AUDITS AND REVIEWS OF HISTORICAL FINANCIAL INFORMATION

2000–2699 Philippine Standards on Review Engagements (PSREs)
• PSRE 2400 Engagements to Review Historical Financial Statements
• PSRE 2410 Review of Interim Financial Information Performed by the Independent
Auditor of the Entity

ASSURANCE ENGAGEMENTS OTHER THAN AUDITS OR REVIEWS OF

HISTORICAL FINANCIAL INFORMATION
3000–3699 Philippine Standards on Assurance Engagements (PSAEs)
• PSAE 3000 Assurance Engagements Other than Audits or Reviews of Historical
Financial Information
• PSAE 3400 The Examination of Prospective Financial Information
• PSAE 3402 Assurance Reports on Controls at a Service Organization
• PSAE 3410 Assurance Engagements on Greenhouse Gas Statements
• PSAE 3420 Assurance Engagements to Report on the Compilation of Pro Forma
Financial Information Included in a Prospectus

RELATED SERVICES
4000–4699 Philippine Standards on Related Services (PSRSs)
• PSRS 4400 Engagements to Perform Agreed-Upon Procedures Regarding Financial
Information
• PSRS 4410 Compilation Engagements
• The AASC’s Standards contain basic principles and essential procedures.
The Authority Attaching to Philippine Standards
• As set forth in the AASC’s Rules of Procedures, “pronouncements on generally accepted
auditing standards, interpretations, and opinions issued by the
AASC apply whenever an independent examination of financial statements of any entity,
whether profit oriented or not, and irrespective of size or legal form when such
examination is conducted for the purpose of expressing an opinion thereon. They may
also have application, as appropriate, to other related activities of auditors.”
• The nature of the Philippine Standards issued by the AASC requires professional
accountants to exercise professional judgment in applying them. In exceptional
circumstances, a professional accountant may judge it necessary to depart from a basic
principle or essential procedure of an Engagement Standard to achieve more effectively
the objective of the engagement. When such a situation arises, the professional
accountant should be prepared to justify the departure.
• Any limitation of the applicability of a specific Philippine Standard is made clear in the
standard.
The Authority Attaching to Practice Statements
• Philippine Auditing Practice Statements (PAPSs) are issued to provide interpretive
guidance and practical assistance to professional accountants in implementing
PSAs and to promote good practice. Philippine Review Engagement Practice Statements
(PREPSs), Philippine Assurance Engagement Practice Statements (PAEPSs), and
Philippine Related Services Practice Statements (PRSPSs) are issued to serve the same
purpose for implementation of PSREs, PSAEs and PSRSs, respectively.
• Professional accountants should be aware of and consider Practice Statements
applicable to the engagement. A professional accountant who does not consider and
apply the guidance included in a relevant Practice Statement should be prepared to
explain how the basic principles and essential procedures in the Engagement Standard(s)
addressed by the Practice Statement have been complied with.

Adoption of Auditing Standards and Statements

• It is the stated policy of the AASC to make the International Standards and Practice
Statements issued by the International Auditing and Assurance Standards
Board (IAASB) the applicable standards and practice statements in the Philippines. Other
PSAs or PAPSs may be issued when deemed necessary by the AASC to address any
unique requirements imposed by Philippine law or practice.
• An exposure draft (ED) is widely distributed to interested organizations and persons for
comment generally within 90 days. Issuance of ED requires approval by a majority of the
members of the Council. The comments and suggestions received are considered and
the ED is revised as appropriate.
• Issuance of final Philippine Standards and Practice Statements, as well as
interpretations, requires approval of at least ten members and submitted to the
PRC through the BOA for approval after which the pronouncements shall be published in
the Official Gazette. After publication, the AASC pronouncement becomes operative from
the effective date stated therein.