under audit. Joy notified the board -of directors about the” ie contributions, bt they refused to take any action because the amoun, involved were immaterial to the financal statements. Joy shout reconsider the intended degree of rence to be placed on the a. Letter of audit inquiry to the client's attorney: . 1b. Prior years’ audit programs Management representition letter a Preliminary judgment about materiality levels. f 99, Anvauditor who discovers that a client's employees have paid smal Dibes to public officals most likely would withdraw from he engagement if the 3 Ghent receives financal’asistance from various government agencies, bb. Beidence’ that is necessary to prove that the illegal acts were committed does not exist. Employees’ icons affect the suditor’s ability to sey oa management's representations 4 a. Notes to the financial statements fil to disclose the employes! © actions. 100, When planing the aut, ifthe auditor has 10 reason to believe tht ‘non-compliance exists, the auditor should 4 Incude audit procedures which have a strong probabilty of detecting non-compliance. b, Sail include ‘some audit procedures. designed .specificaly (© ‘uncover non-compliance. 4 ‘Ignore the topic ; a d Nate nga ‘of management regarding their poise Of tecttg and preventing on-compliance and. regarding th knowledge of violations, nd then ely on normal audit procelutt to detect errors, fraud, and ilegalities. a Chapter 4 THE AUDIT PROCESS © Accepting an Engagement ‘An audit of financial statements generilly begins with the financial statements prepared by the entity's management. Without these financial Statements, there can be no audit to perform. A general approach to auditing financial statements would ‘consideration of financial Statement assertions, audit procedures, and audit evidence before forming an audit opinion i General Approach 1o Auditing Financial Statements Financial Statement Assertions . Scanned with CamScannerFinancial statement assertions Management is responsible for the fair presentation of financial Statements that reflect the nature and operations of the entity. In representing that the financial statements ate in accordance with the applicable financial reporting framework, management implicitly or explicitly makes assertions regarding recognition, measurement, and presentation of classes of transactions and events, account balances and disclosures. The auditor uses these assertions 0 consider the different types of potential misstatements that may occur in the financial statements. - Financial statement assertions can be classified into: > Rights and obligation : Tee catty has rights over the reported assets and that it has valid obligation to settle the reported lables. An example of an audit procedure to test this assertion is to examine ownership, documents such as certificate of title for real property. > Valuation and allocation ae ‘That assets and lables are properly valued and that revenues and expenses are propecly measured. A typical auit procedure to test this assertion includes recaleulation of financial statement “values such as depreciation, accrued interest and amortized costs” of financial assets and liabilities. > Presentation and disclosure That assets and liabilities are. properly classified and that disclosures in the notes to the financial statements are adequate. “Testing this assertion will require the application of the relevant “accounting standatds: In dition’ the auditor may review majot contracts such as loan agreements to identify important information that needs to be disclosed in the notes to the financial ‘statements. 2 > Existence or gccurrence ‘That assets and lables exist is of the financial statement date snd that revenues and expenses’ occured during the reporting Period. One of the most effective audit procedures to test the existence of an asst isthe physical examination or ocular inspection, of the asset. In circumstances where physical examinations not feasible, the auditor may obtain evidence about the existence of asset through external confirmation. > Completeness ‘That all items that should be reported inthe financial statements are so included. A typical procedure to satisfy tig assertion is to start vith a source documents such as sales invoice and determine ifit is recorded inthe sales journal. . Existence and completeness emphasize two opposite audit concems. EBxistence/occurrence assertion is concemed with the potential overstatement of accounts while completeness assertion is concemed with potential understatement of accounts. When ‘designing audit procedures, the direction of test~is a crucial step in satisfying the ‘completeness or the existence/occutence assertions. - When the auditor traces items from the source documents to the ' acecunting records, the auditor is obtaining evideice that all transactions (as represented by thé source documents) have been’ completely recorded. On the other hand, when the auditor wots from »‘the’aécounting records back to the supporting documents, the auditor is obtaining evidence that the recorded items exist and are _ supported by documents Tracing forward from the sousce doiments to the accowsting records a performed primarily to test for understatement. This. procedure. wil satisfy the completeness assertion’ Iacdintast travng backwands w vouching is. ‘performed pamarily.: ict otter ‘to satisfy the cexistence/ocqyrrence assertion. It is patiormed’to: test for pessibhe ‘overstatement of an account. ~ is, Scanned with CamScannerSOURCE DOCUMENTS ACCOUNTING RECORDS Baistence/ Test for Completeness If overstatement Assertion ‘The PSA 500 chsifies the financial statement assertions according to the eategories ofthe financial statement affected: Aerins aout clas of wanzcton and events fo the esd 4 ‘under audit: > Occurrence - innsacion ed eet ta ave been corded have occured and pertain tothe entity. +», Completeness -alltransictics and events that should have been recorded have been recorded, , > Aecuracy ~ amounts snd ‘other data ‘eat recorded Sec heed pa 14 > Cutoff transactions and events have been recorded in the correct accounting period > Classification -transsetions and events have been recorded in the proper accounts. Assertions about account balances t the period end: 2D . Bxistence - assets labiltes, and equity interests exist, > Rights and obligations - the entity holds ot controls the rights to assets, and linbiities are the obligations of the entity. > - Completeness - all assets, liabilities and equity interests that should have been recorded are in fact recorded. > © Valuation and allocation - assets, liabilities, and equity interests are included in the financial statensé[Link] appropriate amounts 2nd any. resulting -valution -or. allocation “adjustments are appropriately recorded. "Asiertions about presentation and disclosure: > Occurrence and rights & obligations - disclosed events, transactions, and other iattérs have occured and pertain to the entity. e > Completeness - al disclosures that should have been included in the financial statements ae in fact included. > Classification and understandability - fiiancial information is appropriately presented and descbed, and dslonures are clearly expressed. >: ‘Accutacy anid valuation - financial and other information are disclosed faily and at appropriaté amounts 115 Scanned with CamScannersertions of may ries of ass ‘The auditor may use the above categories of steric’ 9: MY express them differently so long as sll aspects assertions have been covered, Audit procedures i is to det To ch ioe To a plsh this, auditors normally develop 4 fic audit objectives for each of the relevant assertions. These aves sere age © auditors in aressing NS sks of tal misstatement and in designing the appropriate audit ‘procedures to be performed. the app procedures, to satisfy @ particular Te eal Pe numberof factors inhading the auditors srreament of materiality and risk Regardless of the procedures teed, there is only one basic exterion. The procedures selected | thould enable the auditor to gather appropriate evidence about the validity of an assertion. i the validity of the financial ‘Some of the common audit procedures used by the auditor to gather = ‘sufficient appropriate evidence include: 1 Inspection- involve, examining of tecords, documents, of tangible assets. y 2.” Observation: consists of looking at a process or procedure being performed by others. 7 3. - Inquiry- consists’ of seeking. information from knowledgeable. ~ persons inside or outside the entity. 4. Confirmation: consists of the’ response’ to an inquiry” 10 ‘corroborate information contained inthe accounting fecotds. 5. Computation. consists of checking the arithmetical accuracy of source documents and accounting. records of performing independent calculation : : 6. "Analytical Procedures- consist of the analyis of significant ratios ad trends inchiding the resulting investigation of fluctuations and relationships that ae inconsistent with other relevant information cr deviate from predicted amounts. : Audit Evidence ‘Audit procedures afe the means used by the auditor to obtain sufficient appropriate evidence. Audit evidence refers to the information obtained by the auditor in arriving atthe conclusions on which the audit opinion is based. .Audit evidence will comprise source documents and accounting records underlying the financial statements’ and corroborating information from other éources. This evidence will ether prove or disprove the validity of the assertions made by management on the financial statements. } Audit Opinion ‘The results of the procedures performed and the audit evidenc obtained are carefully evaluated to arsive at the appropriate Opinio: + about the fair presentation of the financial statements. f° Scanned with CamScannerTHE AUDIT PROCESS Of the prospective client's financial statements. A preliminary ‘The audit process is the sequence of different activites involved in an understanding of the clicnt’s business and background audit. The emphasis and order of certain activities may vary depending investigation ofa prospective clint are usually performed at this ‘upon a particular audit, but this process would bisically include the Stage of the audit : following audit activities: 7 ‘The procedures performed at thi stage ofthe audit are referred to in PSA 300 as the “preliminary planning activites” and q would involve: ‘Steps in the Audit Process 4. Performing procedures regarding the continiance of the client relationship and the specific audit engagement; b. Evaluating compliance with ethical requirements, including independence; and Issuing a Report ©. Establishing an understanding of the terms of the engagement. one © Audit Planning In planning an audit, the auitor obtains more detailed knowledge about the client's business and industry. Knowledge of the client's Dbsiness and industry is important because it helps the auditor in understanding the transactions and events affecting the financial statements. In addition, such knowledge also helps in the early identification of the potential problems that might be ‘encountered in the audit. ‘The auditor's understanding of the client, combined with the’ assessment of risk and materiality, should enable the auditor to develop an overall audit plan and a detailed approach for the expected conduct and scope of the audit. = Considering the Internal Control £3. Accepting an Engagement 4 “The auditor is required to give adequate consideration to the cntty’s internal control because the condition of the entity’ internal contol directly affects the reliability of the financial ug “The firststep inthe audit process isto make a decision of whether to accept or reject an audit engagement. This process requites evaluation of the auditor’s qualification ‘as well as the auditability 11k Scanned with CamScannerstatements. ‘The stronger the internal control is) the more assurance it provides about the reliability of the accounting dat and the financial statements. i ves obtain Consideration of internal control _invol og understanding of the ens intemal contol <)sems and + assessing the level of contsol risk- that 4, the risk thatthe | lient’s internal control may not prevent or detect materia ‘misstatements in the financial statements. a Ifthe auditor decides to assess control isk a ess than high lve, saffcient appropiate adit evidence must be obtained 10 prove thatthe intemal contol is functioning effectively and that it can be relied on. This evidence can be obtained by performing tests of controls. Peforming Substantive Tests Based on the resits of audit planning and the consideration of internal contol, the auditor designs and performs substantive tests to obtain reasonable assurance that the financial statements axe presented futly in accordance with the applicable financal_ reporting framework Substantive tests are audit procedures designed to: detect material rnigstatements in the financial statements, ‘The nature, timing and extent of the substantive tests ate highly dependent on the resus of the auditor’ consideration of intemal control Ifbased onthe evaluation of internal control, the auditor has obtained evidence that the internal control is functoniog effectively; the scope of the. auditor’ substantive tests can De seduced. On the other hand, if the results of tests of control pro": ‘hat the’ intemal control is weak, the auditor. will have © ‘compensate for this weakness by performing more effective 4 catensive sabstanive procedares. 120 52 Completing the Audit ‘The auditor must have sufficient appropiate evidence in order to teach a conchuion on the faimess of che financial statements. After the auitor has completed testing the account balances, the auditor performs additional and procedures to comple the audit and become satisfied tha the evidence gatheredis consistent with the opinion to be expressed in auditor's report. Some of the common proceduses performed at this stage ofthe audit include review of subsequent events and contingencies, assessing the [Link] the use of the goiag concer assumption, performing overall analytical review procedures, and obtaining \wittea representations from the clien’s management. [2 Issuing a Report ‘On the bass of aut evidence gathered 2nd evahated, the auditor forms a conclusion about the financial ‘statements. This conclusion (in the form of an opinion) is communicated to various inteiested users through an audit report. © Accepting an Engagement ‘An important element of the firm’s quality control polices and” Procedures is «system for deciding whether to acept or reject an audit engagement. In making this decision, the firm should consider: B Tiscompetence; “> “Its independence; > Is ability to serve the client properly; > "The integrity of the prospective client's management; and The adequacy ofthe accounting records « 121 Scanned with CamScannerL 53 Competence One of the primary considerations before accepting an audit ‘engagement is to determine whether the auditor bas the necessary skills and competence to handle the engagement. According ty © the Code of Ethics, professional accountants should not portay themselves as having expertise which they do n0t possess, Competence i acquired through « combination of education, training and experience. Bef dit 9, the auditor should obtain a Sininay Knowledge of the chent’s business and industry to “uteemine whether the auditor has the degree of competence _ sequired by the engagement ot whether such competence can be ‘obtained before the completion of the audit. EE Independence ‘ 4 -Esiential to the credibility of the auditor’s report isthe concept. “independence. Before acepting an audit engagement, the auditor should consider whether there are any threats to the audit team’s independence and objectivity and, if so, whether adequate safeguards can be established. £2 Ability to serve the client properly Closely related to competence is the auditor's ability to serve the client properly. An engagement should not be accepted if thee ae no enough qualified personne to perform the audit. PSA 220 requires that audit work be assigned to pérsonnel who have the appropriate capabilites, competence and time to perform the audit engagement in accordance with the professional standards In addition, there should be sufficient direction, supervision review of work at all levels in order to provide’ reas0t assurance that the firm's standard of quality is maintained in ht performance of the engagement. a ™ © Integrity of management ‘The recent wave of litigation involving auditors has made pre- Acceptance investigation proceduses' very important. PSA 220 ‘equites the firm to conduct a background investigation of the prospective client in order to minimize the likeliiood of association with clients whose management lacks integrity. This task would involve: 1. Making inquiries of appropriate, parties in the business ‘community such as prospective client's banker, legal counsel, cf underwriter to obtain information about the reputation of the client. 2 Communicating with the predecessor auditor ‘Communication with predecessor auditor is aot only a matter of courtesy to the predecessor auditor. This communication allows the successor auditor to obtain information about ‘the client that will be useful in determining whether the ceagigement will be accepted, But before the successor,auditor contacts the predecessor auditor, the successor auditor should obtia the client's permission to communicate with the predecessor auditor. ‘This is a necessary progedure because the Code of Ethics for Professional “Accountants prevents an auditor from disclosing any information obtained about the client without the client's explicit permission, Refusal of the’ prospective client's management to permit this will mise serious questions as 0 whether the engagement will be accepted. Once pemission of the cient is obtiined, the successor auditor should inquire into matters that may affect the 123 Scanned with CamScanner2 a , senting. accept ‘ ‘engagement. This includes question, > The predecessor auditor's understanding 25 10 the } feasons for the change of auditors; * ’ > Any disagreement between the predecessor auditor and the client; or > Any facts that might have 2 bearing on the integrity of the prospective client’s management. “The predecessor auditor should respond fully to the successor auditor's inquiry and advise the successor auditor if there are any professional reasons why the engagement should not be accepted. ‘ { Adequacy of the Accounting Records "The audit of the financial statements is-petformed on the’ assumption that the financial statements are verifiable. Therefore, the clien’s accounting records and documents supporting the amounts and disclosures in the financal statements mst be adequate enough to permieramination of | accounts. Inadequacy of the accountidg“ecords is sufficient teason for the auditor to decline an audit engagement. © Retention of Exiting Clients ‘The auditor’s evaluation of clients is not a one-time considération ‘Glicats should be evaluated at least once a year or upon occurrence of ‘major events, such as changes in management, directors, ownership, _ ‘atite of cieni’s business, or other changes that may affect the scope of the examination. i ve 124 In general, conditions which would have caused the auditor to reject a Prospective client may also result of lead to a decision of terminating an audit engagement. Engagement letter According to PSA 210, the auditor and the client should agree on the © terms ofthe engagement and the agreed terms will have tobe recorded in an engagement letter, The engagement letter serves asthe writen contract between the auditor andthe cent. This letter sets forth: > The objective of the audit of financal statements which is to ‘xpress an opinion on the financil statements; > The management's responsibilty forthe fi preseatation ofthe financial statement; > Thescope ofthe audit, >> The forms of any reports or other commuication that the auditor expects to issue; > The fact that because of the limitations ofthe audit, cher is an unavoidable risk: that- material misstatements may remain undiscovered; and > The responsibility of the client to allow the auditor to have curesticted access to whatever records, documentation and other information requested in connection with the audit. In addition, the auditor may also include the following items in the engagement letter: . > Billing arrangefnents; > Expecutions of recevog management representation leer; > Amangemeats conceming the iwobrerpeat of others (exper, _ other ators intemal auditors and oer cent personne); and >” Request forthe cient to conf the tas ofthe egageracat A sample format ofan aut engagement letters presented af the end ofthis Chapter. ps Scanned with CamScannerImportance of the engagement letter It isin the interest of both the auditor and the client that he ruditor sends: ¢ eter in order to: 1 Avoid migunderstandings wth respect to eOgemen, 32 Audits of Components * Whea the auditor of a parent entity is also the auditor of its subsidiary, branch or division (Component), the auditor should consider the following factors in making a decision of whether to . and «and confem the autor’ e006 oft send a separate letter to the component appointment. >. Who appoints the auditor of the component; > Whether a separate audit repost is to be issued 6a ‘the component; SF Recurring audits % Lepltegitenens : does noi The extent of any work performed by other aiitos; For recuiring audit engagements, an auditor a : es send new pect letter every yeat. However, the following : Degree of ownership by parent; or factors that may cause the auditor to send & new engagement Degree of independence ofthe component’s management. deter: : > Any indication thatthe client misunderstands the objective and scope of the audit, z 4 > Any revised or special terms of the engigement; > A recent change of senior management, board of directors ot ; ‘ownership; . > A significant change in the nituie or size of the clients: | business; or > Tegal requirements and other goverment agence! pronouncements. . § letter, the auditor should remind the client of the terms of the tiga arangement to reiterate the objectives of the engages. y ‘In cases where the auditor decides not to send a new engagement 4s well asthe responsibilities of both the auditor and the client. a7 a a 126 Scanned with CamScanneroF [Engagement Letter for the Conduct of an Audit of Financial Statements ‘To the Board of Directors of ABC Company: ‘Objective and scope of the audit ‘You have requested that we audit the financial sleet ACen Spe ‘the statement of financial postion 252 1, 2041, q a nee ater often ad atone sare om for the year then ended, and 2 summary of sinicant scouring Policies and other explanatory infomation We a pleased 10 confiem our acceptance and our understanding ofthis ‘audit engagement by means ofthis letter seve wil be conducted wth the objective of our expressing an opinion on the financial statements” ur responsibities We will conduct our audit in accordance with Philippine Standards on Auditing. (PAs), Those standards require that we ‘comply with ethical requirements and plan ‘and perform the audit to obtain reasonable assurance about whether the financial “statements are free from material misstatement. An audit involves performing sete tot st evdence sos the nouns nf loses ne financial statements, The procedures selected depend on the auditor's. judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. An audit also includes evaluating ‘the: “appropriateness of accounting policies used and the reasonableness of accounting ‘estimates made by management, as well as evaluating the overall presentation of Sef atenert Because of the inherent limitations of an audit, together with the inherent — limitations of internal control, thee is an unavoidable risk that some | misstatements may not be detected, even though the audits properly planned 7 performed in accordance with PSAs. 5 {In making our risk assessments, we consider internal control relevant tothe ents — preparation ofthe financial statements in order to design audit procedures that a appropriate inthe circumstances, but not fr the purpose of expressing an opti™ ‘on the effectiveness of the entity's intemal control. However, we will communicate to youin writing concerning any significant defences in internal control relevant tothe auditof the financial statements that we have identified during the audit. ‘Responsibilities of Management and Those Charged with Governance (Our ait willbe conducted onthe basis that management and, where appropriate, those charged with governance acknowledge and understand that they have esponsibility (0) Forte preparation and fi presentation ofthe fran statements in accordance wh hlippne Financial Reporting Standards (PRS); (0) Fersuch internal controls management] deteminesis necessary tenable the preparation of fiandal statements that are free from. matesal mistaterent whether det aud oer and 3 (€) To provide us with: . {paces to alinornatin of which managements aware tatsrelevant to the preparation of the financial statements such as records, documentation and other mater (a) attonalifrmaton hat we may request rom maragement forthe purpose ofthe aut and Unestcted acess to persons win the entity fom whom we determine necessary toa aut evece. ‘As part of our audit process, we will request from management and, where appropriate, those charged with governance, written confirmation concerning representations made to us in connection withthe aut. ‘We look forward to full cooperation from your staff dying our aut. Billing Arrangements ‘Our fees, which wll be biled as work progresses, are based on the time required by the individuals assigned to the engagement plus out-of-pocket expenses. Individual hourly rates vary according to the degree of responsiblity [Link] the ‘experience and sil required. 129 Scanned with CamScanner