ADAMSON UNIVERSITY
AUDITING & ASSURANCE CONCEPTS and APPLICATIONS – PART II
2023 LECTURE GUIDE
MODULE 1 – BASIC CONCEPTS OF FINANCIAL STATEMENT AUDIT
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EXPECTED LEARNING OUTCOMES
Discuss the nature and purpose of a financial statement audit
Identify the management’s assertions when presenting the financial
statements
Describe each major phase in financial statement audit
Discuss the most common procedures applied in financial statement audit.
Explain the purpose of audit documentation.
State the appropriate type of audit report for each conclusion drawn based
on assessment of audit documentation.
Formulate appropriate audit adjusting entries.
Complete a working trial balance.
NATURE OF FINANCIAL STATEMENTS AUDIT
Auditing is defined as a systematic integrated process of accumulating and evaluating evidence by
competent, independent person /persons about economic information, actions and events of an
entity; the purpose of which is to assess and report on the degree of correspondence between the
information and established criteria for the entity’s actions and/or the reporting thereof.
Auditing involves gathering and evaluating evidence relating to management’s assertions as
reflected in the financial statements. It is a form of “attestation” wherein the Certified Public
Accountant communicates to the interested users whether the representations of management
regarding financial statements are fair or not.
THE PURPOSE OF FINANCIAL STATEMENT AUDIT & MANAGEMENT’S ASSERTIONS
Financial statement are primarily the responsibility of the entity’s management who makes the
following assertions:
1. Existence or Occurrence of transactions that result to reported assets, liabilities ad equity at
the reporting date and income and expenses for the reporting period.
2. Completeness of information presented in the financial statements that are the results of
the transactions and other events that actually occurred during the reporting period.
3. Rights or control over all reported assets and obligations for reported liabilities at the
reporting date.
4. Appropriate use of measurement bases for assets, liabilities and equity.
5. Recognition of income and expenses in accordance with the applicable revenue and expense
recognition principles.
6. Appropriate presentation and disclosure of all financial statement components and
accompanying notes to the financial statements.
OBJECTIVE OF AN AUDIT
The auditor’s overall objectives in a risk-based audit are:
1. To obtain reasonable assurance about whether the financial statements as a whole are free
from material misstatement, whether due to fraud or error, thereby enabling the auditor to
express an opinion on whether the financial statements are prepared, in all material aspect,
in accordance with an applicable financial reporting framework; and
2. To report in the financial statements and communicate as required by the PSA, in
accordance with auditor’s findings.
GENERAL PRINCIPLES OF AN AUDIT
The Auditor should comply with the “Code of Ethics for Certified Public Accountants” promulgated
by the Board of Accountancy and approved by the Philippine Professional Regulation Commission
)PRC). Ethical principles governing the auditor’s professional responsibilities are:
a) Independence
b) Integrity
c) Objectivity
d) Professional competence and due care
e) Confidentiality
f) Professional behavior
g) Technical standards
The auditor should conduct an audit in accordance with Philippine Standards on Auditing (PSA) and
should plan and perform the audit with an attitude of professional skepticism recognizing that
circumstances may exist which cause the financial statements to be materially misstated.
SCOPE OF AN AUDIT
The scope of the auditor’s work and the opinion provided are usually confined to whether the
financial statements are prepared, in all material respect, in accordance with the applicable financial
reporting framework.
THE AUDIT PROCESS
The audit process starts when a reporting entity engages the services of an independent auditor for
an independent examination of its financial statements and conclude when an auditor issues an
audit opinion based on the assessment of the evidence gathered in the course of conduct of audit
procedures. The following are the major phases in a financial statement audit:
1. Pre-engagement activities
 Are procedures conducted to determine whether or not to accept a new
engagement or retain an existing client. The following are considered:
 Client’s business reputation
 The changes in client’s ownership
 Client’s reporting practices
2. Audit planning and evaluation of internal control
 Audit planning involves evaluation of internal control to determine the extent of
audit procedures necessary to be performed by the whole audit team of the
following task:
 Obtaining an understanding of the client, its business, industry and
accounting policies
 Obtaining an understanding of the client’s internal control system.
 Assessing materiality and audit risk.
 Identifying audit objectives.
 Determining whether reliance can be placed on certain controls in the
system.
 Determining the nature, extent and timing of substantive tests to be
performed.
 Designing and finalizing the audit program.
3. Evidence gathering/Audit documentation
 This phase must accomplish the objective of documenting the fact that the audit
was adequately planned and sufficient, competent evidential matter is obtained that
serves as the basis for the audit opinion reached.
 Sufficiency refers to the quantity of evidence an auditor acquires.
 Competence refers to the relevance, validity and reliability of the evidence acquired.
 Audit evidence consist of:
 Accounting data – business documents, journals & ledgers
Corroborating information – cancelled checks, invoices, contracts,
promissory notes, etc.
 Audit procedures applied by the auditor are selected based on
The audit objectives.
The quantity and types of evidence available
Materiality
Assessed level of audit risk
 The most common audit procedures applied by the auditor are:
Written confirmation from third parties
Physical count and observation
Inquiry – written and oral information from management, employees and
others
Documentation - obtaining internal and external evidences (contracts,
minutes of meetings, vouchers, bank statement, etc.
Comparisons – establishing trends and valid relationships of information
Recalculations – establishing correctness of account balances
Mechanical test of data – verifying mathematical accuracy of accounting
data (footings, cross-footings)
4. Reporting
 The auditor should review and assess the conclusions drawn from the audit evidence
obtained used as basis for the expression of an opinion on the financial statements..
REASONABLE ASSURANCE
PSAs require the auditor to obtain reasonable assurance about whether the financial statements as a
whole are free from material misstatements, whether due to fraud or error. Reasonable assurance is
a high but not absolute level of assurance. It s obtained when the auditor has obtained sufficient
appropriate audit evidence to reduce audit risk (risk that the auditor expresses an inappropriate
opinion when the financial statements are materially misstated) to an acceptably low level.
WHY INDEPENDENT AUDITING IS NECESSARY
Without wide public acceptance, professions cannot exist and independent auditing is no exception.
Auditing services are used extensively by business, government and other not-for-profit
organizations. 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 risks, are:
1. Remoteness of information users from information providers – decision makers do not get
first hand knowledge about the business enterprise due to:
a) Owners are divorced from management
b) Directors are not involved in day-to-day operations or decisions
c) Business is dispersed among numerous geographic locations and corporate
structure
2. Potential bias and motives of information provider 3. Voluminous data – as business grow, millions of transactions are processed daily. There is
the likelihood that improperly recorded information may be included or buried in the
records.
4. Complex exchange transactions – new and changing business relationship may lead to
innovative accounting and reporting problems
AUDIT RISK AND MATERIALITY
The risk that the auditor expresses an inappropriate audit opinion when the financial statements are
materially misstated is called “audit risk”.
The auditor obtains and evaluates audit evidence to obtain reasonable assurance about whether the
financial statements give a true and fair view or are presented fairly, in all material respects, in
accordance with the applicable financial reporting framework.
RESPONSIBILITY FOR THE FINANCIAL STATEMENTS
While the auditor is responsible for forming and expressing an opinion on the financial statements,
the responsibility for the preparation and presentation of the financial statements in accordance
with the applicable financial reporting framework is that of the management of the enity, with
oversight from those charged with governance.
KEY ELEMENTS OF AUDIT RISK
1. Inherent and Control Risk
a) Inherent risk – refers to the susceptibility of an account balance to material errors
assuming that the client does not have any related internal control
b) Control risk – refers to the risk that a material error in an account will not be prevented
or detected on a timely basis by the client’s system of internal control.
2. Detection risk – refers to the risk to detect a material misstatement in the financial
statement
Requirement in order the auditor may be able to reduce audit risk to an acceptably low level
1. Assess the risks of material misstatement
2. Limit detection risk – this may be achieved by performing procedures that respond to the
assessed risks of material misstatement, both at the financial statement level and at the
assertion level for classes of transactions, account balance and disclosures.
MAJOR STEPS IN THE SYSTEMATIC PROCESS OF FINANCIAL STATEMENT AUDIT
Phase I – Pre-engagement and Audit Planning Activities
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The audit process begins with the preliminary arrangements with the client.
Once the client has signed the engagement letter, the planning process starts as the auditor
concentrates his efforts in obtaining a detailed understanding of the client’s business and an
overall audit strategy. Audit planning includes understanding the client’s:
 Industry environment
 Business and management
 Accounting and reporting systems
 Internal control
On the basis of the initial information gathered by the auditor, he/she assesses the “audit
risk” relative to the engagement. The following assessments are used to develop an overall
audit plan and audit program as:
 Materiality
 Acceptable audit risk
 Inherent risk
 Control risk
Phase II – Gathering and Evaluating Audit Evidence
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When gathering and evaluating audit evidence, auditors perform two basic types of audit
tests :
 Test of controls
 Substantive tests
INTERIM AUDIT PHASE
In this phase, the auditor focuses his attention on both the design and operation of aspects of the
internal control structure to determine whether the necessary controls were functioning as
intended.
 When the auditor’s preliminary assessment of control risk is below the maximum level, they
may decide to perform tests of controls to establish the effectiveness of controls in
preventing or detecting material misstatements in a financial statement assertions.
 When auditor’s assess control risk at the maximum level, they are not required to perform
any tests of controls. Test of controls are performed to determine whether a control is
working. The test of controls involve the following procedures:
 Inquiries of client personnel
 Inspection of documents and records
 Observation of the application of specific policies and procedures
 Reperformance of the application of specific policies and procedures
FINAL AUDIT PHASE
This phase involves substantive tests of details of balances and analytical procedures. Substantive
audit testing is the process of obtaining evidence in support of transactions and balances. The
nature, timing and extent of substantive testing is a function of the auditor’s judgment concerning
audit risk and materiality.
Nature of Substantive Tests
Test of balances refer to:
1. Substantive tests of transactions and balances, and
2. Analytical review procedures performed at or near the balance sheet date that are directed
at the verification of an account balance.
In designing audit programs for tests of balances in a typical audit engagement, the following
approaches are often used:
1. When internal control over a specific class of transaction are effective, tests of balances are
applied to resulting balance sheet account balances and reliance is placed primarily on
internal controls and on analytical review procedures for related income statement account
balances.
2. When internal control over a specific class of transactions are not tested or cannot be relied
upon, tests of balances are applied both to resulting balance sheet and income statement
account balances.
AUDIT OBJECTIVES FOR SUBSTANTIVE TESTS
The specific audit objectives for substantive tests are to determine:
1. Existence or Occurrence and Validity
 This relates to whether specific assets and liabilities exist at a given point in time and
whether recorded transactions represent economic events that occurred during the
year.
2. Completeness and Accuracy
 This involves determining whether all transaction that should have been recorded by
the client are accurately included in the accounts.
3. Rights and Obligations
 This requires the auditor obtain evidence that the client has rights to existing assets
and that existing liabilities and owner’s equity claims against the entity are valid.
4. Proper Valuation or Allocation
 This involves determining whether financial statement elements are stated at the
proper amount in accordance with applicable reporting framework.
5. Proper Statement Presentation and Disclosure
 This involves determining whether statement items are properly identified, classified
and arranged in the statements and whether accompanying disclosures are
adequate.
PREPARING THE AUDIT REPORT
The culminating step in the audit process is the preparation of the audit report. Expressing an audit
opinion is the auditor’s overriding goal. The audit report concisely describes the auditor’s
responsibility, the nature of the examination, the audit finding and his opinion on the financial
statements.
TYPES OF AUDIT REPORTS
The auditor should evaluate the conclusion drawn from the audit evidence obtained as the basis for
forming an opinion on the financial statements. Two general types of audit report are :
1. Unmodified opinion
 When the auditor concludes that the financial statements are presented fairly, in all
material respects, with the applicable financial reporting framework, an unmodified
or unqualified opinion would be appropriate (IFRS)
2. Modified opinion
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When based on the audit evidence obtained, the financial statements as a whole are
not free from material misstatement or when sufficient appropriate audit evidence
could not be obtained to conclude that the financial statements as a whole are free
from material misstatement, a modified opinion is expressed and may take the
following form:
 A qualified opinion
o Should be expressed when either (1) sufficient appropriate audit
evidence was obtained, but the auditor concludes that
misstatements exist, individually or in the aggregate, that are
material but nor pervasive to the financial statements; and (2) the
auditor is unable to obtain sufficient appropriate audit evidence on
which to base the opinion.
 An adverse opinion
o Should be expressed when the effects of misstatements are both
material and pervasive.
A disclaimer opinion
o Means no opinion and should be expressed when the possible
effects of undetected misstatements, if any, could be both material
and pervasive. This opinion is expressed when the auditor is unable
to obtain sufficient appropriate audit evidence on which to base the
opinion.
CASE ANALYSIS / ASSIGNMENT #1
Selected account balances (before adjustments) taken from the books of BELO, Inc. for the year
ended December 31, 2022 are as follows:
Retained earnings, Jan 1, 2022
Sales salaries and commissions
Advertising expense
Legal services
Insurance and licenses
Salesmen’s traveling expense
Depreciation expense – Delivery Equipment
Depreciation expense – Office Equipment
Interest revenue
Utilities
Telephone and postage
Supplies inventory
Miscellaneous selling expenses
Dividends
Dividend revenue
Interest expense
Allow for doubtful accounts (credit balance)
Officer’s salaries
Sales
Sales returns and allowances
Sales discounts
Gain on sale of equipment
Inventory, January 1, 2021
Inventory, December 31, 2021
881,340
70,000
32,180
4,450
17,000
7,120
12,200
9,600
1,400
12,800
2,950
4,360
4,400
66,000
14,300
9,040
740
73,200
990,400
22,400
1,760
37,000
179,400
41,100
Purchases
Freight-in
Accounts receivable
Extraordinary loss, before income tax
Ordinary share capital
346,000
11,050
522,000
145,200
78,000
Data for adjustment:
1. Cost of inventory in the possession of consignees as of December 31, 2022 was not included
in the ending inventory balance, P67,200.
2. The allowance for doubtful accounts is to be increased to 3% of the ending accounts
receivable balance, after assessing the receivables for impairment.
3. Sales commission for the last day of the year had not been accrued. Total sales on December
31 were P27,200. Sales commission averages to 3% of sales.
4. No accrual had been made for a freight bill received on January 5, 2023, for goods received
on December 29, 2022, P1,500.
5. An advertising campaign was initiated November 1, 2022. The cost of P4,200 incurred in
November and December was debited to prepaid advertising.
6. Freight charges of P18,400 paid on sold merchandise and not passed on to the buyers were
netted against sales.
7. Depreciation on a new equipment purchased on March 1, 2022 had not been recognized.
Equipment are depreciated on a straight-line basis, residual value being ignored. This
equipment was purchased for P15,600 and is estimated to be useful for 10 years.
8. The extraordinary loss represents loss from supplies lost and unsalable inventories heavily
damaged by flood in August.
9. Income tax rate is 25%.
REQUIRED:
a) Prepare the adjusting entries necessary.
b) Prepare a statement of comprehensive income following the function of expense method.
THE WORKING TRIAL BALANCE & THE AUDIT ADJUSTING ENTRIES
The working trial balance is a schedule listing the balances of accounts in the general ledger for the
current and previous year, with columns for:
1. Adjusting entries
2. Reclassification entries
3. Financial statement amounts
The working trial balance is of two (2) types, namely:
1. One-section trial balance
 Looks like an ordinary worksheet and lists all ledger accounts, such as:
 Trial Balance
 Adjustments & Reclassifications
 Adjusted comprehensive income
 Adjusted financial position
2. Two-section trial balance
 Is divided into two components :
 the working comprehensive income
 The working financial position
CASE ANALYSIS / ASSIGNMENT #2
Below is the trial balance as of December 31, 2022 of CHAMPOY Company as prepared by its
accountant:
CHAMPOY COMPANY
TRIAL BALANCE
December 31, 2022
Cash
Accounts receivable
Allow for doubtful accounts
Inventory, December 31, 2021
Prepaid expenses
Investments
Furniture and fixtures
Miscellaneous equipment
Accumulated depreciation
Accounts payable
Accrued expenses
Unearned rent income
Ordinary share capital
Retained earnings
Sales
Rent income
Purchases
Salaries expense
Advertising expense
Commission expense
Utilities expense
Supplies expense
Transportation expense
Repairs and maintenance
Miscellaneous expenses
P
Debit
191,000
615,000
Credit
21,000
584,000
8,000
110,000
312,000
90,000
76,400
543,000
51,000
12,800
600,000
182,800
3,500,000
48,000
2,424,000
400,000
124,000
80,000
32,000
12,000
14,000
16,000
23,000
5,035,000
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5,035,000
The following information were gathered for adjustment as follows:
1. The Cash account included equipment acquisition fund amounting to P60,000.
2. A physical inventory taken on December 31, 2022 revealed goods costing P 600,000.
3. Goods purchased under FOB shipping point and verified to have been shipped by the
supplier on December 28, 2022 were received and recorded by CHAMPOY on January 4,
2023, P50,000.
4. The allowance for doubtful accounts should be adjusted to 5% of accounts receivable,
established based on the simplified approach for measuring and assessing expected credit
losses.
5. The company purchased 100 shares of its P100 par value ordinary share capital for P30,000,
the amount having been charged to the investment account.
6. Except for equipment purchased on June 30, 2022 for P20,000 cash, all equipment were
acquired at the inception of the company three years ago. Depreciation for 2022 has not
been recorded.
7. Prepaid expenses include P44,800 insurance premium on a one-year insurance policy taken
on October 1, 2022.
8. Unearned rent income on December 31, 2022 amounted to P10,000.
9. Accrued expenses on December 31, 2022 amounted to P54,000.
REQUIRED:
Disregarding differences between taxable income and financial reporting income –
1. Prepare audit adjusting entries.
2. Prepare a working trial balance to facilitate the preparation of the financial statements for
the year ended December 31, 2022.
END OF MODUDLE 1