Chapter 2

Overview of Auditing
 Philosophy of Audit

Users of the financial statements need reliable and credible

financial information. The process employed to establish
the reliability and unreliability of the financial statements
and supporting records is referred to as an audit
examination.

Auditing is a form of attestation. Attestation, in general

sense, refers to an “expert’s” communication about the
reliability of someone else’s assertion.
 Auditing Defined

Auditing is a systematic process by which a

competent, independent person objectively
obtains and evaluates evidence regarding
assertions about economic actions and events to
ascertain the degree of correspondence
between those assertions and established
criteria and communicating the results to
interested users.
 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 of
transaction 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 independence in mental attitude which
involves impartial and objective thinking.
Objectively obtains and evaluates evidence

This means examining the bases for the

assertions (representations) and
juridiciously evaluating the results without
bias or prejudice either for or against the
individual (or entity) making the
representations.
 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 generally
accepted accounting principles 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. 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.
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.”
 Objective 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.”
 Why Independent Auditing is Necessary
As society becomes more complex, there is an increased
likelihood that unreliable information will be provided to
decision makers referred to as “Information Risk”.

Some of the factors that contribute to information risk are:

a. Remoteness of information users from information
providers
b. Potential bias and motives of information provider
c. Voluminous data
d. Complex exchange transactions
 Remoteness of information users from information
providers

Decision makers, almost always, do not get first hand knowledge about
the business enterprise with which they do business for the reasons
that in many cases,

1. owners are divorced from management

2. directors are not divorced in day-to-day operations or decisions

3. business may be dispersed among numerous geographic

locations and complex structure
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.
 Voluminous data
As business 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.
 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.
 How Information Risk May Be Reduced
1. 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. 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 loss.

3. Have the financial statement 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 unbiased.
 Types of Audit
A. Financial Statements Audit
-also referred to as independent audit or external audit, involves the
examination of financial statements to determine whether they are stated
in accordance with specified criteria, namely generally accepted
accounting principles.
B. Operational Audit
-also known as management audits and performance audits are
examination of all or part of an organization for the purpose of determining
the effectiveness and/or efficiency of its operations.
C. Compliance Audit
- is performed to determine whether the auditee is following specific
procedures or rules set down by some higher authority. This may be
performed for a private business or a governmental unit. Results of
compliance audit are generally reported to someone within the
organization/unit being audited rather than a broad spectrum of users.
Activity: Watch the following videos:
1.“The Financial Statements Audit.flv” (3:45)
2.“The Difference Between Compliance Audit and Operational Audit” (1:44)
 Basic Characteristics of Financial Statements Audit
1. Auditors who perform financial statement audits are
independent of management and financial statement users.
2. Auditors base their opinions on a sample of the financial data
rather than on every item that makes up the financial
statements.
3. Auditors obtain reasonable assurance about whether the
financial statements are free of material misstatements. Auditors
are never absolutely certain that financial statements are
accurate.
4. Auditors express an opinion on the financial statements as a
whole and not on the individual items within financial
statements.
5. Auditors issue their report to a variety of financial statement
users.
 Characteristics of Operational Audit
1. Auditors performing the audit are independent of the activity they
audit.
2. The audit report is directed to an official or department within the
organization that employs the auditor.
3. The assertion is about the efficiency and effectiveness of the
performance of a specific activity.
4. The audit report frequently reports problems or deficiencies
identified during the audit rather than reporting an overall
conclusion.
Operational Management Performance Effectiveness Efficiency

- a focus on - the information - an evaluation - a measure of - is achieved by

operations, as obtained in the of the how well an minimizing the
opposed to audit process is performance of entity or unit of cost of
financial portion. useful to persons or units an entity accomplishing
management in in executing the achieves its an objective.
decision making. entity’s goals or
objectives. purpose.
 Characteristics of Compliance Audit

1. The party employing the auditor frequently

determines the item(s) audited and the
standards followed.
2. The auditors are on the payroll of the entity
interested in determining whether the standards
are being met.
3. The audit reports are directed to an official or
department within the organization that employs
the auditor.
 Types of Auditors
1. Certified Public Accounting Firm
CPA firms have as their primary responsibility the performance of audits of the
published historical financial statements of all publicly traded companies, most other
reasonably large companies and many smaller companies and noncommercial
organizations. Because of the widespread use of audited financial statements, it is
common to use the terms CPA firms, independent auditor, or auditor,
synonymously.
2. Internal Auditors
They are employees of individual companies who perform independent appraisal
activity within an organization such as review of accounting, financial and other
operations as a basis for service to management.
To be able to operate effectively, an internal auditor must be independent of the line
functions in an organization but he or she cannot be totally independent of the entity
as long as an employer-employee relationship exists.
3. Government Auditors
These include the Commission on Audit (COA) and the Bureau of internal Revenue
(BIR).
 Government Auditors
(a) COA Auditors
Government auditors from COA determine whether the government agencies and
other entities that use public funds:
(1) present their financial statements fairly in accordance with Financial Reporting
Standards and applicable laws and regulations,
(2) conduct the programs with economy and efficiency,
(3) desired results are achieved.

(b) BIR Examiners

BIR audits affect individuals as well as business. A form of compliance auditing, BIR
audits or examinations are designed to determine whether the taxpayers have
complied with the tax laws. These audits can be regarded solely as compliance
audits.
Auditing and Accounting Distinguished
Accounting is the process of recording, classifying and
summarizing economic events in a logical manner for the
purpose of providing financial information for decision
making.

Auditing is concerned with the determination of whether the

recorded accounting information for the entity properly
reflects the economic events that occurred during the
accounting period. An auditor must possess nor only an
understanding of the accounting rules but also expertise
in the accumulation and interpretation of audit evidence.
Activity: Watch a video on “Super CPA” – (2:41)