TOPIC 1: OVERVIEW OF THE AUDITING

PROFESSION

Nature of Auditing

AUDITING
● The accumulation and evaluation of evidence about information to determine and
report on the degree of correspondence between the information and established
criteria.
● Auditing should be done by a competent, independent person.

INFORMATION AND ESTABLISHED CRITERIA

INFORMATION CRITERIA

Verifiable Form Standards

May be quantifiable(FS) or subjective Dependent upon what information is

(effectiveness of systems) audited

Financial Statements PFRS

Internal Control COSO Framework

Corporate Governance SEC Rules on CG

ACCUMULATING AND EVALUATING EVIDENCE

EVIDENCE
- any information used by the auditor to determine whether the information
being audited is stated in accordance with established criteria.
Forms of evidence:
1. Transaction data - transactions in journals, ledgers
2. Communications with outsiders - emails with banks, etc.
3. Observations
4. Client Testimony - what the client gave

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Auditors must obtain sufficient and appropriate audit evidence to satisfy the purpose
of the audit.

COMPETENT AND INDEPENDENT PERSON

COMPETENCE INDEPENDENCE
● Qualified to understand the criteria ● Must not be biased in the
used accumulation and evaluation of
● Know the types and amount of evidence
evidence to accumulate in order to ● Internal auditors (although employed)
reach proper conclusion after should be independent.
examining the evidence ● Must be independent of mind and in
● Quality Control (PSQC) PH standard appearance
on quality control In mind = not easily swayed/inlfuenced
Appearance = not receiving gifts or seen
hanging out with clients
● Code of Ethics for Professional
Accountants in the Philippines

REPORTING
● Preparing the audit report - final stage in the auditing process
l→ communicates the auditor’s findings to users.
● Reports
○ differ in nature, but all must inform readers of the degree of
correspondence between the information audited and established
criteria.
○ differ in form and can vary from the highly technical type usually
associated with financial statement audits to a simple oral report in the
case of an operational audit of a small department’s effectiveness.

THE AUDIT PROCESS

1. Pre-engagement Activities
● Negotiating w/ client
● Engagement Letter

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 2. Planning Activities
● Already have engagement letter
● Plans should NOT be disclosed to avoid preparation
3. Evidence Gathering
● There’s audit trail
● Picture picture
● List things found
4. Reporting
● Issue an auditor’s report

DISTINCTION BETWEEN ACCOUNTING AND AUDITING

ACCOUNTING AUDITING

● is the recording, classifying, and ● focus on determining whether recorded information

summarizing of economic events properly reflects the economic events that occurred
to provide financial information for during the accounting period.
decision-making. ● In addition to understanding accounting, auditors must
possess expertise in the accumulation and
interpretation of audit evidence.

In addition to understanding accounting, auditors must possess expertise in the

accumulation & interpretation of audit evidence.

ECONOMIC DEMAND FOR AUDITING

▸ Information risk reflects the possibility that the information upon which a
business decision was made was inaccurate.
▸ Auditing of financial information reduces information risk to the users of
financial information.
Causes of information risk:
● Remoteness of information
● Biases and Motives of the Provider
● Voluminous Data
● Complex Exchange Transactions

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How to reduce information risk:
1. User verifies information
a. the user may go to the business to verify the information.
b. often costly and impractical.
2. User shares information risk with management
a. Management may be held responsible in a lawsuit if inaccurate
information is provided.
3. Audited financial statements are provided
a. External auditors are engaged to provide assurance that the financial
statements are reliable.

ASSURANCE SERVICES
● An independent professional service that improves the quality of information for
decision-makers.
● Assurance services can be provided by CPAs or other professionals.
● Assurance services by CPAs have been common for years, especially regarding
historical financial statement information.

ATTESTATION SERVICES
● Type of service in which the CPA issues a report about a subject matter or
assertion that is made by another party.
● One category of assurance services provided by CPAs.
● Primary categories of attestation services include:
○ Audits of historical financial statements
○ Audits of internal control over financial reporting
○ Reviews of historical financial statements
○ Other attestations that may be applied to a broad range of subjects
Audits: provide high but not absolute assurance; reasonable assurance
Reviews: only give moderate assurance; limited assurance

OTHER ASSURANCE SERVICES

● do not meet the definition of attestation services
● Written report = NOT required

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 ● not be about reliability or compliance.
Examples:
Mystery shopping – Perform anonymous shopping to assess sales personnel dealings
with customers and procedures they follow
ISO 9000 certifications – Certify a company’s compliance with ISO 9000 quality control
standards, which help ensure company products are of high quality

NON-ASSURANCE SERVICES
● CPA firms perform numerous other services that generally fall outside the scope
of assurance services.
● Independence is not required since no assurance is provided.
Examples:
1. Accounting and bookkeeping services
2. Tax services
3. Management consulting services

Assurance Services Non – Assurance Services

Attestation Services • Bookkeeping services

• Audits (PSA) • Tax services
• Reviews (PSRE) • Agreed upon procedures (PSRS)
• Management consulting services

Other Assurance Services (PSAE) PSQC, Code of Ethics

Types of Audits and Auditors

TYPES OF AUDITS
1. Operational audit
a. Evaluates the efficiency and effectiveness of any part of an organization’s
operating procedures and methods.

2. Compliance audit

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 a. Determines whether the auditee is following specific procedures, rules, or
regulations set by some higher authority.

3. Financial statement audit

a. Determines whether the financial statements are stated in accordance
with PFRS.

TYPES OF AUDITORS
● CPA firms
● Government auditors (EX. COA)
● Internal auditors

ACTIVITIES OF CPA FIRMS

● Provide audit services as well as other attestation and assurance services.

● Provide accounting and bookkeeping services, tax services, and management
consulting and risk advisory services.
● CPA firms vary in nature and range of services, which affects the structure of the
firms.

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ORGANIZATIONAL HIERARCHY OF TYPICAL CPA FIRM

QUALITY CONTROL

● For a CPA firm, quality control includes the methods used to ensure that the firm
meets its professional responsibilities to clients.

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Elements: (LRAHEM)

● Leadership responsibilities
● Relevant Ethical Requirements
● Acceptance and continuance of client relationships and specific engagements
● Human Resources
● Engagement Performance
● Monitoring

WHAT IS ETHICS?

● Ethics = a set of moral principles or values.

● Ethical behavior = necessary for a society to function in an orderly manner.
● The need for ethics in society is sufficiently important that many commonly held
values are incorporated into laws.
● There are two primary reasons why people act unethically:
○ The person’s ethical standards differ from general society’s
○ The person chooses to act selfishly

CODE OF PROFESSIONAL CONDUCT

The Code consists of principles and rules, in addition to interpretations.

Only members in public practice can audit financial statements, which is addressed in
Part 1.

The Code establishes a conceptual framework for all professional accountants to

ensure compliance with the five fundamental principles of ethics.

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5 fundamental principles of ethics

1. Integrity - straightforward and honest in all professional and business

relationships
2. Objectivity - should not allow bias, conflict of interest or undue influence of
others
3. Professional Competence and Due Care - maintain professional knowledge
and skill at the level required
4. Confidentiality - should not disclose any such information to third parties without
proper and specific authority
5. Professional Behavior – should comply with the relevant laws and regulations
and should avoid any action that discredits the profession

THREATS TO COMPLIANCE

Compliance with the fundamental principles may potentially be threatened by a broad

range of circumstances. Many threats fall into the following categories:

1. Self-interest threats - may occur as a result of the financial or other interests of

a professional accountant or of an immediate or close family member
2. Self-review threats - may occur when a previous judgment needs to be
re-evaluated by the professional accountant responsible for that judgment
3. Advocacy threats - may occur when a professional accountant promotes a
position or opinion to the point that subsequent objectivity may be compromised
4. Familiarity threats - which may occur when, because of a close relationship, a
professional accountant becomes too sympathetic to the interests of others
5. Intimidation threats - may occur when a professional accountant may be
deterred from acting objectively by threats, actual or perceived

SAFEGUARDS TO THREATS

Safeguards may eliminate or reduce such threats to an acceptable level

2 broad categories:

● Safeguards created by the profession, legislation or regulation

● Safeguards in the work environment

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 TEST YOUR KNOWLEDGE
Which of the following best describes why an independent auditor is asked to
express an opinion on the fair presentation of financial statements?
A. It is difficult to prepare financial statements that fairly present a company’s
financial position, operations, and cash flows without the expertise of an
independent auditor.
B. It is management’s responsibility to seek available independent aid in the
appraisal of the financial information shown in its financial statements.
C. The opinion of an independent party is needed because a company may not be
objective with respect to its own financial statements.
D. It is a customary courtesy that all stockholders of a company receive an
independent report on management’s stewardship of the affairs of the business.

Which of the following professional services is an attestation engagement?

A. A consulting service engagement to provide computer-processing advice to a
client.
B. An engagement to report on compliance with statutory requirements.
C. An income tax engagement to prepare income tax returns.
D. The preparation of financial statements from a client’s financial records.

TOPIC 1.1: PHILIPPINE FRAMEWORK FOR

ASSURANCE ENGAGEMENTS
FRAMEWORK

1. Defines and describes the elements and objectives of an assurance engagement

2. Identifies engagements to which PSAs, PSREs, and PSAEs apply
3. Does not itself establish standards or provide procedural requirements for the
performance of assurance engagements.

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In addition to the Framework and PSAs, PSREs and PSAEs, practitioners who
perform assurance engagements are governed by:

1. The Code of Ethics for Professional Accountants in the Philippines

2. Philippine Standards on Quality Control (PSQCs)

ASSURANCE ENGAGEMENT

an engagement in which a practitioner expresses a conclusion designed to enhance

the degree of confidence of the intended users other than the responsible party about
the outcome of the evaluation or measurement of a subject matter against criteria

SUBJECT MATTER INFORMATION

the outcome of the evaluation or measurement of a subject matter that results from
applying the criteria to the subject matter.

For example:

The recognition, measurement, presentation and disclosure represented in

the financial statements (outcome) result from applying a financial reporting
framework for recognition, measurement, presentation and disclosure, such
as PFRS, (criteria) to an entity’s financial position, financial performance and
cash flows (subject matter)

An assertion about the effectiveness of internal control (outcome) results from

applying a framework for evaluating the effectiveness of internal control, such
as COSO or CoCo (criteria) to internal control, a process (subject matter).

TYPES OF ASSURANCE ENGAGEMENTS

BASED ON WHO PERFORMS EVALUATION OF SUBJECT MATTER AGAINST

CRITERIA

1. Assertion-based engagements – the evaluation or measurement of the subject

matter is performed by the responsible party, and the subject matter
information is in the form of an assertion by the responsible party that is made
available to the intended users.

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 2. Direct reporting engagements – the practitioner either directly performs the
evaluation or measurement of the subject matter or obtains a representation
from the responsible party that has performed the evaluation or measurement
that is not available to the intended users. The subject matter information is
provided to the intended users in the assurance report

BASED ON LEVEL OF ASSURANCE

● Reasonable assurance engagement – objective is a reduction in assurance

engagement risk to an acceptably low level in the circumstances of the
engagement as the basis for a positive form of expression of the practitioner’s
conclusion.
● Limited assurance engagement – objective is a reduction in assurance
engagement risk to a level that is acceptable in the circumstances of the
engagement, but where that risk is greater than for a reasonable assurance
engagement, as the basis for a negative form of expression of the practitioner’s
conclusion.

Elements of an Assurance Engagement (TASSA)

1. Three-party relationship

2. Appropriate Subject matter

3. Suitable Criteria

4. Sufficient appropriate evidence

5. Assurance report

THREE-PARTY RELATIONSHIP

1. Practitioner – broader than the term “auditor”, who only performs audits (PSAs)
or reviews (PSREs)
2. Responsible party
3. Intended users

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APPROPRIATE SUBJECT MATTER

Identifiable, and capable of consistent evaluation or measurement against the

identified criteria;

Such that the information about it can be subjected to procedures for gathering
sufficient appropriate evidence to support a reasonable assurance or limited assurance
conclusion, as appropriate.

May be:

● Financial performance or conditions

● Non-financial performance or conditions
● Physical characteristics
● Systems and processes
● Behavior

SUITABLE CRITERIA

CRITERIA

- benchmarks
- used to evaluate or measure the subject matter including, where relevant,
benchmarks for presentation and disclosure.

Characteristics of a suitable criteria (RUNCR)

● Relevance
● Understandability
● Neutrality
● Completeness
● Reliability

Criteria can be:

● Established criteria
● Specifically developed criteria

SUFFICIENT APPROPRIATE EVIDENCE

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 ▸ Sufficiency is the measure of the quantity of evidence.

▸ Appropriateness is the measure of the quality of evidence; that is, its

relevance and its reliability.

▸ The quantity of evidence needed is affected by the risk of the subject matter
information being materially misstated (the greater the risk, the more
evidence is likely to be required) and by the quality of such evidence (the
higher the quality, the less may be required).

▸ Accordingly, the sufficiency and appropriateness of evidence are interrelated.

However, merely obtaining more evidence may not compensate for its poor
quality.

ASSURANCE REPORT

The practitioner provides a written report containing a conclusion that conveys the
assurance obtained about the subject matter information.

1. In an assertion-based engagement, the practitioner’s conclusion can be

worded either:
● In terms of the responsible party’s assertion (“In our opinion the
responsible party’s assertion that internal control is effective, in all material
respects, based on XYZ criteria, is fairly stated”); or
● Directly in terms of the subject matter and the criteria (“In our opinion
internal control is effective, in all material respects, based on XYZ
criteria”).
2. In a direct reporting engagement, the practitioner’s conclusion is worded
directly in terms of the subject matter and the criteria.
3. In a reasonable assurance engagement, the practitioner expresses the
conclusion in the positive form (“In our opinion internal control is effective, in all
material respects, based on XYZ criteria”).
4. In a limited assurance engagement, the practitioner expresses the conclusion
in the negative form (“Based on our work described in this report, nothing has
come to our attention that causes us to believe that internal control is not
effective, in all material respects, based on XYZ criteria”).

4. Engagement Acceptance

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REQUIREMENTS

1. Relevant ethical requirements, such as independence and professional

competence will be satisfied, and
2. The engagement exhibits all the following characteristics:
1. The subject matter is appropriate;
2. The criteria to be used are suitable and are available to the intended
users;
3. The practitioner has access to sufficient appropriate evidence to
support the practitioner’s conclusion;
4. The practitioner’s conclusion, in the form appropriate, is to be contained in
a written report; and
5. The practitioner is satisfied that there is a rational purpose for the
engagement.

OTHER CONSIDERATIONS

▸ Having accepted an assurance engagement, a practitioner may not change

that engagement to a non-assurance engagement, or from a reasonable
assurance engagement to a limited assurance engagement without
reasonable justification.

▸ A change in circumstances that affects the intended users’ requirements, or

a misunderstanding concerning the nature of the engagement, ordinarily will
justify a request for a change in the engagement.

▸ If such a change is made, the practitioner does not disregard evidence that
was obtained prior to the change.

TEST YOUR KNOWLEDGE

Which of the following statements BEST describes assurance services?

1. Independent professional services that are intended to enhance the credibility of

information to meet the needs of an intended user.
2. Services designed to express an opinion on the fairness of historical financial
statements based on the results of an audit.
3. The preparation of financial statements or the collection, classification, and
summarization of other financial information.

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 4. Services designed for the improvement of operations, resulting in better
outcomes.

A practitioner's assurance report contains the following conclusion:

“Based on our work described in this report, nothing has come to our attention
that causes us to believe that internal control is not effective, in all material
respects, based on ABC criteria.”

What type of assurance engagement was performed?

1. Limited assurance engagement

2. Reasonable assurance engagement
3. Negative assurance engagement
4. Positive assurance engagement

TOPIC 2: AUDIT RESPONSIBILITIES AND

OBJECTIVES

OBJECTIVE TO CONDUCTING AN AUDIT OF FINANCIAL STATEMENTS

The preface to the clarified AICPA auditing standards:

“The purpose of an audit is to provide financial statement users with an opinion by the auditor
on whether the financial statements are presented fairly, in all material respects, in accordance
with the applicable financial accounting framework. An auditor's opinion enhances the degree of
confidence that intended users can place in the financial statements.”

The primary focus is on issuing an opinion on the financial statements.

4 Types of Opinion
1. UNQUALIFIED OPINION / UNMODIFIED – highest form, fairly presented, free from
material misstatements
2. QUALIFIED – ok except for….
3. DISCLAIMER OF OPINION – has scope limitations; able to perform procedures but
limited ; precluded
4. ADVERSE – prevented from doing procedures; OR able to do but things are very wrong

Qualified/Adverse → ginawa mo na pero mali pa rin tlga

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Qualified/ Disclaimer → if precluded

Never meron adverse/disclaimer

Material only = Qualified/Disclaimer

Material & Pervasive = Adverse Opinion

The steps to develop audit objectives are listed in Figure 6-1.

MANAGEMENT’S RESPONSIBILITIES
● Financial statements and internal controls.
● Sarbanes-Oxley increases management’s responsibility for the financial
statements.
● CEO and CFO must certify quarterly and annual financial statements submitted
to the SEC.
Many public companies include a statement regarding management responsibility in relation
to the CPA firm.

AUDITOR’S RESPONSIBILITIES
AICPA auditing standards state:
The overall objectives of the auditor, in conducting an audit of financial statements, are
to:

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 a. 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 presented fairly, in all material respects, in accordance with an applicable
financial reporting framework; and
b. report on the financial statements, and communicate as required by auditing
standards, in accordance with the auditor's findings.
Errors versus Fraud:

ERROR

- unintentional misstatement of financial statements

FRAUD

- intentional
- more difficult to detect because those who are committing the fraud attempt to conceal
the fraud

- 2 types:
a. Misappropriation of assets

- usually committed by employees

- harmful to creditors, stockholders, and others because the assets have
been taken from their rightful owners, the company

b. Fraudulent financial reporting

- usually committed by management

- presents users with incorrect financial information that is used for

decision-making

AUDITOR’S RESPONSIBILITIES FOR DISCOVERING ILLEGAL ACTS

TYPE RESPONSIBILITY

DIRECT-EFFECT → Same as for errors and fraud

INDIRECT → No Assurance

Audit Procedures When Noncompliance Is Identified or Suspected:

● The auditor should obtain an understanding of the situation and discuss the matter with
management at a level above those involved.
● Auditors should obtain sufficient evidence regarding material amounts directly affected
by laws and regulations.

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 ● Laws such as those relating to taxes and pensions usually have a direct effect on the
amounts or disclosures in the financial statements, and therefore require the auditor’s
attention.

Reporting Identified or Suspected Noncompliance:

Unless the matter is inconsequential, the auditor should communicate with those charged with
governance of matters of noncompliance.

PROFESSIONAL SKEPTICISM
Aspects of Professional Skepticism:

2 primary components:

1. A questioning mindset
2. Critical assessment of audit evidence.

Elements of Professional Skepticism:

1. Questioning mindset – “trust but verify” — a disposition to inquiry with some

sense of doubt.
2. Suspension of judgment – withholding judgment until appropriate evidence is
obtained.
3. Search for knowledge — a desire to investigate beyond the obvious, with a
desire to corroborate.
4. Interpersonal understanding —recognition that people’s motivations and
perceptions can lead them to provide biased or misleading information.
5. Autonomy — the self-direction, moral independence, and conviction to decide
for oneself, rather than accepting the claims of others.
6. Self-esteem — the self-confidence to resist persuasion and to challenge
assumptions or conclusions.

PROFESSIONAL JUDGMENT
- is part of professional skepticism.

Elements of the Judgment Process:

❖ Identify and define the issue.

❖ Gather the facts and information and identify the relevant literature.
❖ Perform the analysis and identify potential alternatives.
❖ Make the decision.
❖ Review and complete the documentation and rationale for the conclusion.

Some potential judgment tendencies, traps, and biases to keep in mind:

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FINANCIAL STATEMENT CYCLES
CYCLE APPROACH
● A common form of segmenting
● divides classes of transactions and account balances that are closely related into
segments.

The cycles used in this text are listed below. TRANSACTION CYCLES:

1. Sales and collection cycle

2. Acquisition and payment cycle
3. Payroll and personnel cycle
4. Inventory and warehousing cycle
5. Capital acquisition and repayment cycle

SETTING AUDIT OBJECTIVES

The most efficient way to conduct audits is to obtain some combination of assurance for each
class of transactions and for the ending balances in the related accounts.

Audit objectives for each class of transactions include:

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 ❖ Transaction-related audit objectives (FOR P/L)
❖ Balance-related audit objectives (FOR BALANCE SHEET)
❖ Presentation and disclosure-related audit objectives (FOR NOTES)

MANAGEMENT ASSERTIONS
- implied or expressed representations by management about classes of transactions and
the related accounts and disclosures in the financial statements.
- directly related to the financial reporting framework (U.S. GAAP or IFRS) that forms the
criteria that management uses to record and disclose accounting information in financial
statements.

Management assertions lead to the audit objectives. Therefore, auditors must have a
thorough understanding of management assertions to perform quality audits.

The PCAOB standards describe 5 categories of management assertions: (ECVRP)

● Existence or occurrence - exist, occurred, and recorded

● Completeness - all transactions are included
● Valuation or allocation - included in FS at appropriate amounts
● Rights and obligations - the company controls rights to the ALE
● Presentation and disclosure - components of FS are properly classified, described,
and disclosed

AICPA and IAASB standards describe 3 categories of assertions:

● Assertions about classes of transactions and events

● Assertions about account balances
● Assertions about presentation and disclosure

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TRANSACTION-RELATED AUDIT OBJECTIVES
General Transaction-Related Audit Objectives: (OCCAC)

➢ Occurrence — Recorded transactions exist.

➢ Completeness — Existing transactions are recorded.
➢ Accuracy — Recorded transactions are stated at the correct amounts.
➢ Cut-off — Recorded transactions have been recorded in the correct accounting period
➢ Classification — Transactions and events have been recorded in the proper accounts

Specific Transaction-Related Audit Objectives

The specific transaction-related objectives are tailored to the specific class of

transactions being audited.

Relationship Among Management Assertions and Transaction-Related Audit Objectives

For each management assertion, there are general transaction-related audit objectives
as well as specific transaction-related audit objectives.

Table 6-4 illustrates these relationships using sales transactions.

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General Balance-Related Audit Objectives:

★ Existence — Amounts included exist.

★ Rights and Obligations — Assets are owned or controlled by the entity, and liabilities
are obligations of the entity.
★ Completeness — Existing amounts are included.
★ Valuation and Allocation — Assets, liabilities, and equity interests are included in the
financial statements at appropriate amounts and any resulting adjustments are properly
recorded

Presentation and Disclosure-related Audit Objectives

➔ Occurrence and rights and obligations — Disclosed events, transactions, and other
matters have occurred and pertain to the entity.
➔ Completeness — Existing amounts are included.
➔ Classification and understandability — Financial information is appropriately
presented and described and disclosures are clearly expressed.
➔ Accuracy and valuation — Financial and other information are disclosed fairly and at
appropriate amounts.

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 HOW AUDIT OBJECTIVES ARE MET
Figure 6-8 illustrates four phases of the audit.

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 Phase I: Plan and Design an Audit Approach.

The main objective of an audit is to accumulate enough evidence to provide an opinion on

the financial statements.

Two overriding considerations affect how an auditor approaches the audit:

1. Sufficient appropriate evidence must be accumulated to meet the auditor’s

professional responsibility.

2. The cost of accumulating the evidence should be minimized.

The audit plan should result in an effective audit at a reasonable cost. (cost-benefit
considerations)

Risk assessment procedures include the following:

• Obtain an understanding of the entity and its environment.

• Understand internal control and assess control risk.

• Assess risk of material misstatement. (inherent risk + control risk = risk of material misstatement)

3 types of Audit Risk

● Inherent Risk - innate risk ex. human error; error or omission in a financial
statement due to a factor other than a failure of internal control
● Control Risk - refers to the misstatement of financial statements due to sloppy
accounting practices.
● Detection Risk - risk of not being able to detect misstatement; the risk that the
procedures performed by the auditor will not detect a misstatement that exists
and that could be material, individually or in combination with other
misstatements.

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 Phase II: Perform Tests of Controls and Substantive Tests of Transactions.

• Tests of controls (TOC)

- allow the auditor to evaluate the effectiveness of internal controls and determine
whether the controls can be relied upon to reduce planned control risks.
- not required
- can’t be performed alone (either toc and st or st lng)

• Substantive tests of transactions allow the auditor to evaluate the client’s recording of
transactions.

- required for all audit procedures

Phase III: Perform Substantive Analytical Procedures and Tests of Details of

Balances.

● Analytical procedures consist of evaluations of plausible relationships among financial

and nonfinancial data.

● Tests of details of balances are specific procedures intended to test for monetary
misstatements in the financial statements.

Phase IV: Complete the Audit and Issue an Audit Report.

• After all procedures have been completed, the auditor will reach an overall conclusion as
to whether the financial statements are fairly presented. (4 opinions)

• After the conclusion, the auditor must issue an audit report that will accompany the
client’s financial statements

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 TOPIC 3: AUDIT EVIDENCE

NATURE OF EVIDENCE

AUDIT EVIDENCE DECISIONS

The auditor must make four major decisions regarding what evidence to gather and how much
to accumulate:

1. Which audit procedures to use?

a. Depends on which areas are more risky or what needs attention
2. What sample size to select for a given procedure?
a. Need to consider cost-benefit analysis
3. Which items to select from the population?
4. When to perform the procedures?
a. Nature, Timing, Extent

AUDIT PROGRAM
● includes all of the above information for a given audit.
● Each audit has a unique audit program based on the circumstances of the client.
● details what procedures are to be conducted, the sample sizes, and the timing of the
procedures.
● As the procedures are completed, the auditor “signs off” on the procedure in the audit
program by initialing.

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PERSUASIVENESS OF EVIDENCE
Audit standards require that the auditor accumulate sufficient appropriate evidence to
support the opinion issued.

2 determinants: appropriateness and sufficiency.

Appropriateness of evidence depends on:

❖ Relevance of evidence
➢ means that the evidence must pertain to or be relevant to the audit objective that
is being tested.
❖ Reliability of evidence
➢ refers to the degree to which evidence is believable or worthy of trust. Reliability
depends on the following characteristics:
1. Independence of provider - more trustworthy from banks/ not affiliated
2. Effectiveness of client’s internal controls
3. Auditor’s direct knowledge
4. Qualifications of individuals providing the information - ex. lawyers
5. Degree of objectivity -
6. Timeliness -

Sufficiency of evidence refers to the quantity of evidence obtained.

The sample size that is considered sufficient is affected by two factors:

❖ The auditor’s expectation of misstatements

❖ The effectiveness of the client’s internal controls

Combined Effect—The persuasiveness of the evidence can be evaluated only after

considering the combination of appropriateness and sufficiency.

In making decisions about audit evidence, both persuasiveness and cost must be considered.
The relationships between evidence decisions and persuasiveness are illustrated in Table 7-2.

TYPES OF AUDIT EVIDENCE

Every audit procedure obtains one or more of the following types of evidence : RIORICA

1. Reperformance —The auditor’s test of client’s accounting procedures or controls.

• reperform the procedures done by the accountant ex. recount inventory

2. Inquiry—Obtaining written or oral information from the client in response to auditor

questions. Usually not considered conclusive unless it is corroborated.(confirmed)

3. Observation—Watching a process or procedure being performed by others.

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 4. Recalculation—Rechecking a sample of calculations made by the client.

• ex. cash - recalculate to see if balanced

5. Inspection—The auditor’s examination of the client’s documents and records to

substantiate the information in the financial statements.

● Documents can be internal (prepared by the client’s organization) or external (prepared

or handled by someone outside the organization who is a party to the transaction)
○ Vouching
■ Using documents to support recorded transactions (occurrence)
■ From Books → supporting documents
○ Tracing
■ Testing from source documents to recorded amounts (completeness
objective)
■ Supporting documents→ Books
6. Confirmation—The receipt of a direct written response from a third party verifying the
accuracy of information that was requested by the auditor. Information often confirmed is
detailed in Table 7-3.

2 types of Confirmation:

1. Positive Confirmation - need reply; big amounts

2. Negative Confirmation - no need to respond; small amounts

7. Analytical Procedures—The evaluation of financial information through analysis of

plausible relationships among financial and nonfinancial data and are required during
planning and completion phases of all audits.

Purposes of analytical procedures include:

● Understand the Client’s Industry and Business — Used in planning to gain

knowledge about the client.
● Assess the Entity’s Ability to Continue as a Going Concern — Many ratios
can be an indicator of potential financial problems.
● Indicate the Presence of Possible Misstatements in the Financial
Statements — The presence of unusual fluctuations noted in comparing current
and prior years could signal misstatements.
● Provide Evidence Supporting an Account Balance — If reliable relationships
exist, substantive analytical procedures can be used to support account
balances.

Cost of Types of Evidence:

❖ Most expensive:
➢ Confirmation

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 ❖ Moderately costly:
➢ Reperformance
➢ Inspection
➢ Analytical procedures
❖ Least expensive:
➢ Recalculation
➢ Inquiries of the client
➢ Observation

OBJECTIVE 7-5 (Know the types of analytical procedures and their purposes.)

ANALYTICAL PROCEDURES
Purposes of Analytical Procedures During the Audit Engagement:

1. Analytical procedures are required in the planning phase as part of risk assessment to
understand the client’s business and industry.

2. Analytical procedures are often done during the testing phase of the audit as
substantive tests in support of an account balance.

3. Analytical procedures are required during the completion phase of the audit, serving as
a final review for material misstatements.

Types of Analytical Procedures — Auditors compare client data with:

1. Industry data

2. Similar prior-period data

3. Client-determined expected results

4. Auditor-determined expected results

Internal comparisons and relationships are detailed in Table 7-6.

An example of a substantive analytical procedure is included in Figure 7-2.

COMMON FINANCIAL RATIOS

Financial ratios fall into several categories: ➢ Days to collect receivables
➢ Inventory turnover
❖ Short-Term Debt-Paying Ability:
➢ Days to sell inventory
➢ Cash ratio
➢ Ability to Meet Long-Term Debt
➢ Quick ratio
Obligations:
➢ Current ratio
➢ Debt to equity
❖ Liquidity Activity Ratios:
➢ Times interest earned
➢ Accounts receivable turnover
❖ Profitability Ratios:

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 ➢ Earnings per share ➢ Return on assets
➢ Gross profit percentage ➢ Return on common equity
➢ Profit margin

AUDIT DOCUMENTATION
- the record of the audit procedures performed, relevant audit evidence, and conclusions
the auditor reached.

Purposes of Audit Documentation:

➢ Basis for planning the audit

➢ Record of the evidence accumulated and the results of the tests
➢ Data for determining the proper type of audit report
➢ Basis for review by supervisors and partners

Ownership of the Audit Files: All audit files are the property of the auditor.

Confidentiality of Audit Files:

The AICPA Code of Professional Conduct states that a member in public practice shall not
disclose any confidential client information without the specific consent of the client.

Requirements for Retention of Audit Documentation:

• Auditing standards require records of private companies be retained for a minimum of

five years.

• Sarbanes-Oxley Act requires auditors of public companies to maintain audit files for a
minimum of seven years.

Permanent Files: Contain data of a historical or continuing nature. These provide a convenient
source of information that is used from year to year:

• Copies of company documents such as articles of incorporation, bylaws, bond

indentures, and long-term contracts

• Analyses of accounts from previous years that have continuing importance

• Information related to understanding internal controls and assessing control risk

• Results of analytical procedures from prior years’ audits for comparison

Current Files: Includes all documentation for the current year audit including:

● Audit Program
● Working Trial Balance—Each line in the trial balance is supported by a lead schedule. A
typical lead schedule for Cash is included in Figure 7-4.
● Adjusting Entries—Auditors propose adjusting entries for material misstatements. An
adjusting entry to Cash is illustrated in Figure 7-4.

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 ● Supporting Schedules—Major types:
○ Analysis
○ Trial balance or list
○ Reconciliation of amounts
○ Substantive analytical procedures
○ Summary of procedures
○ Examination of supporting documentation
○ Informational
○ Outside documentation

Preparation of Audit Documentation—Audit documentation should be in sufficient detail to

provide a clear understanding of the work performed, evidence obtained, and conclusions
reached.

Documentation should have these characteristics:

● Identified with the client’s name, period covered, description of the contents, initials of
the preparer, date of preparation, and an index code.
● Files should be indexed and cross-referenced to aid in organization.
● Documentation should clearly indicate the audit work performed through memos,
initialing the procedures in the audit program, or tick marks on the schedules.
● Include sufficient information to fulfill the audit objectives.
● Conclusions reached about the segment of the audit should be clearly stated

TOPIC 4: AUDIT PLANNING AND MATERIALITY

PLANNING
AICPA auditing standards state:
“The auditor must plan the work and properly supervise any assistants.”

Planning means developing a general strategy and a detailed approach for the
expected nature, timing, and extent of the audit. The auditor plans to perform the audit
in an efficient and timely manner.
3 main reasons why the auditor should properly plan the audit engagement:
1. Enable the auditor to obtain sufficient appropriate evidence for the
circumstances.
2. Help keep audit costs reasonable.
3. Avoid misunderstandings with the client.

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8 major steps in audit planning are:
1. Accept client and perform initial audit planning.
2. Understand the client’s business and industry.
3. Perform preliminary analytical procedures. (required in planning stage)
4. Set preliminary judgment of materiality and performance materiality.
5. Identify significant risks due to fraud or error.
6. Assess inherent risk
7. Understand internal control and assess control risk.
8. Finalize overall audit strategy and audit plan.

Three risk terms relevant to audit planning: 3 TYPES OF RISK

● Acceptable audit risk: A measure of how willing the auditor is to accept that the
financial statements may be materially misstated after the audit is completed and
an unmodified opinion has been issued.
- risk na may material misstatement AFTER audit due to fraud or error
- Audit Risk = Inherent Risk X Control Risk X Detection Risk
● Client business risk: The risk that the entity fails to achieve its objectives or
execute its strategies.
- risk na hindi maging profitable, perspective of client
● Risk of material misstatement: The risk that the financial statements contain a
material misstatement due to fraud or error prior to the audit.
- inherent risk + control risk = risk of material misstatement
All three types of risks must be considered by the auditor during the audit
planning process.

STEP 1: ACCEPT CLIENTS AND PERFORM INITIAL AUDIT PLANNING

Initial audit planning involves 4 things:
1. The auditor decides whether to accept a new client or continue serving an
existing client.

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 2. The auditor identifies why the client wants or needs an audit.
3. To avoid misunderstandings, the auditor obtains an understanding with the client
about the terms of the engagement. (send engagement letter)
4. The auditor develops the overall strategy for the audit, including engagement
staffing and any required audit specialists.

1. Client Acceptance and Continuance

New Client Investigation: CPA firms must take care in accepting new clients. The
new (successor) auditor is required by auditing standards to communicate with
the predecessor auditor.
• Due to confidentiality requirements, the client must consent to this
communication.
• The purpose is to determine if the client lacks integrity or if there were
disputes about accounting principles.
Although there is healthy competition for acquiring new clients, CPAs must take
care to establish the integrity of the potential client before accepting the
engagement. An association with a client that lacks integrity can be highly
detrimental to the CPA firm.
Continuing Clients: CPA firms evaluate existing clients to determine whether a
continuing client presents risks due to lack of integrity.
- renew yearly, can stop anytime
2. Identify Client’s Reasons for Audit
Risk factors associated with the client’s reasons for an audit include the
likely statement users and the intended uses of the statements.

3. Obtain an Understanding with the Client

A clear understanding of the terms of the engagement should exist
between the auditor and the client. Auditing standards require that there be an
engagement letter that includes the engagement’s objectives.

The auditor must understand the client’s reasons for seeking an audit,
because it helps the auditor to assess the risk of accepting the new client. Once

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the auditor understands the reasons for the audit, it is imperative that the terms
of the audit engagement are carefully detailed in an engagement letter.
- Bawal mag-audit if walang audit letter
4.1 Develop Overall Audit Strategy
After understanding the client’s reason for an audit, the auditor should
develop and document a preliminary audit strategy.
- should not be given to the management (to prevent preparations from client)
4.2 Select Staff for Engagement and Evaluate Need for Outside Specialists.
Auditors are responsible for having appropriate competence and
capabilities to perform the audit.
The CPA firm must select staff for the engagement who are knowledgeable
about the client’s business. If the CPA firm lacks expertise, it may need to hire
outside specialists.
The auditor will develop an overall audit strategy as soon as the terms of the
engagement are clear. This includes the assignment of personnel who will work
on the audit, as well as determining if there is a need for outside specialists.

STEP 2: UNDERSTAND THE CLIENT’S BUSINESS AND INDUSTRY

Auditing standards require the auditor to perform risk assessment
procedures to obtain an understanding of the client’s business and its
environment to assess the risk of material misstatements.
The auditor identifies and assesses risks of material misstatement, whether
due to fraud or error, based on an understanding of the entity and its
environment, including the entity’s internal control.

An overview of the strategic approach to understanding the client’s

business and industry is illustrated in Figure 8-3.
In order to conduct an effective audit, the auditor must have a clear
understanding of the client’s business and the industry in which it operates.

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 A. Industry and External Environment — There are 3 primary reasons for
obtaining a good understanding of the client’s industry and external
environment:
1. Risks associated with specific industries may affect the auditor’s
assessment of client business risk.
2. Many risks are common to all clients in certain industries.
3. Many industries have unique accounting requirements that the
auditor must understand to evaluate whether the financial
statements are in accordance with accounting standards.
B. Business Operations and Processes — The auditor should understand factors
such as major sources of revenue, key customers and suppliers, sources of
financing, and information about related parties that may increase client business
risk.
Tour Client Facilities and Operations — Touring facilities is helpful in
obtaining an understanding of the client’s operations. (mag-observe)
Identify Related Parties — Because related party transactions may not be at
arm’s length, auditing standards require that related parties and related

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 party transactions be disclosed in the financial statements. (notes to
financial statements, usually have numbers delegated to related parties e.g
if parent, subsidiary, etc)
C. Management and Governance — The auditor needs to assess management’s
philosophy and operating style and its ability to identify and respond to risk.

Governance includes the organizational structure as well as operations of the

board of directors and the audit committee.
Code of Ethics — Public companies must disclose whether they have
adopted a code of ethics that applies to senior management. Auditors
should have an understanding of the code of conduct and investigate any
changes.
Minutes of Meetings — Corporate minutes are the official record of the
meetings of the board of directors. They include key authorizations and
summaries of important topics discussed. The auditor should read the
minutes to identify matters relevant to the audit.

-ask organizational chart

D. Client Objectives and Strategies — The auditor should understand the client
objectives related to: R-E-C
1. Reliability of financial reporting
2. Effectiveness and efficiency of operations
3. Compliance with laws and regulations
- Related to the 3 types of audit (operational, compliance, financial audits)
Business risks can arise that threaten management’s objectives. Knowledge of
management’s objectives and strategies helps the auditor assess client business
risk and the risk of misstatements.

-mission and vision ng company

E. Measurement and Performance — A client’s performance measurement system
includes key performance indicators (KPIs) that management uses to evaluate
progress toward its objectives.
Examples include:
● market share

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 ● sales per employee
● unit sales growth
● Web site visitors
● same-store sales
● sales/square foot
If the client has set unreasonable objectives, especially when employees are
incentivized to meet performance goals, there may be an incentive for aggressive
accounting, which increases the risk of financial statement misstatement.
- how do they measure their own performance?

STEP 3: PERFORM PRELIMINARY ANALYTICAL PROCEDURES

As noted in Chapter 7, auditors are required to perform preliminary analytical
procedures as part of risk assessment.
Key financial ratios, along with industry standards, are presented in Table
8-1.
Common-size financial statements are also often used for one or more years
for comparison as a preliminary analytical procedure. This is illustrated in Figure 8-4 on
page 233.
Preliminary analytical procedures help in the development of the audit
program through the assessment of risk.

STEP 4: SET PRELIMINARY JUDGMENT OF MATERIALITY AND

PERFORMANCE MATERIALITY.
The fourth step in audit planning is to make a preliminary judgment about
materiality for the audit.
Auditing standards define materiality as the magnitude of misstatements that
individually, or when aggregated with other misstatements, could reasonably be
expected to influence the economic decision of users.

- minimum misstatement na kaya natin iaccept

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 There are five steps to applying materiality as noted in Figure 8-5. The first two
are part of the planning process.
Because the audit opinion addresses the idea that the financial statements are
free of material misstatements, applying materiality throughout the audit process is
essential.
Steps in Applying Materiality:
● Step 1: Set materiality for the financial statements as a whole.
● Step 2: Determine performance materiality.
● Step 3: Estimate total misstatement in segment.
● Step 4: Estimate the combined misstatement.
● Step 5: Compare combined estimate with preliminary or revised judgement about
materiality.

OBJECTIVE 8-6 (Make a preliminary judgment about what amounts to consider

material.)

MATERIALITY FOR FINANCIAL STATEMENTS AS A WHOLE

Step 1 in Figure 8-5 is to set materiality for the financial statements as a whole as
part of the planning process.
Factors Affecting Preliminary Materiality Judgment:
• Materiality is a relative rather than an absolute concept. (it depends tlga)
• Benchmarks are needed for evaluating materiality.
• Qualitative factors also affect materiality.
Illustrative guidelines are shown in Figure 8-6 in the form of policy guidelines of a CPA
firm.

DETERMINE PERFORMANCE MATERIALITY

Step 2 in Figure 8-5 is to determine performance materiality, which can also be referred
to as the allocation of the preliminary judgment about materiality to segments.
• PCAOB standards refer to performance materiality as tolerable misstatement.

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 • Auditors have three major difficulties when allocating materiality to balance sheet
accounts:
1. Auditors expect certain accounts to have more misstatements than others.
2. Both overstatements and understatements must be considered.
3. Relative audit costs affect the allocation.

Figure 8-7 illustrates the allocation process.

Performance materiality
● refers to the materiality amount that is determined for specific segments of the
audit.
● often set at 50–75 percent of overall materiality.

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ESTIMATE MISSTATEMENTS AND COMPARE WITH PRELIMINARY
JUDGMENT
Auditors document all misstatements found for each audit segment. These may be
known misstatements or likely misstatements.
Known misstatements are those that the auditor can determine the amount of
misstatement in the account.

There are two types of likely misstatements:

1. Differences between management and the auditor’s judgment about estimates of
account balances
2. Projections of misstatements based on the auditor’s tests of a sample
The last three steps in applying materiality are illustrated in Table 8-2.
At the end of the audit, the auditor must evaluate the number of misstatements, both
known and likely, and make a determination regarding the original preliminary
materiality judgment.

TOPIC 5: ASSESSING THE RISK OF MATERIAL

MISSTATEMENT
Define risk in AUDITING

● Auditors accept some level of risk or uncertainty in performing audits.

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 ● Risk of Material Misstatement at the Overall Financial Statement Level:
Refers to the risks that relate pervasively to the financial statements as a whole
and potentially affect a number of different transactions and accounts.

● Risk of Material Misstatement at the Assertion Level:

There are two components to risk at the assertion level:
1. Inherent risk—Susceptibility of an assertion to material misstatement.
Ex: Cash → easy to missappropriate
Without the consideration of controls ; it’s in the nature na nila to be risky

2. Control risk—Risk that internal controls will not prevent or detect material
misstatement.
Even with internal controls, meron pa rin risk
There are several types of risk in auditing. This chapter defines and discusses the types
of risks, their relationships, and how they affect what the auditor does.

OBJECTIVE 9-2 (Distinguish the different types of risk assessment procedures.)

Risk Assessment Procedures (RAPs)

Risk assessment procedures include the following:
1. Inquiries of management and others within the entity
2. Analytical procedures
3. Observation and inspection
4. Discussion among engagement team members
5. Other risk assessment procedures
IAOI
Inquiry - asking questions to management
Analytical Procedures - plausible relationships
Observation -
Inspection - supporting documents
The role of risk assessment procedures is detailed in Figure 9-1.
Because there are risks with any audit, risk assessment procedures are part of the
audit planning process.

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Considering Fraud Risk
Risk assessment procedures include assessing the risk of material misstatement due to
fraud or error.
The auditor’s consideration of fraud risk is made at both the:
● Financial statement level and
● Assertion level for classes of transactions, account balances, and presentation
and disclosures.
Because several high-profile cases of financial statement fraud involve misstatements
in revenue recognition, auditing standards require the auditor to presume that risks
of fraud exist in revenue recognition.
Part of risk assessment is assessing the risk of fraud at both the financial statement
level and at the assertion level for classes of transactions.

Identification of significant risks

Auditor must determine whether any of the risks identified are significant risk.
A significant risk is any risk that the auditor deems to require special attention.
● Nonroutine transactions, including related-party transactions, often
represent significant risk.
● Account balances or transactions that require estimates for which significant
measurement uncertainty exists also may require more attention.
All fraud risks are normally considered to be significant risks.
FRAUD RISK = SIGNIFICANT RISK

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Audit risk model
The risk of material misstatement at the assertion level consists of two components:
inherent risk and control risk.
Auditors consider these risks by applying the audit risk model:

PDR: AAR = Direct Relationship

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 Planned Detection Risk
● The risk that the audit evidence for an audit objective will fail to detect
misstatements exceeding performance materiality.
● dependent on the other three factors in the model and will change only if the
auditor changes one of the other factors.
Inherent Risk: The auditor’s assessment of the susceptibility of an assertion to
material misstatement.
Control Risk: The auditor’s assessment of the risk that a material misstatement
could occur in an assertion and not be prevented or detected by the client’s internal
controls.
Acceptable Audit Risk: How willing the auditor is to accept that the financial
statements may be materially misstated after the audit is complete and an
unmodified opinion has been issued.

The audit risk model uses all four types of risk to determine the risk involved in an audit.

Assessing acceptable Audit risk

Auditors must decide on appropriate acceptable audit risk.

Acceptable audit risk must be determined in order for the auditor to properly plan the audit.

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 Auditors must first decide engagement risk and use it to modify acceptable audit risk.

Engagement risk
- is the risk that the auditor (or firm) will suffer harm after the audit is finished, even
though the report was correct.
- is closely related to client business risk because the risk that the auditor will be
sued is often related to business failure after the audit is finished.

Factors Affecting Acceptable Audit Risk:

● The degree to which external users rely on the statements based on these
factors:
○ Client size - if bigatin si client,bigatin din mga users, so high reliance
○ Distribution of ownership
○ Nature and amount of liabilities
● The likelihood that a client will have financial difficulties after the audit based on
these factors:
○ Liquidity position
○ Profits (losses) in previous years
○ Method of financing growth
○ Nature of the client’s operations
○ Competence of management
● The auditor’s evaluation of management’s integrity
Assessing acceptable risk depends on the factors listed on this slide—many of these
items are also used in gaining an understanding of the client, its business, and the
industry in which it operates.

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Making the Acceptable Audit Risk Decision

Assessing inherent risk

● is an attempt by the auditor to predict where misstatements are most and least
likely in the financial statement segments.
● affects the amount of audit evidence that the auditor needs to accumulate.
● The auditor must assess the factors that make up the risk and modify
procedures for audit evidence to take them into consideration.
● This consideration takes place during the planning phase and is updated
throughout the audit process. (pede magchange ang plans)
Inherent risk is the amount of risk involved with an account balance or class of
transactions that comes from the type of account or transaction that it is.

Factors to Consider when Assessing Inherent Risk:

● Nature of the client’s business
● Results of previous audits
● Initial versus repeat engagement
● Related parties
● Complex or nonroutine transactions
● Judgment required to correctly record account balances and transactions
● Makeup of the population
● Factors related to fraudulent financial reporting
● Factors related to misappropriation of assets
OBJECTIVE 9-8 (Discuss the relationship of risk to audit evidence.)

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Relationship of risks to evidence and factors influencing risks

Figure 9-3 summarizes the relationship of risk factors and audit evidence.

In addition to modifying audit evidence, the auditor can also make the following
changes to respond to risks:

1. The engagement may require more experienced staff.

2. The engagement will be reviewed more carefully than usual.

Audit Risk for Segments—The risk of material misstatement, control risk, and
inherent risk are assessed for each audit objective in each segment of the audit.

Relating Performance Materiality and Risks to Balance-Related Audit Objectives

Although it is common to assess inherent and control risks for each balance-related
audit objective, it is not common to allocate materiality to those objectives.

Measurement Limitations
One major limitation in the application of the audit risk model is the difficulty of
measuring the components of the model. It is a highly subjective process, so most
auditors use broad categories such as low, medium, and high.

Tests of Details of Balances Evidence-Planning Worksheet

Auditors develop various types of decision aids to help link judgments affecting audit
evidence with appropriate evidence to accumulate.
One such worksheet is illustrated in Figure 9-4.

Revising Risks and Evidence—The audit risk model is primarily a planning model and
is of limited use in evaluating results.
If audit evidence suggests that the risk is higher than originally thought, the auditor
must revise the original assessment and consider the effect of the revision on evidence
requirements.

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RELATIONSHIP OF RISK AND MATERIALITY TO AUDIT EVIDENCE
The concepts of materiality and risk in auditing are closely related and inseparable.
Risk is a measure of uncertainty.
Materiality is a measure of magnitude.

TOPIC 6: AUDIT REPORTS

Describe the parts of the standard unmodified opinion audit report for nonpublic entities under AICPA
auditing standards.

Parts of standard unmodified opinion audit report

1. Report title
2. Audit report address
3. Introductory paragraph
4. Management’s responsibility
5. Auditor’s responsibility
6. Opinion paragraph
7. Signature and address of CPA firm
8. Audit report date
The audit report details what the auditor did and how it was done in order to form an
opinion on the financial statements. Auditors’ responsibility versus management
responsibility is clearly stated.

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Conditions for standard unmodified opinion audit report

1. Includes all financial statements

2. Sufficient appropriate evidence accumulated

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 3. Financial statements are presented fairly in accordance with GAAP or other
framework
4. No circumstances requiring the addition of an emphasis-of-matter paragraph or
modification

If any of the circumstances required for the unmodified opinion are not met, another
type of opinion must be issued. These are detailed in Figure 3-2.

OBJECTIVE 3-3

Understand reporting on financial statements and internal control under PCAOB

auditing standards.

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Standard audit report and report on internal control over financial
reporting under PCAOB auditing standards

Two significant audit reporting differences for public companies.

1. The standard unmodified opinion audit report is different. The differences are
detailed in Figure 3-3.
2. Auditors of larger public companies must also issue an opinion on internal control
over financial reporting.

Section 404(b) of the Sarbanes-Oxley Act requires the auditor of a public company to
report on the effectiveness of internal control over financial reporting.

PCAOB Auditing Standard 5 requires the audit of internal control to be integrated with
the audit of financial statements.

However, the auditor may issue separate reports, such as the separate report on
internal control over financial reporting shown in Figure 3-4, or a combined report.

Separate reporting is more common.

The PCAOB requires that the audit of internal control over financial reporting be a
part of the overall financial audit. The report on internal controls may be
combined with the audit opinion report, or it may be a separate report.

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OBJECTIVE 3-4

Describe the five circumstances when an emphasis-of-matter explanatory paragraph or

nonstandard wording is appropriate to include in an unmodified opinion audit report.

Unmodified opinion audit report with emphasis-of-matter explanatory

paragraph or nonstandard report wording

The unmodified opinion audit report with emphasis-of-matter paragraph or nonstandard

report wording

● Meets the criteria of a complete audit with financial statements that are fairly
presented

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 ● But auditor wants to draw attention to certain matters or is required to
provide additional information.

The most important causes of the addition of an emphasis-of-matter paragraph or a

modification of wording under both AICPA and PCAOB audit standards:

● Lack of consistent application of standards

● Substantial doubt about going concern as illustrated in Figure 3-6
● Auditor agrees with departure from promulgated accounting principles
● Emphasis of other matters
● Reports involving other auditors as illustrated in Figure 3-7

Examples of emphasis of other matters include the following:

● The existence of material related party transactions

● Important events occurring subsequent to the balance sheet date
● The description of accounting matters affecting the comparability of the
financial statements with those of the prior year
● Material uncertainties disclosed in the footnotes such as unusually important
litigation or regulatory action
● A major catastrophe that has had or continues to have a significant effect on
the entity’s financial position

Emphasis-of-matter can include anything that the auditor deems important enough to
include in the audit report.

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Emphasis of a Matter

● Significant related party transactions

● Material subsequent events
● Accounting matters affecting comparability of the financial statements
● Material uncertainties disclosed in the footnotes

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OBJECTIVE 3-5

Identify the types of audit reports that can be issued when an unmodified opinion is not
justified.

Modifications to the opinion in the audit report

Three conditions requiring a modification to the audit opinion:

1. The scope of the audit has been restricted (scope limitation).

2. The financial statements have not been prepared in accordance with generally
accepted accounting principles (GAAP departure).
3. The auditor is not independent.

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Three types of reports may be appropriate:

1. Qualified opinion — Can be used for a scope limitation or departure from

GAAP, but only when the auditor concludes that the overall financial statements
are fairly stated.
2. Adverse opinion — Used when financial statements are so materially misstated
or misleading that they do not present fairly the financial position of the entity.
This is uncommon and is rarely used.
3. Disclaimer of opinion — Used when the auditor cannot form an opinion on the
financial statement due to a severe scope limitation, lack of knowledge on the
part of the auditor, or lack of independence.

Qualified opinions use the language “except for” to indicate what the limitation
or GAAP departure is.

MATERIALITY

A common definition of materiality as it applies to accounting and auditing is:

A misstatement in the financial statements can be considered material if knowledge of

the misstatement will affect a decision of a reasonable user of the statements.

Three levels of materiality are used for determining the type of opinion to issue:

1. Amounts are immaterial: A standard unmodified opinion audit report is

appropriate.
2. Amounts are material but do not overshadow the financial statements as a
whole: A qualified opinion using “except for” is appropriate.
3. Amounts are so material or so pervasive that overall fairness of the
statements is in question: A disclaimer or adverse opinion is appropriate

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Materiality Decisions

Decisions regarding materiality in specific audit situations involves judgment on the part
of the auditor. These decisions are based on the following:

● Materiality decisions — Non-GAAP condition

● Dollar amounts compared with a benchmark
● Measurability
● Nature of the item

Materiality decisions — Scope limitations conditions

There are no simple rules to determine materiality in an audit. The auditor must
consider the above items in each specific situation and use his or her professional
judgement to make a determination on materiality.

Discussion of conditions requiring a modification of opinion

Modification of the audit opinion can arise from several different circumstances:

Auditor’s Scope Has Been Restricted

● Caused by the client or by conditions beyond the control of either the client or the
auditor.
● A scope restriction can lead to a qualified report (as illustrated in Figure 3-8) or a
disclaimer of opinion (as illustrated in Figure 3-9), depending on the facts in the
situation.

Statements Are Not in Conformity with GAAP

A departure from GAAP may result in a qualified report or an adverse opinion

depending on the facts in the situation.

In a scope restriction and in a departure from GAAP situation, the auditor must decide if
the limitation or departure is severe enough to warrant a disclaimer of opinion or not. If
not, a qualified opinion with the “except for” clause is used.

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Auditor Is Not Independent

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If the auditor is not independent as specified by the AICPA Code of Professional
Conduct, a disclaimer of opinion is required even though necessary audit procedures
were performed. The wording in Figure 3-12 is recommended in this situation.

OBJECTIVE 3-8

Determine the appropriate audit report for a given audit situation.

Auditor’s decision process for audit reports

● Determine whether any condition exists requiring a departure from a standard

unmodified opinion report.
● Decide the materiality for each condition.
● Decide the appropriate type of report for the condition, given the materiality level.
● Write the audit report.
● Determine if more than one condition requiring a departure or modification exists.
● Table 3-2 summarizes the conditions requiring a departure from a standard
unmodified opinion report.

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OBJECTIVE 3-9

Understand use of international accounting and auditing standards by U.S. companies.

International Accounting and auditing standards

U.S. public companies are required to prepare financial statements that are filed with
the Securities and Exchange Commission (SEC) in accordance with U.S. GAAP.

An auditor may be engaged to report on financial statements prepared in accordance

with IFRS. In that situation, the auditor refers to those standards rather than GAAP in
the audit report as follows:

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