MODULE 2:

1. INTRODUCTION TO AUDIT

I. Pre-test / Activity
1. When the auditor is an employee of the organization being audited (auditee), the audit is
classified as an _____ audit.
A. internal C. compliance
B. external D. both A & B

2. Which of the following terms best describe the audit of a taxpayer’s return by a BIR auditor?
A. Operational audit C. Compliance audit
B. Internal audit D. Government audit

II. Learning Outcomes

At the end of the topic the students should be able to:
 Understand, and explain the nature, purpose and scope of audits
 Understand and explain the need of external audits in the corporate world
 Understand and enumerate the different major types of audits
 Understand and enumerate the different types of auditors

III. Content
NATURE, PURPOSE AND SCOPE OF AUDITS
Reliable information becomes an essential aspect of decision-making. However, in most instances,
this information is prepared and provided by other persons or organizations, whose interest
contradicts those of the users of the information. This situation created the need for an objective
evaluation of the information by an independent professional accountant. Such service is widely
known as an audit.
The primary objective of an audit function is to improve the quality of or lend credibility to the
information prepared by a particular entity. This objective is met through the expression of an opinion
that provides users with reasonable assurance that the subject matter of the audit service is free from
material misstatements. Such opinion is then communicated to the users through an audit report.
Attachment of the audit report to the subject matter of an audit engagement means that the information
can be relied upon by the users.

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
those assertions and established criteria and communicating the results to interested
users. (American Accounting Association)

This definition contains several key elements.

1. A systematic process
Audit is composed of a logical, ordered, and structured series of steps and procedures.
Auditing standards require that auditors go to great lengths to plan and prepare for the audit.

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 Significant work is put into planning well in advance of performing any audit procedures.
Auditors follow this detailed plan, which is called an audit program, as they carry out the audit
procedures to obtain and evaluate evidence.

2. It involves objectively obtaining and evaluating evidence about assertions

Assertions are representations made by an audit client, explicit or otherwise about economic
actions and events. The auditor’s overall objective is to determine whether these assertions
are valid. In order to achieve this objective, the auditor obtains and evaluates relevant evidence
that will either corroborate or refute the assertions.

Objectivity requires the auditor to make an impartial assessment of all the relevant
circumstances in forming a conclusion. Auditors should not allow bias, conflict of interest or
the undue influence of others to override professional judgment.

3. It ascertains the degree of correspondence between assertions and established criteria

In order to meet the objective of an audit engagement, an auditor must be able to express an
opinion. To do that, the auditor uses criteria (standard or benchmark) to verify the validity of
the assertions prepared and presented by the audit client.

4. It includes communication of the results to interested users

After obtaining sufficient appropriate evidence, the auditor prepares a report which contain
an overall opinion. Such a report is then communicated to interested users in a timely manner.
This is considered to be the most important characteristics of an audit. Failure to communicate
the results will render the audit engagement useless.

Definition of Auditing

Independent Auditor

Following a systematic process

Objectively obtains and evaluates evidence

Establishes the degree of correspondence between

Assertions Established
Criteria

Communicates the results to interested users

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Theoretical Framework of Auditing
The audit function operates within a theoretical framework. Below are selected postulates,
assumptions or ideas that support many auditing concepts and standards.

1. Audit function operates on the assumption that all financial data are verifiable
All balances reported in the financial statements must have supporting documents or evidence
to prove their validity. If no evidence exists in relation to the financial statements on which
an auditor is to express an opinion, then there can be no audit to perform.

2. The auditor should always maintain independence with respect to the financial
statements under audit
Independence is essential for ensuring the credibility of the auditor’s report. The report of the
auditor will be of little or no value to the readers of the financial statements if the readers are
aware that the auditor is not independent with respect to the client.

3. There should be no long-term conflict between the auditor and the client management
Short-term conflicts may exist regarding the application of auditing procedures and
accounting principles, but in the end, both the auditor and the management must be interested
in the fair presentation of the financial statements.

4. Effective internal control system reduces the possibility of material misstatements of the
financial statements
The condition of the entity’s internal control system directly affects the reliability of the
financial statements. The stronger the internal control is, the more assurance it provides about
the reliability of the accounting data and financial statements.

5. Consistent application of the applicable financial reporting framework such as the PFRS
result in fair presentation of financial statements
Auditors often use different criteria to evaluate the validity of an assertion. In the case of a
financial statement audit, the criteria are usually the financial reporting frameworks which
could be the PFRS, PFRS for Small and Medium-sized Entities, or PFRS for Small Entities.

It is assumed that fair presentation is achieved when the applicable financial reporting
framework is applied. Hence, any deviation from the specific requirements of the framework
would render the financial statements materially misstated.

6. What was held in the past will continue to hold true in the future in the absence of known
conditions to the contrary
Experience and knowledge accumulated from auditing a client in prior year can be used to
determine the appropriate audit procedures that need to be performed.

7. An audit benefit the public

Financial statements are ordinarily prepared and presented in order to meet the common
information needs of a wide range of users. These users who rely on the financial statements

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 as their major source of information are the primary beneficiary of the financial statement
audit.

THE NEED FOR EXTERNAL AUDITS

The need for an independent audit of financial statements stems from the following interrelated
sources:

1. Conflict of interest between management and users of financial statements

In a sense, financial statements may be viewed as a report by management as to how the entity
performed under their direction and supervision. Managers are frequently placed in positions
where they can benefit by providing outside parties with overly optimistic or even false
financial information. Outside parties, however, want unbiased, realistic financial statements.
Recognizing this inherent conflict of interest, users of financial statements have become
skeptical of unaudited financial statements.

2. Expertise
The complexity of accounting and auditing requires expertise in verifying the quality of the
financial information. Since most of the users of financial information are not equipped with
the necessary skills and competence to determine whether the financial statements are reliable,
a qualified person is hired by users to verify the reliability of the financial statements on their
behalf.

3. Remoteness
Users of financial information are usually prevented from directly assessing the reliability of
the information. Most of the users do not have access to the entity’s records to personally
verify the quality of the financial information. Consequently, an independent auditor is needed
to assist them in verifying the reliability of the financial information.

4. Financial consequences
Misleading financial information could have substantial economic consequences for a
decision maker. It is therefore important that financial statements be audited first before they
are used for making important decisions.

MAJOR TYPES OF AUDITS

Based on the nature of assertion or data, there are three major types of audit, namely financial
statement, operational and compliance audits.

1. Financial statement audit

A type of audit pertaining to the gathering of evidence on the assertions embodied in the
financial statements of an entity to determine whether the financial statements are fairly
presented in accordance with generally accepted accounting principles or another
comprehensive and authoritative financial reporting framework. The results of this type of
audit are for the use of external users.

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 2. Operational audit
A type of audit involving a systematic review of the organization’s activities in relation to
specified objectives for the purpose of assessing the performance, identifying opportunities
for improvement, and developing recommendations for improvement or further action. Also
known as management audit or performance audit.

3. Compliance audit
A type of audit involving the review of organization’s procedures to determine whether the
organization has adhered to specific procedures, rules, or regulations. The performance of a
compliance audit is dependent upon the existence of verifiable data and recognized criteria
established by an authoritative body.

DIFFERENT TYPES OF AUDITORS

Auditors can be classified according to their affiliation with the entity being examined.

1. External auditors
These are independent Certified Public Accountants (CPAs) who offer their professional
services to different clients on a contractual basis. It emphasizes that the auditor must not be
a member of the entity being audited.

2. Internal auditors
Internal auditors are entity’s own employees who investigate and appraise the effectiveness
and efficiency of operations and internal controls. The main function of internal auditors is to
assist the members of the organization in the effective discharge of their responsibilities.

3. Government auditors
These are government employees who main concern is to determine whether government
funds are being handled properly and in compliance with existing laws and whether programs
are being conducted efficiently and effectively. Can provide financial statements, operational
and compliance audits to public entities including government-owned and controlled
corporations (GOCCs).

Comparison of the different types of audit

Financial Statement Operational Compliance
Audit Audit Audit
Assertions Financial statements Operations are Activities complied with
are fairly presented conducted efficiency applicable laws, rules,
and effectively regulations, contracts, or
management policy
Suitable Philippine Financial Objective set by the Applicable contracts,
Criteria Reporting Standards management rules, regulations, laws,
(PFRSs) or any other or management policy
identified financial
reporting framework

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 Report An opinion on whether Report on efficiency and Degree of compliance
the financial statements effectiveness. This will with applicable laws,
are fairly presented in also include rules, regulations, or
conformity with an recommendations to management policy
identified financial improve operations
reporting framework
Generally
performed External auditors Internal auditors Government auditors
by

IV. Activity
Discussion Questions
1. What are the key concepts in the definition of auditing?
2. What are the main differences between a financial statement audit, operational audit, and
compliance audit?
3. Discuss the similarities between financial statement audits, operational audits, and compliance
audits.
4. To do an audit, it is necessary for information to be in a verifiable form and some criteria by
which the auditor can evaluate the information.
a. What information and criteria would an independent CPA firm use when auditing a
company’s historical financial statements?
b. What information and criteria would a Bureau of Internal Revenue auditor use when
auditing that same company’s income tax return?
c. What information and criteria would an internal auditor use when performing an
operational audit to evaluate whether the company’s computerized payroll processing
system is operating efficiently and effectively?

Multiple Choice Questions

1. One objective of an operational audit is to _____.
a. determine whether the financial statements fairly present the entity’s operations
b. evaluate the feasibility of attaining the entity’s operational objectives
c. make recommendations for improving performance
d. report on the entity’s relative success in attaining profit maximization

2. Which of the following types of audit uses laws and regulations as its criteria?
a. Operational audit
b. Financial statement audit
c. Compliance audit
d. Performance audit

3. Which of the following types of auditing is performed most commonly by CPA’s on a

contractual basis?
a. Internal auditing
b. Income tax auditing
c. Government auditing
d. External auditing

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4. An audit involves ascertaining the degree of correspondence between assertions and
established criteria. In the case of an audit of financial statements, which of the following
would be a valid criterion?
a. International Standard on Auditing
b. Philippine Standards on Auditing
c. Philippine Financial Reporting Standards
d. Quality Control Standards

5. Which of the following is more difficult to evaluate objectively?

a. Efficiency and effectiveness of operations
b. Compliance with applicable government regulations
c. Presentation of financial statements in accordance with the applicable financial
reporting criteria
d. All the given criteria are equally difficult to evaluate objectively

6. Internal auditing is an independent appraisal function established within an organization to

examine and evaluate its activities. To that end, internal auditing provides assistance to _____.
a. External auditors
b. Stockholders
c. Management and the board of directors
d. Government

7. Which of the following statements is not a distinction between external auditors and internal
auditors?
a. External auditors represent third party users, whereas internal auditors report directly
to management
b. Although external auditors strive for both validity and relevance of evidence, internal
auditors are concerned almost exclusively with validity
c. Internal auditors are employees of the auditee, whereas independent auditors are
independent contractors
d. The internal auditor’s span of coverage goes beyond financial auditing to encompass
operational and performance auditing

8. The auditor communicates the results of his or her work through the medium of the _____.
a. engagement letter
b. audit report
c. management letter
d. financial statements

9. An audit that involves obtaining and evaluating evidence about the efficiency and
effectiveness of an entity’s operating activities in relation to specified objectives is a(n) _____.
a. external audit
b. compliance audit
c. operational audit
d. financial statement audit

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