AUDITING
THEORY
LECTURE
WEEK 1
AY 20212022
AUDIT- An Overview
The primary function of an independent audit is to lend credibility to the financial statement of an
entity. The auditor’s opinion enhances the value and usefulness of these financial statement. By
attaching a report to the financial statement, the auditor provides increased assurance to users
that the financial statement are reliable.
♦ Auditing Defined
To enable the auditor to express an opinion whether the financial statements are prepared, in all
materials respects, in accordance with the applicable financial reporting framework.
Operational and compliance auditing are becoming more and more important.
A more comprehensive definition of auditing is given by the American Accounting Association:
“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 interest users.”
This definition conveys the following thoughts.
1. Auditing is a systematic process
Auditing proceeds by means of an ordered and structure series of steps.
2. An audit involves obtaining and evaluating evidence about assertions regarding
economic actions and events
Assertions are represented made by an auditee about economic actions and events.
The auditor’s objective is to determine whether these assertions are valid. To satisfy this
objective, the auditor performs audit procedures and gathers evidence that corroborates
or refutes the assertions.
3. An audit is conducted objectively
The auditor should conduct the audit without bias. Impartial attitude must be maintained
by the auditor when evaluating evidence and formulating his conclusion.
4. Auditors ascertains the degree of correspondence between assertions and
established criteria Established criteria are needed to judge the validity of the
assertions. These criteria are important because they establish and inform the users of
the basis against which the assertion have been evaluated or measured.
5. Auditors communicate the audit results to various interested user
For the audit to be useful, the result must be communicated to interest users on a timely
basis.
♦ Types of Audits
Based on primary audit objectives, there are three major types of audit financial, compliance and
operational audits.
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Financial statement audit
An audit conducted to determine whether the financial statement of an entity are fairly
presented in accordance with the applicable financial reporting framework.
Compliance audit
This involves a review of an organization’s procedure to determine whether the
organization has adhered to specific procedures, rules or regulations. A common
example of this type of audit is the examination conducted by BIR examiners to
determine whether entities comply with tax rules and regulation.
Operational audit
Operational audit is a study of a specific unit of an organization for the purpose of
measuring its performance. The objective of this audit is to assess entity’s performance,
identify areas for improvements and make recommendations to improve performance.
Also known as performance audit or management audit.
It should be noted that, although there are different types of audit, all audits possess the same
general characteristics. They all involve:
1. Systematic examination and evaluation of evidence which are undertaken to ascertain
whether assertion comply with established criteria; and
2. Communication of the result of the examination, usually in a written report to the party by
whom, or on whose behalf, the auditor was appointed.
Unlike compliance and financial statement audits, where the criteria are usually defined, criteria
used in operational audit to evaluate the effectiveness and efficiency of operation are not clearly
established.
♦ Types of Auditors
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External auditors
Independent CPAs who offer professional services to different clients on a contractual
basis. The ones who generally conduct financial statement audit.
Internal auditor
The main function of internal auditor is to assist the members of the organization in the
effective discharge of their responsibilities. These are entity’s own employee. They
usually perform operational audits.
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Government auditors
These are government employees whose main concern is to determine whether person or
entities comply with government rules and regulations. They usually perform compliance
audits.
♦ The Independent Financial Statement Audit
To enhance the degree of confidence of intended users in the financial statement. This is
achieved by the expression of an opinion by the auditor on the fair presentation of the financial
statement,
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Responsibility for the financial statement
This responsibility includes the design, implementation and maintenance of internal
control relevant to the preparation and presentation of financial statement that are free
from material misstatement, whether due to fraud or error and to provide the auditor with
unrestricted access to all information, records and documents relevant to the financial
statements.
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Assurance provided by the auditor
To provide only reasonable assurance (not absolute assurance) that the financial
statements taken as a whole are free from material misstatement. The auditor is not and
cannot obtain absolute assurance because there are inherent limitations of audit that
affect the auditor’s ability to detect material misstatement.
The use of testing / Sampling risk
Auditors do not examine all evidence available. Only sample of evidence.
Error in application of judgement / Non-sampling risk
Human weaknesses can cause auditors to commit mistakes in the application of audit
procedures and evaluation of evidence.
Reliance on management’s representation
Some evidence supporting the financial statements must be obtained by oral or written
representations from management. If the management lacks integrity, management may
provide the auditor with false representation causing the auditor to rely on unreliable
evidence.
Inherent limitations of the client’s accounting and internal control system.
Although the auditor performs procedures to detect material misstatement when
auditing the financial statements, such as procedure may not be effective in detecting
misstatement resulting from collusion among employees or management’s
circumvention of internal control.
Nature of evidence
It compromises pieces of information and impressions which are gradually accumulated
during the course of an audit and which, when taken together, persuade the auditor
about the fairness of the financial statements.
◆General principles governing the audit of financial statements
1. The auditor should comply with relevant ethical requirements, including those
relating to independence, relating to financial statements audit engagements.
Auditors must adhere to standard of ethical conduct that embody and demonstrate
integrity, objectivity, and concern for the public rather than self-interest.
2. The auditor should conduct an audit in accordance with Philippine Standard in
auditing.
This standard is designed to assist auditors in interpreting and applying the auditing
standard.
3. The auditor should exercise professional judgment in planning and performing an
audit of financial statements.
Professional judgment is the hallmark of an auditing. The distinguishing feature of the
professional judgment expected of an auditor is that it is exercised by an auditor whose
training, knowledge and experience have assisted in making competent and reasonable
judgment.
4. The auditor should obtain sufficient appropriate audit evidence to reduce audit
risk to an acceptable low key to enable the auditor to express an opinion on the
financial statements.
It is cumulative in nature and is primarily obtained from audit procedures performed
during the audit. Evidence must be both sufficient and appropriate to afford a reasonable
basis for an opinion on the financial statements.
5. The auditor should plan and perform the audit with an attitude of professional
skepticism recognizing that circumstances may exist which may cause the
financial statement to be materially misstated.
An attitude of professional skepticism means the auditor makes a critical assessment,
with a questioning mind, of the validity of audit evidence obtained and is alert to audit
evidence that contradicts or bring into question the reliability of documents to be
materially misstated,
In planning and performing an audit the auditor neither assumes that the management is
honest nor dishonest.
In planning and performing an audit, the auditor neither assumes that the management is
honest nor assumes unquestioned honesty.
◆Need for an independent financial statement audit
1. Conflict of interest between management and users of financial statements.
Managers are frequently placed in position where they can benefit by providing outside
parties with overly optimistic or even false financial information.
2. Expertise
The complexity of accounting and auditing requires expertise in verifying the quality of the
financial information.
3. Remoteness
Most of the users do not have the access to the entity’s records to personally verify the
reliability of the financial statements. As a result, 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 statement be audited before these
statements are used for making important decision.
◆Theoretical framework of Auditing
The audit function operates within a theoretical framework.
1. Audit function operates on the assumption that all financial data are verifiable.
All balances reported in the financial statement must have supporting documents or
evidence to prove their validity.
2. The auditor should always maintain independence with respect to the financial
statement under audit.
Independence is essential for ensuring the credibility of the auditor’s report.
3. There should be no long-term between the auditor and the client management.
Short-term conflicts may exist regarding the application of auditing procedures and
accounting policies, but in 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 errors and fraud
affecting the financial statements.
The stronger the internal control is, the more assurance it provides about reliability of the
accounting data and financial statements.
5. Consistent compliance with applicable financial reporting framework results in
fair presentation of financial statements.
In the case of the independent audit of financial statements, the criteria are usually the
PFRSS or PFRS for SMEs.
6. What was held true in the past will continue to hold true in the future in the
absence of known condition to the contrary.
Experience and knowledge accumulated from auditing a client in prior years can be used
to determine the appropriate audit procedures that need to be performed.
7. An audit benefits the public.
These users who rely on the financial statements as their major source of information are
the primary beneficiary of the financial statement audit.