CHAPTER TWO

AUDITS OF FINANCIAL STATEMENTS: An Introduction

I. AUDITING DEFINED

Auditing

 American Accounting Association (AAA):

Auditing – 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.

 TWO PROCESSES: (IR)

o Investigation
 Systematic gathering and evaluation of evidence as a basis
for determining whether the assertions or representations
made by a RP in a company’s FS correspond with the
established financial reporting criteria such as GAAP.
o Reporting
 Communicating an evaluation or opinion in an audit to
interested users

A systematic process Logical sequence of procedures

objectively obtaining and evaluating Objectivity – combination of
evidence impartiality, intellectual honesty and
freedom from conflicts of interest
Evidence: oral representations,
electronic media, written docus
assertions about economic actions and Assertions – representations of mgmt,
events explicit or otherwise, are embodied in
FS components, records, or systems.
degree of correspondence between these Criteria – standards or benchmarks
assertions and established criteria
communicating the results to interested May written report sa opinion (or
users disclaimer of opinion) of the the CPA
II. AUDITING AND ACCOUNTING DISTINGUISHED

 Auditing is NOT a branch of accounting

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 Accounting
o Process of recording, classifying, summarizing economic events in a
logical manner for the purpose of providing financial information (ex:
FS) for decision making.
o A service activity
 Auditing
o Concerned if the info is reflected properly
o The auditor must possess not only an understanding of acctg rules but
also an expertise in the accumulation and interpretation of audit
evidence. (distinguishing chorva)

III. ASSURANCE SERVICES AND AUDIT SERVICES

DISTINGUISHED

 Assurance Services encompass Assertion-based Engagements

 Assurance Services
o One where a professional accountant will evaluate a subject matter
that is responsibility of another party against a suitable criteria, and
expresses an opinion which provides the intended users with a level of
assurance about that particular subject matter
o Giving assurance to users
 Both Assurance Services and Assertion-based Engagements encompass
audits
 All the 3 services follow the same process
 The difference of the 3 lies in the scope of services

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 Service Value Added to Info Reported on
Audit Engagements Reliability, Credibility
Assertion-based Engagements Reliability, Credibility
(attestation)
Assurance Engagements Reliability, Credibility, RELEVANCE,
TIMELINESS

IV. TYPES OF AUDITS

 Accdg to subject matter/ nature of data/ assertion being audited:
o FS audit
o Operational audit
o Compliance audit

TYPE ASSERTIONS CRITERIA REPORT

FS audit FS are fairly Identified fin Audit report
presented reporting
framework
Operational audit Operational / Mgmt. objectives Report on
performance data efficiency w/
constructive
suggestions
Users: mgmt. and
BOD
Compliance audit Compliance w/ laws & regulations Degree of
applicable laws & or mgmt policy compliance report
regulations or Users: mgmt. and
mgmt policy BOD

 accdg to the type of auditor performing in the engagement

o external audit
- by independent auditors or external auditors
o internal audit
- internal auditing staff reports to the audit committee of
BOD/ president/ high executive

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 o government audit (state audit)
 Commission on Audit
- Supreme audit institution in the PH
 3 main divisions:
1. COMPLIANCE AUDIT
 Laws and regulations
2. FINANCIAL AUDIT
 Reliability of recorded financial data
3. PERFORMANCE AUDIT
 Financial and operational performance
 ECONOMY & EFFICIENCY AUDIT
o Mgmt. audit
o Appraisal of mgmt.
performance from a least cost
pt of view & analysis of cost –
benefit relationship
 EFFECTIVENESS AUDIT
o Program results audit
o Evaluation of programs, projs,
activities (if naachieve goals)

V. THE OBJECTIVE AND SCOPE OF AN FS AUDIT

 OBJECTIVE: Express an opinion on the fairness of FS

Auditor’s report – medium (must indicate that it was made in
accordance with Philippine Standards on Auditing (PSA))
 SCOPE:
o The auditor normally determines the scope of an audit in accordance
with the requirements of the legislation, regulations or relevant
professional bodies
o The audit should be organized to cover adequately all aspects of the
entity as far as they are relevant to the FS being audited.

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 VI. INFORMATION RISK

Information risk – risk that the information is misstated or misleading

Factors:

1. Remoteness of information users from info providers

2. Potential bias and motives of info provider
3. Voluminous data
4. Complex exchange transactions

Approaches to reduce information risk:

1. Allow users to verify information

2. User shares information risk with the mgmt.
3. Have the FS audited

VII. THE AUDIT REPORT

Audit report – means through which the auditor provides reasonable assurance
that the FS are fairly stated.

 Uniform in format & suitably titled to avoid confusion

VIII. LIMITATIONS OF AN AUDIT

** Audit is NOT a guarantee of the exactness of accuracy of assertions in the FS

Enhancement lang ito sa confidence; No absolute assurance nga or certainty

INHERENT LIMITATIONS arising from:

1. The nature of financial reporting

2. The nature of audit procedures
3. The need for the audit to be conducted within a reasonable period of
time and at a reasonable cost
>>> audit is also necessarily limited by its SCOPE and OBJECTIVE.
The audit does not express matters an opinion on such matters as:
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 a. Future viability of entity
b. Efficiency or effectiveness sa affairs and
internal control
c. Extent of compliance w/ laws and
regulations that MAY BE applicable to
the entity

IX. HISTORY AND EVOLUTION OF AUDITING

 Early Mesopotamian Civilizations (Egypt, Babylonia)

o Scribes
o Audit function evidence: checkmarks, ticks, dots…
 The word audit (Latin term) = hearing, listening
 Ancient Greece and Rome
 Medieval and Renaissance Period
o Manorialism - organization of rural economy and society in medieval
western and part of central parts of Europe, characterized by vesting
of legal and economic power in a lord supported economically from
his own direct landholding and from the obligatory contributions of a
legally subject part of the peasant population under his jurisdiction.
o Auditor listens to the reading of the accounts together with the lord of
the manor
 EX: Auditor of the Exchequer in England in 1314
 EX: auditors of the Imprest (under Queen Elizabeth I) in
1559
 17th to 19th century
Commissioners for Auditing the Public Accounts (1780)
1834 >>> worked s/ exchequer
William Ewart Gladstone – chancellor of exchequer
Production of annual accounts: “appropriation accounts”
- Comptroller and Auditor General (C&AG)
o Two functions:
 Authorize issue of public money
 Audit gov’t depts. And report sa parliament
- Exchequer and Audit Department (E&AD)
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  The industrial revolution (1750 - 1850)
“Shareholder audits” – may stock dapat siya sa ino-audit na company
Independent auditor’s report was born
Audit sampling

 Early 20th century (1933 - 1940)

American focus: actual financial condition; audit sampling; “present fairly”
British: detection of fraud or error; detailed testing; “present true and fair
view”
 WWII upto 80’s (1940 onwards)
Audit sampling nalang
Internal checks = internal control
Computerized info sys
“systems-based auditing”
1972 – audit risk
 Today

RISK – BASED APPROACH

National Commission on Fraudulent Financial Reporting (the Treadway

Commission)

Internal control – integrated framework

 Enron & aftermath

PCAOB: Public Company Acctg Oversight Board – Sarbanes-Oxley Act of 2002

Or Public Company Acctg Reform and Investor Protection Act of 2002