CHAPTER 7: INTRODUCTION TO

FINANCIAL STATEMENT AUDIT

INDEPENDENT AUDITING
DEFINED
◦ Auditing is a systematic process by which a component, Independent person objectively obtains and
evaluates evidence regarding assertions about economic actions and events to ascertain the degree of
correspondence between those assertions and established criteria and communicating the results to
intended users.
OBJECTIVES OF AUDITING
◦ The objective of an audit of financial statements is to enable the auditor to express an opinion whether
the financial statements are prepared, in all material respects, in accordance with an identified financial
reporting framework.
◦ The phrase used to express the auditor’s opinion is “present fairly, in all material aspects”
In conducting an audit of financial statements, the overall responsibilities of the auditor are:
a. To obtain reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to a fraud or error, thereby enabling the auditor to express an
opinion whether the financial statements are prepared, in all material respects, in accordance with an
applicable financial reporting framework; and
b. To report on the financial statements, and communicate as required by the Philippine Standards on
Auditing (PSAs), in accordance with the auditor’s findings.
SCOPE OF INDEPENDENT AUDIT
◦ The term “scope of an audit” refers to the audit procedures deemed necessary in the circumstances to
achieve the objective of the audit. The procedures required to conduct an audit in accordance with PSAs,
relevant professional bodies, legislation, regulation and, where appropriate. The terms of the audit
engagement and reporting requirements.
WHY INDEPENDENT FINANCIAL
AUDITING IS NECESSARY
◦ As society becomes more complex, there is an increased likelihood that unreliable information will be
provided to decision makers. This is referred to as “information risk”. Some of the factors that contribute
to information risk are:
a. Remoteness of information users from information providers
b. Potential bias and motives of information provider
c. Voluminous data
d. Complex exchange transactions
e. Consequences
HOW INFORMATION RISK MAY BE
REDUCED
◦ Allow users to verify information
◦ User shares information risk with management
◦ Have the financial statements audited
ADVANTAGES AND PRACTICAL BENEFITS OF
INDEPENDENT AUDIT
◦ To the auditee or client
1. Independent audit makes the financial statements more credible and reliable.
2. Management is the beneficiary of constructive suggestions in improving business operations.
3. Commission of fraud by management and employee is minimized.
4. Audited financial statements provide a more credible basis for the tax return preparations.
5. Better and sound management decisions may be made if financial records and reports are accurately maintained and provided.
◦ To creditors, prospective investors, employees
1. Financial institutions have more credible basis in deciding whether financial assistance will be extended to the auditee.
2. Suppliers and other creditors will have more reliable basis in making decisions related to extension of credit.
3. Potential and current investors will have more credible basis in evaluating managerial efficiency.
4. Employees will have a better and credible basis in requesting for fringe benefits and wage adjustments.
5. In the event of sale, purchase, or merger of a business, both buyer and seller will have more confident basis for aiming at a decision
as to the terms and conditions of the arrangement.
◦ To Government Agencies and Legal Community
1. BIR has more assurance concerning accuracy and dependability of tax return if they have been based
on audited financial statements.
2. Government institutions like GSIS, SSS, DBP will have better basis in extending financial assistance to
business enterprises.
3. Audited statements provide the legal community in independent basis for administering estates and
trust, setting action in bankruptcy and insolvency, etc.
Audit Formulation Process
Phase I Risk Assessment
Performing Risk Assessment including Client acceptance and Continuance
Phase II Risk Response
Obtaining Evidence about IC
Obtaining substantive Evidence
Phase III Reporting
Completing the Audit and Making reporting decisions
GENERAL PRINCIPLES OF AN
AUDIT
◦ Compliance with ethical requirements
◦ Reasonable assurance
◦ Responsibility for the financial statements
◦ Skills and knowledge needed in financial statement audit
◦ Parties involved in preparing and auditing financial statements
◦ The context of financial statement auditing
◦ The business entity as the primary context of auditing
◦ Relating the audit process components to the business model
Management Assertions
◦ Assertions about classes of transactions and events for the period
Occurrence
Completeness
Authorization
Accuracy
Cut off
Classification
Preparation
Management Assertions
◦ Assertions about balances
Existence
Completeness
Accuracy, valuation and allocation
Classification
Presentations
Assurance Engagement According to
Structure
◦ Assertion based Engagement-In this type of engagement , 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.
◦ Direct Reporting Engagement- In this type of engagements, the practitioner either directly performs the
evaluation of 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.
Fundamental Concepts in FS Audit
◦ Materiality
◦ Audit risk
◦ Evidence
Comprehensive Example of Assertion-based and Direct Reporting
Engagements

A firm is engaged to provide assurance on the total proven oil reserves of 10 independent companies. Each
company has conducted geographical and engineering surveys to determine their reserves (subject matter).
There are established criteria to determine when a reserve may be considered to be proven which the
practitioner determines to be suitable criteria for the engagement. The proven reserves for each company as
at December 31, 2012 were as follows:
 Proven Oil Reserves
(in thousands of barrels)
Company 1 5200
Company 2 725
Company 3 3260
Company 4 15000
Company 5 6700
Company 6 39126
Company 7 345
Company 8 175
Company 9 24135
Company 10 9635
TOTAL 104301
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The engagement could be structured in differing ways:

Assertion-Based Engagement
1. Each company measures its reserves and provides an assertion to the firm and to intended users.
2. An entity other than the companies measures the reserves and provides an assertion to the firm and to
intended users.

Direct Reporting Engagements

3. Each company measures the reserves and provides the firm with a written representation that measures
its reserves against the established criteria for measuring proven reserves. The representation is not
available to the intended users.
4. The firm directly measures the reserves of some of the companies.