Auditing Theory.docx

AUDITING THEORY 1. Professional Accountant He or she is an individual who holds a valid certificate issued by the Board of Accountancy (i.e., Certified Public Accountant), whether he/she be in public practice, industry, commerce, the public sector or education.

He or she is a person who, after obtaining the required education passes an extensive examination and is licensed by the country to practice as a professional accountant.

Regulatory Government Agencies Scope of Practice of Professional Accountants 3. Practice of Public Accountancy This shall constitute in a person, be it in his/her individual capacity, or as a partner or a staff member in an accounting or auditing firm, holding out himself/herself as one skilled in the knowledge, science and practice of accounting, and as a qualified person to render professional services as a certified public accountant. 4. Practice in Commerce and Industry This shall constitute in a person involved in decision making requiring professional knowledge in the science of accounting, or when such employment of position requires that the holder thereof must be a certified public accountant. 5. Practice in Education or Academe This shall constitute in a person in an educational institution which involve teaching of accounting, auditing, management advisory services, finance, business law, taxation and other technically related subjects. 6. Practice in the Government This shall constitute in a person who holds, or is appointed to, a position in the accounting professional group in government or in a government-owned and/or controlled corporation, including those performing proprietary functions, where decision making requires professional knowledge in the science of accounting, or where a civil service eligibility as a certified public accountant is a prerequisite. ***

9. Professional Regulation Commission (PRC) PRC administers, implements and enforces the regulatory policies of the National Government with respect to the regulation and licensing of various professions under its jurisdiction including the maintenance of professional standards and ethics and the enforcement of the rules and regulations relative thereto. 10. Professional Regulatory Board of Accountancy (BOA) This board, consisting of a chairman and six members, is the agency that is empowered to administer the Accountancy Law. As a licensing agency of the government, the board is the only body that may issue and revoke CPA certificates and grant licenses to practice. 11. Securities and Exchange Commission (SEC) This is the government agency that regulates the registration and operations of corporations, partnerships and other forms of associations in the Philippines. 12. Commission on Audit (COA) This is the agency that audits or determines whether government units handle their funds according to existing laws and whether their programs are being conducted efficiently and economically. 13. Bureau of Internal Revenue (BIR) The BIR is responsible for enforcement of the tax laws, rules and regulations. Professional Organization

7. Certified Public Accountant “We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 15. Philippine Institute of Certified Public Accountants (PICPA) PICPA is the accredited national professional organization of CPAs. It serves all members in the different sectors of the accounting profession. Year-round professional development programs and regular fellowship and sport activities are sponsored by the association for its members.

21. International Auditing Practices Committee (IAPC) The IAPC is a standing committee of the Council of IFAC and is responsible for the development and issuance on behalf of the Council, standards and statements on a variety of audit and attests functions in order to improve the degree of uniformity of auditing practices and related services throughout the world.

16. Sectoral Professional Organizations

22. Auditing and Assurance Standards Council (AASC) The AASC is the body authorized to establish and promulgate generally accepted auditing standards (GAAS) in the Philippines.

a. Association of CPAs in Public Practice (ACPAPP) b. Association of CPAs in Education (ACPAE) c. Association of CPAs in Commerce and Industry (ACPACI) d. Government Association of CPAs (GACPA) Standard Setting Bodies 18. International Federation of Accountants (IFAC) IFAC has as its mission the development and enhancement of the profession to enable it to provide services of consistently high quality in the public interest. It is a non-profit, non-governmental, non-political international organization of accountancy bodies. 19. International Accounting Standards Board (IASB) The Board is committed to developing, in the public interest, a single set of high quality, global accounting standards that require transparent and comparable information in general purpose financial statements. 20. Financial Reporting Standards Council (FRSC) As the successor of Accounting Standards Council (ASC), FRSC’s main function is to establish generally accepted accounting principles (GAAP) in the Philippines.

Philippine Standards Issued by AASC 24. Philippine Standards on Auditing (PSAs) These standards are applicable to the audit of historical financial information. 25. Philippine Standards on Review Engagements (PSREs) These standards are applicable to the review of historical financial information. 26. Philippine Standards on Assurance Engagements (PSAEs) These standards are applicable to assurance engagements dealing with subject matters other than historical financial information. 27. Philippine Standards on Related Services (PSRSs) These standards are applicable to related services such as compilation engagements, engagements to apply agreed-upon procedures to information and other related services engagements as specified by the AASC. *** 28. Philippine Standards on Quality Control (PSQC)

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY These standards are to be applied for all services falling under the AASCs engagement standards. 29. Philippine Auditing Practice Statements (PAPSs) These provide interpretative guidance and practical assistance to professional accountants in implementing Philippine Standards and promote good practice. 30. AASC Bulletins and AASC Alerts These refer to a regular publication issued by the AASC to provide guidance to auditors in the application of PSAs. These are not part of PSAs and do not change the requirements of relevant PSAs. 31. Philippine Framework for Assurance Engagements This Framework defines and describes the elements and objectives of an assurance engagement, and identifies engagements to which PSAs, PSREs and PSAEs apply. It does not of itself establish standards or provide procedural requirements for the performance of assurance engagements. Types of Services of Professional Accountants in Public Service 33. Assurance Services or Engagements These refer to engagements in which a practitioner expresses a conclusion designed to enhance the degree of confidence that intended users can have about the evaluation or measurement of a subject matter that is the responsibility of a party, other than the intended users or the practitioners, against criteria. 34. Non-Assurance Services or Engagements These refer to those that do not result in a practitioner’s expression of a conclusion that provides a level of assurance, whether negative assurance or other form of assurance. ***

35. Assertion-Based Engagements One party measures or evaluates the subject matter against suitable criteria and makes an assertion. Another party provides assurance on the reliability of the assertion. 36. Direct Reporting Engagements One party measures or evaluates the subject matter against suitable criteria. The same party reports directly on the subject matter. Types of Assurance Engagements 38. Reasonable Assurance Engagement It is an engagement that aims to reduce the assurance engagement risk to an acceptably low level in the circumstances of the engagement as the basis for a positive form of expression in the practitioner’s conclusion. “In our opinion, the accompanying financial statements present fairly, in all material respects, (or give a true and fair view of) the financial position, financial performance and cash flows of the company for the year ended in accordance with IFRSs.” 39. Limited Assurance Engagement It is one that aims to reduce the assurance engagement risk to a level that is acceptable in the circumstance of the engagement but where that risk is greater than for a reasonable assurance engagement as a basis for a negative form of expression of the practitioner’s conclusion. “In our opinion, nothing has come to our attention that causes us to believe that the accompanying financial statements are not presented fairly, in all material respects, in accordance with PAS.” 40. Other Assurance Services These are assurance services performed by professional accountants not falling under either reasonable or limited assurance engagement classification (e.g., annual environmental audit, compliance with trading policies and procedures, ISO 9000 certifications, assurance services on information technology, etc.)

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

Specific Examples of Assurance Engagements 42. Independent Financial Statements Audit Engagement It is an assurance engagement to provide a high (reasonable) level of assurance that the financial statements are free of material misstatement. 43. Review of Financial Statements It involves limited investigation of much narrower scope than an audit and undertaken for the purpose of providing limited (negative) assurance that the statements are presented in accordance with identified financial reporting standards. 44. Other Review Engagements Financial institutions may require debtors to engage CPAs to provide assurance about the debtors’ compliance with certain covenant provisions stated in the loan agreement. Other examples are review of investment performance statistics for organizations such as mutual funds and computer software review. *** 45. Elements of an Assurance Engagement a. b. c. d. e.

A three-party relationship An appropriate subject matter Suitable criteria Sufficient appropriate evidence A written assurance report

46. A Three-Party Relationship Assurance engagements always involve three separate parties namely, the practitioner, responsible party and intended user. The last two will often but not necessarily be from separate organizations (e.g., responsible party – accounting department, intended user – board of directors). Components of the Three-Party Relationship

He or she is the person who provides the assurance to the intended users about a subject matter that is the responsibility of another party. 49. Responsible Party He or she (sometimes they) is the person who in a direct-reporting engagement, is responsible for the subject matter (the matter represented by the financial statements); or in an assertion-based engagement, is responsible for the subject matter information (assertion or the specific contents of the financial statements itself), and may be responsible for the subject matter. 50. Intended Users They are the person, persons or class of person for whom the practitioner prepares the assurance report. The responsible party can be one of the intended users, but not the only one. *** 51. An Appropriate Subject Matter It is the matter presented for consideration in the engagement. Forms of Appropriate Subject Matter 53. Financial Performance or Conditions Examples: historical or prospective financial position, financial performance and cash flows. 54. Non-Financial Performance or Conditions Example: operating efficiency of the production division of an entity 55. Physical Characteristics Example: capacity of a facility

56. Systems and Processes Examples: an entity’s internal control or IT system 57. Behavior

48. Practitioner “We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY Examples: corporate governance, compliance with regulation, human resource practices *** 58. Criteria for Appropriateness of Subject Matter Suitable Criteria An appropriate subject matter is: a. Identifiable and capable of consistent evaluation or measurement against identified criteria; and b. Such that the information can be subjected to procedures for gathering sufficient appropriate evidence to support a reasonable assurance or limited assurance conclusion, as appropriate.

65. Ways of How Criteria Are Made Available to Intended Users a. Publicly b. Through inclusion in a clear manner in the presentation of the subject matter information c. Through inclusion in a clear manner in the assurance report d. By general understanding (e.g., criterion for measuring time in hours and minutes) 66. Audit Evidence It is all the information used by the auditor in arriving at the conclusions on which the audit opinion is based and includes the information contained in the accounting records underlying the financial statements and other information.

Characteristics of Suitable Criteria 60. Relevance Relevant criteria contribute to conclusions that assist decision-making by the intended users. 61. Completeness Criteria are sufficiently complete when relevant factors that could affect the conclusions in the context of the engagement circumstances are not omitted. 62. Reliability Reliable criteria allow reasonably consistent evaluation or measurement of the subject matter including, where relevant, presentation and disclosure, when used in similar circumstances by similarly qualified practitioners. 63. Neutrality Neutral criteria contribute to conclusions that are free from bias. 64. Understandability Understandable criteria contribute to conclusions that are clear; comprehensive, and not subject to significantly different interpretations. ***

67. Sufficient Appropriate Evidence The practitioner plans and performs an assurance engagement with an attitude of professional skepticism to obtain sufficient appropriate evidence about whether the subject matter information is free of material misstatement. 68. Professional Skepticism An attitude of professional skepticism means the practitioner makes a critical assessment, with a questioning mind, of the validity of evidence obtained and is alert to evidence that contradicts or brings into question the reliability of documents or representations by the responsible party. 69. Sufficiency of Evidence Sufficiency is the measure of the quantity of evidence. 70. Appropriateness of Evidence Appropriateness is the measure of the quality of evidence; that is, its relevance and reliability.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 71. Relationship between the Quantity of Evidence Needed and the Risk of the Subject Matter Information Being Materially Misstated The greater the risk, the more evidence is likely to be required (direct relationship). 71. Relationship between the Quantity of Evidence Needed and the Quality of Such Evidence The higher the quality of audit evidence, the less may be required. However, merely obtaining more evidence may not compensate for its poor quality (interrelated). 72. Generalizations Evidence

about

the

Reliability

of

a. Evidence is more reliable when it is obtained from independent sources outside the entity. b. Evidence that is generated internally is more reliable when the related controls are effective. c. Evidence obtained directly by the practitioner (e.g., observation) is more reliable than evidence obtained indirectly or by inference (e.g., inquiry). d. Evidence is more reliable when it exists in documentary form (e.g., written record vs. oral representation). e. Evidence provided by original documents is more reliable than evidence provided by photocopies or facsimiles. 73. Corroboration of Evidence The practitioner ordinarily obtains more assurance from consistent evidence obtained from different sources or of a different nature that from items of evidence considered individually. In addition, obtaining evidence from different sources or of a different nature may indicate that an individual item of evidence is not reliable. 74. Materiality It is the threshold above which missing or incorrect information in the financial statements is

considered to have an impact on the decision making of users. 75. Relationship between the Quantity of Evidence Needed and Materiality The higher the materiality level, the lower the audit risk and vice versa (inverse relationship). 76. Relationship between the Quantity of Evidence Collected Assurance Engagement Risk It is the risk that the practitioner expresses an inappropriate conclusion when the subject matter information is materially misstated. The lesser evidence collected, the higher the assurance engagement risk and vice versa. 77. Written Assurance Report The practitioner provides a written report containing a conclusion that conveys the assurance obtained about the subject matter information. Specific Examples of Non-Assurance Engagements 79. Agreed-upon Procedures Services It is a type of engagement in which the party engaging the professional accountant or the intended user determines the procedures to be performed and the professional accountant provides a report of factual findings as a result of undertaking those procedures. 80. Compilation of Financial or Other Information Its objective is for the CPA to use accounting expertise, as opposed to auditing expertise, to collect, classify and summarize financial information (preparation of financial statements). 81. Tax Services A CPA is considered qualified to prepare corporate and individual tax returns for both audit and non-audit clients. 82. Management Consulting / Advisory Services

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY It refers to the work done by professional accountants which focuses on advising companies on the best ways to manage and operate their business. 83. Accounting and Data Processing or Information Technology System Services Services under these items include doing manual or automated bookkeeping, journalizing and posting adjusting entries or preparing (or compiling) financial statements. Also, other businesses have begun to see “outsourcing: as an alternative for information system, tax, stock and transfer agency and internal auditing. 84. Reports on Non-Assurance Engagements Reports on these types of engagements must be clearly distinguished from reports on assurance engagements. So as not to confuse the users, a report that is not an assurance report avoids the following: a. b. c.

Implying compliance with the Framework, PSAs, PSREs and PSAEs; Inappropriately using the words “assurance”, “audit” or review”; and Including a statement that could reasonably be mistaken for a conclusion designed to enhance the degree of confidence of intended users about the outcome of the evaluation or measurement of a subject matter against criteria.

85. Summary of Reports Provided by Different Types of Engagements a. b. c. d.

Audit – Positive assurance on assertion(s) Review – Negative assurance on assertion(s) Agreed-Upon Procedures – Factual findings on procedures Compilation – Identification of information compiled

86. Conversion of an Assurance Engagement to a Non-Assurance Engagement

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 which may be any of the following but not limited to: a. A change in circumstances that affects the intended users’ requirements; or b. A misunderstanding concerning the nature of the engagement. If such a change is made, the practitioner does not disregard evidence that was obtained prior to the change. 87. Challenges Faced by the Public Accounting Profession a. Accounting in highly complex business environment or increasingly complex transaction and organizational standard. b. Computer systems are complex. c. Many companies are global. d. There is time pressure to get the audit done and to report more quickly than ever before. e. There is a need to generate audit fees sufficient to both attract new people to the profession and retain managers and partners, who often operate under having stress to fulfill this most important obligation. 88. Expectation Gap It is the gap between what auditors attempt to do in an audit and the user’s expectations of the audit.

89. Auditing It is a systematic process by which a competent, independent person objectively obtains and evaluates evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY assertions and established criteria communicating the results to intended users.

and

The likelihood that unreliable information will be provided to decision makers. It is the reason why independent auditing is necessary.

Key Words and Phrases in the Definition of Auditing 100. Factors that Contribute to Information Risk 91. Systematic Process This implies a structured, logical and organized series of steps and procedures. 92. Competent, Independent Person The auditor must be qualified to understand the criteria used and the competence to know how and what evidence to accumulate to reach the proper conclusion. 93. Objectively Obtains and Evaluates Evidence This means examining the bases for the assertions (representations) and judiciously evaluating the result without bias or prejudice either for or against the individual (or entity) making the representations. 94. Assertions about Economic Actions and Events These are the representations made by the individual or entity.

95. Degree of Correspondence This refers to the closeness with which the assertions can be identified with established criteria. 96. Established Criteria These are the standards against which the assertions or representations are judged. 97. Communicating the Results This is often referred to as attestation. The final stage in the audit process is the audit report – the communication of the findings to users. 98. Interested Users These are individuals who use (rely on) the auditor’s findings (e.g., stockholders, management, creditors, governmental agencies and the public). *** 99. Information Risk

a. Remoteness of information users from information providers b. Potential bias and motives of information provider c. Voluminous data d. Complex exchange transactions 101. Ways of Reducing Information Risk a. Allow users to verify information. b. User shares information risk with management. c. Have the financial statements audited. General Types of Audit 103. Independent Financial Statements Audit It consists of methodological review and objective examination of financial statements prepared by an enterprise (auditee) to determine if such statements have been prepared in conformity with financial reporting practices that are appropriate for the auditee. 104. Internal Audit It is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by brining a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and government processes. 105. Government Audit It involves the determination of whether government funds are being handled properly and in compliance with existing laws and whether the programs are being conducted efficiently and economically. Types of Auditors

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 106. Independent or External Auditor He or she is a certified public accountant (CPA) who examines the financial records and business transactions of a company with which he is not affiliated.

It means that there is absolutely no misstatement in the financial statement and thus financial statements are absolutely reliable and relevant for the user of financial statements. ***

107. Internal Auditor He or she could be from a CPA firm hired by the entity as consultant or employee of an individual company who perform independent appraisal activity within the organization such as review of accounting, financial and other operations as a basis for service to management.

114. Inherent Limitations in an Audit Hindering the Achievement of Absolute Assurance

108. Government Auditor He or she maintains and examines records of government agencies and of private businesses or individuals performing activities subject to government regulations or taxation. *** 109. Objective and Scope of Independent Audit Since the objective of an independent audit is to express an opinion on the company’s financial statement, the auditor will conduct a critical and systematic examination of the statements and of the related documents, records, procedures and control. Types of Assurance 111. Reasonable Assurance It is the level of confidence that the financial statements are not materially misstated that an auditor, exercising professional skill and care, is expected to attain from an audit (also known as high level of assurance). 112. Limited Assurance It is the level of assurance obtained where engagement risk is reduced to a level that is acceptable in the circumstances of the engagement, but where that risk is greater than for a reasonable assurance engagement. 113. Absolute Assurance

a. The use of testing b. Inherent limitations of any accounting and internal control system (e.g., possibility of collusion) c. The fact that most audit evidence is persuasive rather than conclusive d. The use of judgment in some aspects of the auditor’s work 115. Persuasive Evidence It is evidence that has the power to influence or persuade someone to believe in its truth (e.g., evidence gathered through sampling). 116. Conclusive Evidence It is a solid evidence after which no further proof or inquiry is required & evidence in itself is complete (e.g., evidence gathered if the whole population is tested). 117. Responsibility for the Financial Statement While the auditor is responsible for forming and expressing an opinion on the financial statements, the responsibility of preparing and presenting the financial statements is that of the management of the entity. 118. Objective and Scope of Internal Auditing The objective of internal auditing is to assist all members of management in the effective discharge of their responsibilities, by furnishing them with analyses, appraisals, recommendations, and pertinent comments concerning the activities reviewed. 119. Independence Required for Internal Auditors Internal auditors are required to be independent so that they would be able to render

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY impartial and unbiased judgment in the conduct of their engagement. Internal Auditing Approaches and Techniques 121. Operational Auditing This is a future-oriented, independent and systematic evaluation performed by the internal auditor for management of the operational activities controlled by top-, middle-, and lower-level management for the purpose of improving organizational profitability and increasing the attainment of the other organizational objectives. 122. Management Auditing It is an assessment of methods and policies of an organization’s management in the administration and the use of resources, tactical and strategic planning, and employee and organizational improvement. 123. Financial Auditing It refers to a historically oriented, independent evaluation performed by the internal auditor for the purpose of ensuring the fairness, accuracy and reliability of the financial data. Divisions of State or Government Auditing 124. Compliance Audit It is the examination, audit and settlement in accordance with law and regulation. 125. Financial Audit It is the audit of the accounting and financial system and controls to ensure reliability of recorded financial data. 126. Performance Audit It is an objective examination of the financial and operational performance of an organization, programme, activity or function and is oriented towards opportunities for greater economy, efficiency and effectiveness. ***

127. Other Types of Audit Classified as Limited Assurance Engagements a. Audits of financial statements prepared on an other comprehensive basis, cash or tax basis of accounting b. Audits of specified elements, accounts or items in a financial statement c. Audits of information accompanying the basic financial statements (clientprepared or auditor-submitted documents) d. Compliance with contractual agreements e. Summarized financial statements 128. Auditing and Accounting Distinguished Accounting is the process of recording, classifying and summarizing economic events in a logical manner for the purpose of providing financial information for decision making. On the other hand, auditing is concerned with the determination of whether the recorded accounting information for the entity properly reflects the economic events that occurred during the accounting period.

129. Philippine Accountancy Act of 2004 (R.A. 9298) It is an act regulating the practice of accountancy in the Philippines, repealing for the purpose P.D. No. 692, otherwise known as the revised accountancy law, appropriating funds therefor and for other purposes. 130. Objectives of R.A. 9298 a. The standardization and regulation of accounting education; b. The examination for registration of certified public accountants; and c. The supervision, control, and regulation of the practice of accountancy in the Philippines.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 131. Scope of Practice of Public Accountancy a. b. c. d.

Practice of public accountancy Practice in commerce and industry Practice in education or academe Practice in the government

132. Professional Regulatory Accountancy (PRBOA or BOA) See no. 10 for relevant notes.

Board

of

133. Composition of BOA The Professional Regulatory Board of Accountancy, hereinafter referred to as the Board, under the supervision and administrative control of the Professional Regulation Commission, hereinafter referred to as the Commission, shall be composed of a chairman and six (6) members to be appointed by the President of the Philippines from a list of three (3) recommendees each position and ranked by the Commission, from list of five (5) nominees for each position submitted by the accredited national professional organization of certified public accountants The board shall elect a vice-chairman from among its members for a term of one (1) year meetings of the board and in the event of a vacancy in the office of the chairman, the vice chairman shall assume such duties and responsibilities until such time as a chairman is appointed. 134. Accredited Professional Organization (APO) Philippine Institute of Certified Public Accountants (PICPA) 135. Qualification of Members of BOA A member of the board shall, at the time of his/her appointment, possess the following qualifications: a. Must be a natural born citizen and a resident of the Philippines; b. Must be a duly registered Certified Public Accountant with at least ten (10) years of work experience in any scope of practice of accountancy;

c. Must be a good moral character and must not have been convicted of crimes involving moral turpitude; and d. Must not have any pecuniary interested, directly or indirectly, in any schools, college, university or institution conferring an academic degree necessary for admission to the practice of accountancy or where review classes in preparation for the licensure examination, are being offered or conducted, nor shall he/she be a member of the faculty or administration thereof at the time of his/her appointment to the Board. 136. Term of Office of the Members of BOA The chairman and members of the board shall hold office for a term of three years Any vacancy occurring within the term or a member shall be filled up for the unexpired portion of the term only No person who has served two (2) successive complete terms shall be eligible for reappointment until the lapse of one (1) year Appointment to fill-up an expired term is not to be considered as a complete term. 137. Compensation and Allowances of the Board The chairman and members of the board shall receive compensation and allowances comparable to that being received by the chairman and members of existing regulatory boards under the commission as provided for in the General Appropriations Act. 138. Powers and Functions of the Board The board shall exercise the following specific powers, functions and responsibilities: a. To prescribe and adopt the rules and regulations necessary for carrying out the provisions of this Act; b. To supervise the registration, licensure and practice of accountancy in the Philippines;

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY c. To administer oaths in connection with the administration of this Act; d. To issue, suspend, revoke, or reinstate the Certificate of Registration for the practice of the accountancy profession; e. To adopt an official seal of the Board; f. To prescribe and/or adopt a Code of Ethics for the practice of accountancy; g. Other powers as expressed by the provisions of R.A. 9298. 139. Administrative Supervisions of the Board, Custodian of Its Records, Secretariat and Support Services The Board shall be under the administrative supervision of the Commission All records of the Board, including applications for examination and administrative and other investigative cases conducted by the Board shall be under the custody of the Commission The Commission shall designate the secretary of the Board and shall provide the secretariat and other support services to implement the provisions of this Act. 140. Grounds for Suspension or Removal of the Members of the Board The President of the Philippines, upon the recommendation of the Commission, after giving the concerned member an opportunity to defend himself in a proper administrative investigation to be conducted by the Commission, may suspend or remove any member on the following grounds. a. Neglect of duty or incompetence; b. Violation or tolerance of any violation of this Act and its implementing rules and regulations or the Certified Public Accountant’s Code of Ethics and the technical and professional standards of practice for Certified Public Accountants; c. Final judgment of crimes involving moral turpitudes; and d. Manipulation or rigging of the certified accountants licensure examination results, disclosure of secret and

confidential information in the examination questions prior to the conduct of the said examination or tampering of grades. 141. Annual Reporting Requirements for BOA The Board shall, at the close of each calendar year, submit an annual report to the President of the Philippines through the Commission giving a detailed account of its proceedings and accomplishments during the year and making recommendations for the adoption of measures that will upgrade and improve the conditions affecting the practice of accountancy in the Philippines. 142. The Certified Public Accountant (CPA) Examinations All applicants for registration for the practice of accountancy shall be required to undergo a licensure to be given by the Board in such places and dates as the Commission may designate subject to compliance with the requirements prescribed by the Commission in accordance with Republic Act No 8981. 143. Qualifications of Applicants for Examinations Any person applying for examination shall establish the following requisites to the satisfaction of the Board that he/she: a. is a Filipino citizen; b. is of good moral character; c. is a holder of the degree of Bachelor of Science in Accountancy conferred by a school, college, academy or institute duly recognized and/or accredited by the CHED or other authorized government offices; and d. has not been convicted of any criminal offense involving moral turpitude. 144. Scope of Examinations The licensure examination for certified public accountants shall cover, but are not limited to the following subjects:

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY a. b. c. d. e. f. g.

Theory of Accounts Business Law and Taxation Management Services Auditing Theory Auditing Problems Practical Accounting Problems I Practical Accounting Problems II

The Board, subject to the approval of the Commission, may revise or exclude any of the subjects and their syllabi, and add new ones as the need arises. 145. Rating in the Licensure Examination To be qualified as having passed the licensure examination for accountants, a candidate must obtain a general average of seventy-five percent (75%), with no grades lower than sixty-five percent (65%) in any given subject In the event a candidate obtains the rating of seventy-five percent (75%) and above in at least a majority of subjects as provided for in this Act, he/she shall receive a conditional credit for the subjects passed: Provided, That a candidate shall take an examination in the remaining subjects within two (2) years from the preceding examination: Provided, further, That if the candidate fails to obtain at least a general average of seventy-five percent (75%) and a rating of at least sixty-five percent (65%) in each of the subjects reexamined, he/she shall be considered as failed in the entire examination. 146. Report of Ratings The Board shall submit to the Commission the ratings obtained by each candidate within ten (10) calendar days after the examination, unless extended for just cause Upon the release of the results of the examination, the Commission shall send by mailing the rating received by each examinee at his/her given address using the mailing envelope submitted during the examination. 147. Failing Candidates to Take Refresher Course Any candidate who fails in two (2) complete Certified Public Accountant Board Examinations shall be disqualified from taking another set of

examinations unless he/she submits evidence to the satisfaction of the Board that he/she enrolled in and completed at least twenty-four units of subject given in the licensure examination. For purposes of this Act, the examination in which the candidate was conditioned together with the removal examination on the subject in which he/she failed shall be counted as one complete examination. 148. Oath All successful candidates in the examination shall be required to take an oath of profession before an member of the Board or before any government official, authorized by the Commission or any person authorized by law to administer oaths upon presentation of proof of his/her qualification, prior to entering upon the practice of the profession. 149. Issuance of Certificate of Registration and Professional Identification Card A certificate of registration shall be issued to examinees who pass the licensure examination subject to payment of fees prescribed by the Commission The Certificate of Registration shall bear the signature of the chairperson of the Commission and the chairman and members of the Board, stamped with the official seal of the Commission and of the Board, indicating that the person named therein is entitled to the practice of the profession with all the privileges appurtenant thereto The said certificate shall remain in full force and effect until withdrawn, suspended or revoked in accordance with this Act. A Professional Identification Card bearing the registration number, date of issuance, expiry date, duly signed by the chairperson of the Commission, shall likewise be issued to every registrant renewable every three (3) years. 150. Roster of CPAs A roster showing the names and place of business of all registered certified public accountant shall be prepared and updated by the

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY Board, and copies thereof shall be made available to any party as may be deemed necessary. 151. Indication of Certificate of Registration, Identification Card and Professional Tax Receipt The certified public accountant shall be required to indicate his/her certificate of registration number, and date of issuance, the duration of validity, including the Professional Tax Receipt number on the documents he/she signs, uses or issues in connection with the practice of his/her profession. 152. Refusal to Issue Certificate of Registration and Professional Identification Card The Board shall not register and issue a certificate of registration and professional identification card to any successful examinee convicted by a court of competent jurisdiction of a criminal offense involving moral turpitude or guilty of immoral and dishonorable conduct or to any person of unsound mind In the event of refusal to issue certificate for any reason, the Board shall give the applicant a written statement setting forth the reasons for such action, which statement shall be incorporated in the record of the Board. 153. Suspension and Revocation of Certificates of Registration and Professional Identification Card and Cancellation of Special Permit The Board shall have the power, upon due notice and hearing, to suspend or revoke the practitioner’s certificate of registration and professional identification card or suspend him/her from the practice of his/her profession or cancel his/her special permit for any of the causes or grounds mentioned under section 23 of this Act or for any unprofessional or unethical conduct, malpractice, violation of any of the provisions of this Act, and its implementing rules and regulations, the Certified Public Accountant’s Code of Ethics and the technical and professional standards of practice for certified public accountants. 154. Reinstatement, Reissuance and Replacement of Revoked Loss Certificates

The Board may, after the expiration of two (2) years from the date of revocation of a certificate of registration and upon application and for reasons deemed proper and sufficient, reinstate the validity of a revoked certificate of registration and in so doing, may, in its discretion, exempt the applicant from taking another examination. A new certificate of registration to replace lost, destroyed, or mutilated certificate/license may be issued, subject to the rules promulgated by the Board and the Commission, upon payment of the required fees. 155. Prohibition in the Practice of Accountancy Vested Rights to CPAs Registered When R.A. 9298 Was Passed No person shall practice accountancy in this country, or use the title “Certified Public Accountant”, or use the abbreviated title “CPA” or display or use any title, sign, card, advertisement, or other device to indicate such person practices or offers to practice accountancy, or is a certified public accountant, unless such person shall have received from the Board a certificate of registration/professional license and be issued a professional identification card or a valid temporary/special permit duly issued to him/her by the Board and the Commission. 156. Vested Rights: Certified Public Accountants Registered When This Law is Passed All certified public accountants registered at the time this law takes effect shall automatically be registered under the provisions hereof, subject however, to the provisions herein set forth as to future requirements Certificates of registration/professional license held by such persons in good standing shall have the same force and effect as though issued after the passage of this Act. 157. Limitation of the Practice of Public Accountancy Single practitioners and partnerships for the practice of public accountancy shall be registered certified public accountants in the Philippines:

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY Provided, That from the effectivity of this Act, a certificate of accreditation shall be issued to certified public accountants in public practice only upon showing, in accordance with rules and regulations promulgated by the Board and approved by the Commission, that such registrant has acquired a minimum of three (3) years meaningful experience in any of the areas of public practice including taxation: Provided, further, That this requirement shall not apply to those already granted a certificate of accreditation prior to the effectivity of this Act The Securities and Exchange Commission shall not register any corporation organized for the practice of public accountancy. 158. Ownership of Working Papers All working papers, schedules and memoranda made by a certified public accountant and his staff in the course of an examination, including those prepared and submitted by the client, incident to or in the course of an examination, by such certified public accountant, except reports submitted by a certified public accountant to a client shall be treated confidential and privileged and remain the property of such certified public accountant in the absence of a written agreement between the certified public accountant and the client, to the contrary, unless such documents are required to be produced through subpoena issued by any court, tribunal, or government regulatory or administrative body. 159. Accredited Professional Organization All registered certified public accountants whose names appear in the roster of certified public accountants shall be united and integrated through their membership in a one only registered and accredited national professional organization of registered and licensed certified public accountants, which shall be registered with the Securities and Exchange Commission as a nonprofit corporation and recognized by the Board, subject to the approval by the Commission The members in the said integrated and accredited national professional organization shall receive benefits and privileges appurtenant thereto upon

payment of a required fees and dues Membership in the integrated organization shall not be a bar to membership in any other association of certified public accountants. 160. Accreditation to Practice Public Accountancy Certified public accountants, firms and partnerships of certified public accountants, engaged in the practice of public accountancy, including partners and staff members thereof, shall register with the Commission and the Board, such registration to be renewed every three (3) years: Provided, That subject to the approval of the Commission, the Board shall promulgate rules and regulations for the implementation of registration requirements including the fees and penalties for violation thereof. 161. Continuing Professional Education (CPE) Program All certified public accountants shall abide by the requirements, rules and regulations on continuing professional education to be promulgated by the Board, subject to the approval of the Commission, in coordination with the accredited national professional organization of certified public accountants or any duly accredited educational institutions For this purpose, a CPE Council is hereby created to implement the CPE program. 162. Seal and Use of Seal All licensed Certified Public Accountants shall obtain and use a seal of a design prescribed by the Board bearing the registrant’s name, registration number and title The auditor’s reports shall be stamped with said seal, indicating therein his/her current Professional Tax Receipt (PTR) number, date/place of payment when filed with government authorities or when used professionally. 163. Foreign Reciprocity Subjects or citizens of foreign countries may be allowed to practice accountancy in the Philippines in accordance with the provisions of

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY existing laws, international treaty obligations including mutual recognition agreements entered into by the Philippine government with other countries A person who is not a citizen of the Philippines shall not be allowed to practice accountancy in the Philippines unless he/she can prove, in the manner provided by the Rules of Court that, by specific provision of law, the country of which he/she is a citizen, subject or national admits citizens of the Philippines to the practice of the same profession without restriction. 164. Coverage of Temporary/Special Permits Special/temporary permit may be issued by the Board subject to the approval of the Commission and payment of the fees the latter, has prescribed and charged thereof to the following persons: a. A foreign certified public accountant called for consultation or for a specific purpose which, in the judgment of the Board, is essential for the development of the country: Provided, That his/her practice shall be limited only for the particular work that he/she is being engaged: Provided, further, That there is no Filipino Certified Public Accountant qualified for such consultation or specific purposes; b. A foreign certified public accountant engaged as professor, lecturer or critic in fields essential to accountancy education in the Philippines and his/her engagement is confined to teaching only; and c. A foreign certified public accountant who is an internationally recognized expert or with specialization in any branch of accountancy and his/her service is essential for the advancement of accountancy in the Philippines. 165. Penal Provisions Any person who shall violate any of the provisions of this Act or any of its Implementing rules and regulations as promulgated by the Board

subject to the approval of the Commission, shall, upon conviction, be punished by a fine of not less than Fifty thousand pesos (P50,000.00) or by imprisonment for a period not exceeding two (2) years or both. 166. CPAs Legal Liability Audit professionals have a responsibility under common law to fulfill expressed and implied contracts with clients. They are liable to their clients for negligence and/or breach of contracts should they fail to provide services or not exercise due care in their performance. 167. Management’s Responsibility of Compliance with Laws and Regulations It is management’s responsibility to ensure that the entity’s operations are conducted in accordance with laws and regulations. The responsibility for the prevention and detection of noncompliance rests with management. The auditor is no, and cannot be held responsible for preventing non-compliance. The fact that an annual audit is carried out may, however, act as a deterrent. An audit is subject to the unavoidable risk that some material misstatements of the financial statements will not be detected, even though the audit is properly planned and performed in accordance with PSAs. This risk is higher with regard to material misstatements resulting from non-compliance with laws and regulations. 168. Procedures When Noncompliance is Discovered When the auditor believes there may be noncompliance, the auditor should document the findings and discuss them with the following (in order of priority): a. Management b. Entity’s lawyer if the management does not provide satisfactory information that it is in fact in compliance. c. Auditor’s own lawyer if it is not considered appropriate to consult the

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY entities lawyer or when the auditor is not satisfied with the opinion.

169. Ethics Ethics consist of moral principles and standards of conduct. It is a branch of philosophy that deals with the study of the rightness or wrongness of human actions. 170. Unethical Behavior It refers to a conduct that differs from what people believe would have been appropriate given the circumstances. 171. Reasons Why People Act Unethically a. The person’s ethical standards are different from those of society as a whole; or b. The person chooses to act selfishly. In many instances, both reasons exist.

177. Loyalty (Fidelity) Be faithful and loyal to family, friends, employers, clients and country; do not use or disclose information learned in confidence; in a professional context, safeguard the influences and conflicts of interest. 178. Fairness Be fair and open-minded, be willing to admit error and, where appropriate, change positions and beliefs, demonstrate a commitment to justice, the equal treatment of individuals, and tolerance for and acceptance of diversity; do not overreach or take undue advantage of another’s mistakes or adversities. 179. Caring for Others Be caring, kind, and compassionate; share, be giving, be of service to others; help those in need and avoid harming others.

172. Rationalizing Unethical Behavior a. Everybody does it. b. If it’s legal, it’s ethical. c. Likelihood of discovery consequences

letter of an agreement; do not interpret agreements in an unreasonably technical or legalistic manner in order to rationalize noncompliance or create excuses and justifications for breaking commitments.

and

Characteristics and Values Associated with Ethical Behavior 174. Integrity Be principled, honorable, upright, courageous and act on convictions; do not be twofaced, or unscrupulous, or adopt an end-justifiesthe-means philosophy that ignores principle. 175. Honesty Be truthful, sincere, forthright, straightforward, frank, candid; do not cheat, steal, lie, deceive, or act deviously. 176. Promise Keeping Be worthy of trust, keep promises, full commitments, abide by the spirit as well as the

180. Respect for Others Demonstrate respect for human dignity, privacy, and the right to self-determination of all people; be courteous, prompt, and decent; provide others with the information they need to make informed decisions about their own lives; do not patronize, embarrass, or demean. 181. Responsible Citizenship Obey just laws; if all law is unjust, openly protest it, exercise all democratic rights and privileges responsibly by participation (voting and expressing informed views), social consciousness, and public service; when in a position of leadership or authority, openly respect and honor democratic processes of decision making, avoid unnecessary secrecy or concealment of information, and assure that others have all the information they need to make intelligent choices and exercise their rights.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

182. Pursuit of Excellence Pursue excellence in all matters, in meeting your personal and professional responsibilities, be diligent, reliable, industrious, and committed; perform all tasks to the best of your ability, develop and maintain a high degree of competence, be well informed and well prepared; do not be content with mediocrity; do not “win at any cost.” 183. Accountability Be accountable, accept responsibility for decisions, for the foreseeable consequences of actions and inactions, and for setting an example of others. Parents, teachers, employers, many professionals, and public officials have a special obligation to lead by example, to safeguard and advance the integrity and reputation of their families, companies, profession, and the government itself; an ethically sensitive individual avoids even the appearance of impropriety, and takes whatever actions are necessary to correct or prevent inappropriate conduct of others. CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS IN THE PHILIPPINES

189. Confidentiality To respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose any such information to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose, nor use the information for the personal advantage of the professional accountant or third parties. 190. Professional Behavior To comply with relevant laws and regulations and avoid any action that discredits the profession. 191. Threats to Compliance with Fundamental Principles When a professional accountant identifies threats to compliance with the fundamental principles and based on an evaluation of those threats, determines that they are not at an acceptable level, the professional accountant shall determine whether appropriate safeguards are available and can be applied to eliminate the threats or reduce them to an acceptable level.

Fundamental Principles of Ethics 186. Integrity To be straightforward and honest in all professional and business relationships. 187. Objectivity To prevent bias, conflict of interest or undue influence of others to override professional and business judgments. 188. Professional Competence and Due Care To maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments in practice, legislation and techniques and act diligently and in accordance with applicable technical and professional standards.

Categories of Threats 193. Self-Interest Threat It refers to the threat that financial or other interest will inappropriately influence the professional accountant’s judgment or behavior. 194. Self-Review Threat It pertains to the threat that a professional accountant will not appropriately evaluate the results of a previous judgment made or service performed by the professional accountant, or by another individual within the professional accountant’s firm or employing organization, on which the accountant will rely when forming a judgment as part of providing a current service.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 195. Advocacy Threat It is the threat that a professional accountant will promote a client’s or employer’s position to the point that the professional accountant’s objectivity is compromised. 196. Familiarity Threat It refers to the threat that due to a long or close relationship with a client or employer, a professional accountant will be too sympathetic to their interests or too accepting of their work. 197. Intimidation Threat It pertains to the threat that a professional accountant will be deterred from acting objectively because of actual or perceived pressures, including attempts to exercise undue influence over the professional accountant. 198. Safeguards against Threats to Compliance with Fundamental Principles Safeguards are actions or other measures that may eliminate threats or reduce them to an acceptable level. Categories of Safeguards that May Eliminate or Reduce Threats to an Acceptable Level 200. Safeguards Created by the Profession, Legislation or Regulation a. Educational, training and experience requirements for entry into the profession; b. Continuing professional development requirements; c. Corporate governance regulations; d. Professional standards; e. Professional or regulatory monitoring and disciplinary procedures; and f. External review by a highly empowered third party of the reports, returns, communications or information produced by a professional accountant. 201. Safeguard in the Work Environment

a. Leadership of the firm that stresses the importance of compliance with fundamental principles; b. Leadership of the firm that establishes the expectation that the members of an assurance team will act in the public interest; c. Policies and procedures to implement and monitor quality control of engagements; d. Documented policies regarding the:  Identification of threats to compliance;  Evaluation of the significance of those threats;  Application of safeguards to eliminate or reduce the threats to an acceptable level; and/or  Termination or decline of the relevant engagement when appropriate safeguards are not available or cannot be applied; e. Documented internal policies and procedures requiring compliance with the fundamental principles; f. Policies and procedures that will enable the identification of interests or relationships between the firm or members of engagement teams and clients; and g. Others *** 202. Conflicts of Interest It refers to a situation in which the concerns or aims of two different parties are incompatible. An example relevant to the work of a professional accountant would be: “Advising two clients at the same time who are competing to acquire the same company where the advice might be relevant to the parties’ competitive position.” 203. Second Opinions It arises when a member or member firm agrees to give professional advice to a third party in connection with any matter that has, or might be

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY expected to have been, considered by that party's auditors. There may be a threat to professional competence and due care in circumstances where the second opinion is not based on the same set of facts that were made available to the existing auditor, or is based on inadequate evidence. 204. Independence It refers to the auditor’s independence from the client company ensuring that the audit opinion will not be influenced by any relationship existing between them. Aspects of Independence 206. Independence of Mind It pertains to the state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional skepticism. 207. Independence in Appearance It pertains to the avoidance of facts and circumstances that are so significant that a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, would reasonably conclude a firm’s, or a member of the assurance team’s, integrity, objectivity or professional skepticism had been compromised. *** 208. Network and Network Firms An accounting network or accounting association is a professional service network whose principal purpose is to provide members resources to assist the clients around the world and hence reduce the uncertainty by bringing together a greater number of resources to work on a problem. The networks and associations operate independently of the independent members. The largest accounting networks are known as the Big Four.

209. Certificate of Accreditation Is issued to certified public accountants in public practice only upon showing, in accordance with rules and regulations promulgated by the Board (BOA) and approved by the Commission (PRC), that such registrant has acquired a minimum of three (3) years meaningful experience in any of the areas of public practice including taxation. 210. Organization of CPA Firms a. Sole proprietorships b. Partnerships 211. Advantages of Sole Proprietorship Form of Organization a. The practitioner is his own boss and is independent. b. He does not keep regular office hours. c. He can earn more than a mere salaried employee can. d. He can attain self-fulfillment or satisfaction from the success of his own practice. 212. Disadvantages of Sole Proprietorship Form of Organization a. b.

c.

He assumes all the risk and responsibilities of entrepreneurship. His income may not be regular and therefore should be supplemented from other sources. He must rely on his own judgment in making decisions.

213. Advantages Organization

of

Partnership

Form

of

a. The practice has greater stability and continuity. b. Responsibility, risks and cost of practice can be shared. c. Opportunity for specialization is increased.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY d. A partnership can handle larger engagements more efficiently and adequately. e. Partners can combine their talent, resources, time and experience to serve the clients better.

He or she is concerned about the overall quality of each audit. An audit partner signs the audit report, accepting ultimate responsibility for each audit, and is generally involved in maintaining client relationships, planning audits and evaluating the audit findings.

214. Disadvantages of Partnership Form of Organization a. Personal differences between partners may arise and therefore good and close working relationships may not be established. b. One partner may feel that the other partner is not contributing to the welfare of the firm. 215. Prohibition against the Organization of Corporations for the Practice of Public Accountancy a. As a legal requirement, corporate practice of CPAs is prohibited in the Philippines. b. The reporting requirements of corporation are generally higher than those of partnerships. As a professional firm which usually involve sensitive information, the less transparent the better. c. Corporate practice also requires annual audit. No accounting firm want to be audited by their competitors. d. Tax rate for unincorporated business is generally more favorable than that for incorporated ones. e. Major accounting firm enjoys global exposure. The structure is complex. In order to avoid further complication, they may prefer to operate under partnership in all regions, regardless of the allowance of corporate practice in some countries. Public Accounting Firm Organization 217. Audit Partner

218. Audit Manager/Supervisor He or she administers important aspects of audit engagements, scheduling the audit work to be done with client personnel, assigning work to audit staff, supervising staff and reviewing staff work. 219. Senior (In-Charge) Auditor He or she works under the direction of audit managers and assist them in administering the audit. They generally participate in audit planning and provide direct supervision to staff auditors. They also review work performed by staff auditors and summarize audit findings for the audit partner to review. 220. Staff (Associate) Auditor He or she performs various audit procedures and gather audit evidence to be used as basis for the audit reports. They may perform procedures that relate to a variety of aspects of a client’s activities. *** 221. Representation Letter to the SEC A CPA in public practice should file with the Securities and Exchange Commission a representation letter for audit clients he has which are required to file with the said government agency (SEC) their financial statements. 222. Marketing Professional Services When a professional accountant in public practice solicits new work through advertising or other forms of marketing, there may be potential threats to compliance with the fundamental principles.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY Moreover, a professional accountant in public practice should not bring the profession into disrepute when marketing professional services. The professional accountant in public practice should be honest and truthful and should not: a. Make exaggerated claims for services offered, qualifications possessed or experience gained; or b. Make disparaging references to unsubstantiated comparisons to the work of another.

223. Quality Control System It refers to a set of policies and procedures designed to provide reasonable assurance that the public accounting firm complies with professional standards. 224. Elements of a System of Quality Control a. Leadership responsibilities for quality within the firm b. Ethical requirements c. Acceptance and continuance of client relationships and specific engagements d. Human resources e. Engagement performance f. Monitoring 225. Leadership Responsibilities for Quality within the Firm The firm’s leadership and the examples it sets significantly influence the internal culture of the firm. The promotion of a quality-oriented internal culture depends on clear, consistent and frequent actions and messages from all levels of the firm’s management emphasizing the firm’s quality control policies and procedures. 226. Ethical Requirements The firm’s policies and procedures emphasize the fundamental principles (integrity, objectivity, professional competence and due care,

confidentiality, and professional behavior), which are reinforced in particular by: a. b. c. d.

The leadership of the firm; education and training; monitoring; and A process of dealing compliance

with

non-

Independence requirements are also needed to be achieved by implementing appropriate safeguards (e.g., At least annually, the firm shall obtain written confirmation of compliance with its policies and procedures on independence from all firm personnel required to be independent by the Revised Code of Ethics). 227. Acceptance and Continuance of Client Relationships and Specific Engagements An audit firm shall undertake or continue relationships and engagements where it can reasonably assure that: a. It is competent to perform the engagement and has the capabilities, time and resources to do so; b. It can comply with ethical requirements; and c. It has considered the integrity of the client and does not have information that would lead it to conclude that the client lacks integrity. The specific policies and procedures related to this matter will be discussed further during the risk assessment phase of the audit. 228. Where the Firm Obtains Information that Would Have Caused it to Decline an Engagement if that Information Had Been Available Earlier The policies and procedures on the continuance of the engagement and the client relationship shall include the consideration of: a. The professional and legal responsibilities that apply to the circumstances, including whether there is a requirement for the firm to report to

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY the person or persons who made the appointment or, in some cases, to regulatory authorities; and b. The possibility of withdrawing from the engagement or from both the engagement and the client relationship. 229. Human Resources The firm shall establish policies and procedures designed to provide it with reasonable assurance that it has sufficient personnel with the capabilities, competence and commitment to ethical principles. The following are the personnel issues to be addressed by such policies and procedures: a. b. c. d. e. f. g. h. i.

Recruitment Performance evaluation Capabilities Competence Career development Competence Promotion Compensation Estimation of personnel needs

230. Engagement Performance The firm promotes consistency in the quality of the engagement performance through its policies and procedures. This is often accomplished through written or electronic manuals, software tools or other forms of standard documentation. Matters addressed may include: a. How engagement teams are briefed on the engagement to obtain understanding of the objectives of their work; b. Processes for complying with applicable engagement standards; c. Processes of engagement supervision, staff training and coaching; d. Methods of reviewing the work performed, the significant judgments made and the form of report being issued;

e. Appropriate documentation of the work performed and of the timing and extent of the review; and f. Processes to keep all policies and procedures current. 231. Supervision Supervision involves directing the efforts of assistants who are involved in accomplishing the objectives of the audit and determining whether those objectives were accomplished. Elements of supervision include instructing assistants, keeping informed of significant problems encountered, reviewing the work performed, and dealing with differences of opinion among firm personnel. The extent of supervision appropriate in a given instance depends on many factors, including the complexity of the subject matter and the qualifications of persons performing the work. 232. Review The work of the members of the audit team is important for the success of the engagement. Therefore, the firm needs to make sure the good quality of each output. This requires proper review and supervision from the person who has better experiences and knowledge. 233. Consultation It includes discussion, at the appropriate professional level, with individuals within or outside the firm who have specialized expertise, to resolve a difficult or contentious matter. 234. Differences of Opinion As necessary, the engagement partner informs members of the engagement team that they may bring matters involving differences of opinion to the attention of the engagement partner or others within the firm as appropriate without fear of reprisals. 235. Engagement Quality Control Review It ordinarily involves discussion with the engagement partner, a review of the financial statements or other subject matter information and the report, and, in particular, consideration of

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY whether the report is appropriate. It also involves a review of selected working papers relating to significant judgments the engagement team made and the conclusions they reached. 236. Engagement Quality Control Reviewer He or she conducts the review in a timely manner at appropriate stages during the engagement so that significant matters may be promptly resolved to the reviewer’s satisfaction before the report is issued. 237. Monitoring Its objective is to provide reasonable assurance that the policies and procedures relating to the system of quality control are relevant, adequate, operating effectively and complied with in practice. It includes an ongoing consideration and evaluation of the firm’s system of quality control including a periodic inspection of a selection of completed engagements. 238. Documentation Its purpose is to provide evidence of the operation of each element of an audit firm’s system of quality control.

d. The auditor inquires about controls in place to mitigate those risks (usually high-risk areas are the main concern) e. The auditor tests those controls in place and subsequently re-assesses the prior risk ratings f. Auditor performs analytical reviews on low risk areas (if adequate, with minimal substantive testing) g. Auditor performs analytical reviews on medium/high risk areas with intensive substantive testing. 241. Account-Based Audit Approach In this audit approach, auditors first obtain an understanding of control and assess control risk for particular types of errors and frauds in specific accounts. a. Management provides a set of accounts b. Management provides internal control report (ICR) c. The auditor proceeds to test each line item in the Financial Statement, and sample of controls from ICR. 242. Risk It is the potential for uncontrolled loss of something of value.

Approaches to Auditing

Critical Components of Risk

240. Risk-Based Audit Approach It is an audit approach that begins with an assessment of the types and likelihood of misstatements in account balance and then adjusts the amount and type of audit work, to the likelihood of material misstatements occurring in account balances.

244. Audit Risk It refers to the risk that an auditor may give an unqualified opinion on financial statements that are materially misstated.

a. The auditor performs an understanding of the business, and assesses the risks involved in the industry sector (competition, trends, new products on the market, past client issues) b. Management provides a set of accounts c. The auditor identifies risk areas (low, medium, high)

245. Engagement Risk It pertains to the economic risk that a CPA firm is exposed to simply because it is associated with a particular client including loss of reputation, inability of the client to pay the auditor, or financial loss because management is not honest and inhibits the audit process. It is controlled by careful selection and retention of client. 246. Financial Reporting Risk

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY It is the risk that relate directly to the recording of transactions and presentation of financial data in an organization’s financial statements. 247. Business Risk It refers to the risk that affects the operations and potential outcomes of organizational activities. ***

Phase I-A: Performance of Preliminary Engagement Activities to Decide whether to Accept or Continue an Audit Engagement 252. Purpose of Performing Preliminary Engagement Activities The main purpose of performing preliminary engagement activities is to eliminate engagement risks through the ensuring of the following: a.

248. Ways to Control Audit Risk a. Avoid audit risk by not accepting certain companies as client (i.e., reduce engagement risk to zero); and b. Set audit risk at a level that the auditor believes will mitigate the likelihood that the auditor will fail to identify material misstatements. 249. Phases of the Risk-Based Audit Process 





Phase I: Risk Assessment o Phase I-A: Performance of Preliminary Engagement Activities o Phase I-B: Planning the Audit o Phase I-C: Performance of Risk Assessment Procedures Phase II: Risk Response o Phase II-A: Designing Overall Responses and Further Audit Procedures o Phase II-B: Implementing Responses to Assessed Risk of Material Misstatement Phase III: Reporting o Phase III-A: Evaluating the Audit Evidence Obtained o Phase III-B: Forming an Opinion Based on Audit Findings and Preparing the Auditor’s Report

PHASE I: RISK ASSESSMENT

b.

c.

The auditor maintains necessary independence and ability to perform the engagement; There are no issues with management integrity that may affect the auditor’s willingness to continue the engagement; and There is no misunderstanding with the client as to the terms of the engagement.

253. Items to Be Assessed before Accepting an Engagement Before accepting an engagement with a new client, the CPA firm shall assess whether it: a. Is competent to perform the engagement and has the capabilities, including time and resources to do so; b. Can comply with the relevant ethical requirements; c. Has considered the integrity of the client and does not have information that would lead it to conclude that the client lacks integrity. 254. Preconditions for an Audit to Be Established a. Whether the financial reporting framework to be applied in the financial statements are acceptable; and b. Agreement of management that it acknowledges and understands its responsibilities. 255. Responsibilities of the Management

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY a.

b.

c.

For the preparation of financial statements in accordance with applicable financial reporting framework; For the internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatements whether due to fraud or error; and To provide the auditor with access to all relevant information and persons for the purpose of the audit.

256. Audit Engagement Letter An engagement letter defines the legal relationship (or engagement) between the audit firm and its client(s). This letter states the terms and conditions of the engagement, principally addressing the scope of the engagement and the terms of compensation for the firm (fees are optional). 257. Contents of an Engagement Letter a. The objective and scope of the audit of the financial statements; b. The responsibilities of the auditor; c. The responsibilities of the management; d. Identification of the applicable financial reporting framework for the preparation of financial statements; and e. Reference to the expected form and content of any reports to be issued by the auditor and a statement that there may be circumstances in which a report may differ from its expected form and content. 258. Considerations Relating to Recurring Audits a. The auditor shall assess whether circumstances require the terms of the audit engagement to be revised whether there is a need to remind the entity of the existing terms of the audit engagement. b. The auditor shall not agree to the change in the terms of the audit

engagement where there is no reasonable justification for doing so. c. If the terms of the audit are changed, auditor and management shall agree on and record the new terms of the engagement in an engagement letter or other suitable form of written agreement. 259. Disagreement between the Auditor and Management Regarding a Change in the Terms of the Audit Engagement If the auditor is unable to agree to a change in the terms of the audit engagement and is not permitted by management to continue the original engagement, the auditor shall: a. Withdraw from the audit engagement where withdrawal is possible under applicable law or regulation; and b. Determine whether there is any obligation, either contractual or otherwise, to report the circumstances to other parties, such as those charged with governance, owners or regulators. Phase I-B: Planning the Audit to Develop an Overall Audit Strategy and Audit Plan 261. Audit Planning It involves the establishment of the overall audit strategy for the engagement and developing an audit plan, in order to reduce audit risk to an acceptably low level. 262. Overall Audit Strategy It sets the scope, timing and direction of the audit and guides the development of the more detailed audit plan. 263. Aspects of Materiality a. Quantitative considerations which relate to the peso amount of the error to the financial statements under examination. b. Qualitative considerations which relate to the causes of misstatement (e.g., attributed to an irregularity or an illegal

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY act by the client). In other words, small amounts of misstatement may still be considered material depending on its nature. 264. Relevance of Materiality in Audit Planning In planning the audit, materiality should be considered by the auditor when: a. Determining the nature, timing and extent of audit procedures; b. Identifying and assessing the risks of material misstatement; and c. Determining the nature, timing and extent of further audit. Levels of Materiality 266. Overall Materiality It refers to the materiality for the financial statements as a whole. It is based on the auditor’s professional judgment as to the highest amount of misstatements that could be included in the financial statements without affecting the economic decisions taken by a financial statement user. 267. Specific Materiality It refers to materiality set for specific aspects of financial information (especially for sensitive areas such as particular note disclosures, compliance with legislation or certain terms in a contract, or transactions upon which bonuses are based) which are intended to be lesser in amount than overall materiality to put more caution in dealing with said item. 268. Performance Materiality It is set at a lower amount (or amounts) than overall and specific materiality. The objective is to perform more audit work than would be required by the overall or a specific materiality to: a. Ensure that misstatements less than overall or specific materiality are detected, so as to appropriately reduce the probability that the aggregate of uncorrected errors and undetected

misstatements exceed materiality for the financial statements as a whole; and thus b. Provide a margin or buffer for possible undetected misstatements. This buffer is between detected but uncorrected misstatements in the aggregate and the overall or specific materiality. 269. Planning Materiality Auditors make a preliminary assessment of materiality of the financial statements as a whole by determining the amount by which they believe the financial statements could be misstated without affecting users’ decisions. This planning materiality is based on professional judgment and may change during the engagement if circumstances change. It is helpful to the auditor in a way that it allows him or her to plan the appropriate evidence to accumulate. If the auditor sets a low peso amount, more evidence is required than for a high amount. 270. Relationship between Materiality and Audit Risk The higher the level of audit risk, the lower the materiality level can be set to and vice versa (inverse relationship).

₱₱₱

₱

High IR and CR Entity

Low IR and CR Entity

In the above illustration, the cylinders refer to the accounting data, the shaded portions to the appropriate level of materiality and the “x” marks to the misstatements in the financial statements. Observe that if the materiality level on the left side is increased to the same level as the other, more misstatements are going to be left undetected. The higher the risk, the more thorough the tests should be.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

271. Audit Plan The audit plan shall include a description of: a. The nature, timing and extent of planned risk assessment procedures; b. The nature, timing and extent of planned further audit procedures at the assertion level; and c. Other planned audit procedures that are required to be carried out so the engagement complies with PSAs. 272. Difference between Overall Audit Strategy and Audit Plan The overall audit strategy helps the auditor decide on how her or she is going to tackle the audit. That is the big picture. It could be that he or she decides there are no good internal controls. His or her strategy would then be to not do any test of controls and concentrate on substantive procedures. Having decided that, then he or she has to plan how he or she will use substantive procedures to get sufficient appropriate audit evidence. 273. Direction, Supervision and Review The auditor should plan the nature, timing and extent of direction and supervision of engagement team members and review of their work depending on the following factors: a. The size and complexity of the entity; b. The area of the audit; c. The assessed risks of material misstatement (the higher the risk, the more extensive are the nature, timing and extent of direction, supervision and review); and d. The capabilities and competence of the individual team members performing the audit work. 274. Changes to Planning Decisions during the Course of the Audit Planning an audit is a continual and iterative process throughout the audit engagement. The overall audit strategy and the audit plan should be

updated and changed as necessary during the course of the audit. 275. Documentation The auditor should document the overall audit strategy and the audit plan, including any significant changes made during the audit engagement. 276. Additional Considerations in Initial Audit Engagements The auditor should perform the following activities prior to starting an initial audit: a. Perform procedures regarding the acceptance of the client relationship and the specific audit engagement; b. Communicate with the previous auditor in c`ompliance with relevant ethical requirements; and c. Expand the planning activities because the auditor does not ordinarily have previous experience with the entity that is considered when planning recurring engagements. 277. Analytical Procedures These are auditing procedures that involve analysis of relationship between financial and nonfinancial data. These involve investigation of identified variances and relationships that seem inconsistent with each other or with other available audit evidence. 278. Application of Analytical Procedures in Planning the Audit When used for planning purposes, analytical procedures assist the auditors in planning the nature, timing and extent of audit procedures that will be used for the specific accounts. 279. Establishment of an Engagement Team or Audit Team Factors to be considered in the establishment of an engagement team:

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY a. Levels of expertise and experience b. Qualification to handle audit positions (engagement partner, manager, at least one senior, and one or more staff auditors) c. Number of people depends on the size and complexity of the audit d. Availability of personnel e. Entities in a regulated industry, such as banking, requires that the major members of the audit team have necessary knowledge and experience in that industry. 280. Consideration of Work Performed by the Predecessor Auditor Communication with the predecessor auditors can provide the successor CPA with background information about the client, details about the client’s system of internal control, and evidence as to the account balances at the beginning of the year under audit. 281. Consideration of Work Performed by Other Auditors in the Audit of Components a. A principal auditor is the auditor with responsibility for reporting on the financial statements of an entity when those financial statements include financial information of one or more components audited by another auditor. b. Other auditor means an auditor, other than the principal auditor, with responsibility for reporting on the financial statements of a component which is included in the financial statement audited by the principal auditor. 282. Involvement of Experts or Specialists CPAs may lack the qualifications necessary to perform certain technical tasks relating to the audit. A specialist brings unique knowledge and judgment in a field other than accounting and auditing (e.g., appraiser for the values of works of

art, mineralogist for the physical characteristics of mineral resources, etc.). 283. Use of Client’s Staff The auditors may set up the columnar headings for certain working papers and give instructions to the client’s staff as to the information to be gathered. These working papers should bear the label “Prepared by Client” or PBC, and also the initials of the auditor who verifies the work performed by the client’s staff. Working papers prepared by the client should never be accepted at face value; such papers must be reviewed and tested by the auditors. 284. Consideration of Work Performed by Internal Auditors a. Internal auditors can enhance internal control (e.g., review of bank reconciliations), thus reducing the extent of substantive testing after the independent auditor has considered the degree of subjectivity involved in evaluating the accumulated audit evidence. b. Internal auditors may also assist independent auditors in performing specific audit procedures (e.g., observation of client personnel taking the inventory). 285. Assessment of Going Concern Assumption Auditors are required to evaluate whether substantial doubt exists about an entity’s ability to continue as a going concern, based on procedures planned and performed to obtain evidence about the management assertions embodied in the financial statements. That is, an auditor is not required to design specific procedures to evaluate whether an entity is a going concern. 286. Identification of Related Parties A related-party transaction is a deal or arrangement between two parties who are joined by a preexisting business relationship or common interest. It is important for auditors to identify them

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY because they are required to be disclosed in the financial statements if they are material.

287. Client’s Legal Obligations The auditor should review the following: a. Minutes of directors’ and stockholders’ meetings b. Changes to the articles of incorporation or by-laws c. Any significant contracts executed during the year 288. Completion of the Initial Audit Program An audit program is a set of audit procedures specifically designed for each audit. The program which includes both substantive tests and tests of controls will enable the auditor to express an opinion on the financial statements taken as a whole. 289. Preparation of a Time Budget A time budget is an estimate of the total hours an audit is expected to take. 290. Assignment of Personnel to the Engagement Staffing is important for the continuity of the CPA firm’s operation from year to year. Also, the immersion, familiarity with the technical requirements and specialization of the audit personnel are to be considered. 291. Scheduling of Work Performing audit work during the interim period has numerous advantages in addition to facilitating the timely release of the audited financial statements. However, this results in additional risk that must be controlled by the auditor. Significant errors or irregularities could arise in the accounts during the remaining period between the time that the interim test was performed and the statement of financial position date.

The following are the contents of the documentation of the planning process: a. Audit plans b. Audit programs c. Time budget 293. Planning a Repeat Engagement The auditor should not merely duplicate last year’s audit program but should modify his approach to the audit for any changes in the client’s operations, internal control structure or business environment.

Phase I-C: Performance of Risk Assessment Procedures to Identify or Assess Risk of Material Misstatement through Understanding the Entity 295. Risk Assessment Procedures These are procedures conducted to obtain an understanding of the entity and its environment, including its internal control to assess the risk of material misstatements thereafter. Types of Risk Assessment Procedures 297. Inquiry It consists of seeking information of knowledgeable persons, both financial and nonfinancial, inside or outside the entity. For example, the auditor may consider inquiring from the following: a. b. c. d. e. f.

Entity’s external legal counsel Valuation experts Analysts, banks or rating agencies Those charged with governance Internal audit personnel Employees involved in initiating, processing or recording complex or unusual transactions g. In-house legal counsel h. Marketing or sales personnel

292. Documentation of Audit Plan/Audit Program 298. Application of Analytical Procedures “We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY For example, the auditor reviews the current ratio over several reporting periods. This comparison of current assets to current liabilities should be about the same over time, unless the entity has altered its policies related to accounts receivable, inventory, or accounts payable. This is a form of ratio analysis. (See no. for definition.) 299. Observation Observation is one of the audit procedures that auditors use to obtain an understanding and gather audit evidence mainly to the real process or the ways how clients have done some specific business processes.

300. Inspection Inspection refers to verification or vouching of documents. The auditor may inspect documents, records and internal control manuals. Moreover, reading interim financial statements, quarterly management report and minutes of the board of directors’ meetings may also form part of the inspection procedures done by an auditor. *** 301. Walk-through Test A walk-through test traces a transaction step-by-step through the accounting system from its inception to the final disposition (requires both observation and inspection). 302. Use of Information about the Entity and Its Environment Obtained in Prior Periods When the auditor intends to use information about the entity and its environment obtained in prior periods, the auditor should determine whether changes have occurred that may affect the relevance of such information in the current audit. Aspects of the Entity and Its Environment to Be Understood by the Auditor 304. Industry Conditions a. Competitive environment

b. c. d. e. f.

Supplier and customer relationships Barriers to entry Strength of competitors Bargaining power of suppliers of raw materials and labor Bargaining power of customers

305. Regulatory Environment a. Governmental regulations b. Legal and political environment 306. Other External Factors a. b. c. d.

Economic conditions Financial trends Changes in technology Widely used accounting methods

307. Applicable Financial Reporting Framework It may be identified through any of the following (usually in order of hierarchy): a. Legislative and regulatory requirements; b. Jurisdiction in which the entity is registered or operates c. local practice, industry practice, user needs or other factors. 308. Nature of the Entity An understanding of the nature of an entity enables the auditor to understand the classes of transactions, account balances, and disclosures to be expected in the financial statements. 309. Objectives and Strategies Related to Business Risk Business risks result from significant conditions, events, circumstances, actions or inactions that could adversely affect the entity’s ability to achieve its objectives and execute its strategies, or through the setting of inappropriate objectives and strategies. 310. Measurement and Review of the Entity’s Financial Performance Performance measures, whether external or internal, create pressures on the entity that, in turn, may motivate management to take action to

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY improve the business performance or to misstate the financial statements. 311. Understanding the Client’s Internal Control Before auditors can evaluate the effectiveness of internal control, they need a knowledge and understanding of how it works; what controls exist and who performs them, how various types of transactions are processed and recorded, and what accounting records and supporting documentation exist, ***

315. Audit Risk Model It is a tool used by auditors to understand the relationship between various risks arising from an audit engagement enabling them to mange the overall audit risk. Audit Risk = Inherent Risk × Control Risk × Detection Risk

Components of Audit Risk 312. Identifying and Assessing the Risk of Material Misstatement The auditor should identify and assess the risks of material misstatement at the financial statement level, and at the assertion level for classes of transactions, account balances and disclosures.

317. Inherent Risk It is the susceptibility of an account balance or class of transactions to misstatement that could be material, individually or when aggregated with misstatements in other balances or classes, assuming there are no related internal controls.

313. Material Weakness in Internal Control The auditor shall communicate material weaknesses in internal control identified during the audit on a timely basis to management at an appropriate level of responsibility, and with those charged with governance (unless all of those charged with governance are involved in the managing entity).

318. Control Risk It is the risk that a misstatement, that could occur in an account balance or class of transactions and that could be material individually or when aggregated with misstatements in other balances or classes, will not be prevented or detected and corrected on a timely basis by the accounting and internal control systems.

314. Documentation The auditor should document:

319. Detection Risk It is the risk that an auditor’s substantive procedures will not detect a misstatement that exists in an account balance or class of transactions that could be material, individually or when aggregated with misstatements in other balances or classes.

a. The discussion among the engagement team regarding the susceptibility of the entity’s financial statements to material misstatement due to error or fraud, and the significant decisions reached; b. Key elements of the understanding obtained regarding each of the aspects of the entity and its environment; c. The identified and assessed risks of material misstatement (inherent risk and control risk) at the financial statement level and at the assertion level; and d. The risks identified and related controls evaluated.

320. Relationship between the Risks of Material Misstatement and Detection Risk The higher the assessed degree of risks of material misstatement, the lower detection risk must be allowed (inverse relationship) to maintain the desired level of audit risk.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 321. Assessment of Inherent Risk at the Financial Statement Level a. The integrity of management b. Management experience and knowledge and changes in management during the period (e.g., inexperience of management) c. Unusual pressures on management (e.g., industry experiencing a large number of business failures) d. The nature of the entity’s business (e.g., potential for technological obsolescence of its products and services) e. Factors affecting the industry in which the entity operates (e.g., economic and competitive conditions as identified by financial trends and ratios) 322. Assessment of Inherent Risk at the Account Balance and Class of Transaction Level a. Financial statement accounts likely to be susceptible to misstatement (e.g., inventories, related party transactions, intangibles, etc.) b. The complexity of underlying transactions and other events which might require using the work of an expert c. The degree of judgment involved in determining account balances d. Susceptibility of assets to loss or misappropriation (e.g., cash) e. The completion of unusual and complex transactions particularly at or near period end f. Transactions not subjected to ordinary processing 323. Preliminary Assessment of Control Risk It is the process of evaluating the effectiveness of an entity’s accounting and internal control systems in preventing or detecting, and correcting material misstatements. 324. Assessment of Control Risk at a High Level

This shall be reached when: a. the entity’s accounting and internal control systems are not effective; or b. evaluating the effectiveness of the entity’s accounting and internal control systems would not be efficient. 325. Assessment of Control Risk at Less than High Level This shall be reached when the auditor: a. is able to identify internal controls relevant to the assertion which are likely to prevent or detect, and correct a material misstatement; and b. plans to perform tests of control to support the assessment. 326. Substantive Procedures These are those activities performed by the auditor to detect material misstatements or fraud at the assertion level.

327. Relationship between the Nature, Timing and Extent of Substantive Procedures and Detection Risk The lower the allowable detection risk there is, the more extensive substantive procedures should be performed (nature – more effective, timing – year end instead of interim, extent – larger sample size). 328. Summary of the Interrelationship of the Components of Audit Risk Control Risk Assessment

Inherent Risk Assessme nt

High

Med

Low

High

Lowest

Lower

Med

Med

Lower

Med

Higher

Low

Med

Higher

Highes t

*The 3 x 3 group of cells located in the lower right refer to detection risk.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

329. Internal Control It is a process designed and effected by those charged with governance, management and other personnel to provide reasonable assurance about the achievement of the entity’s objectives with regard to the reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations. 330. Internal Control System It refers to all policies and procedures (internal controls) adopted by the management of an entity to assist in achieving management’s objective of ensuring, as far as practicable, the orderly and efficient conduct of its business. 331. Objectives of Internal Control a. Reliability of the entity’s financial reporting b. Effectiveness and efficiency of operations c. Compliance with applicable laws and regulations 332. Elements of Internal Control a. Control Environment b. Entity’s Risk Assessment Process c. Information System and Related Business Processes d. Control Activities e. Monitoring of Controls 333. Control Environment It refers to the overall attitude, awareness and actions of directors and management regarding the internal control systems and its importance in the entity. 334. Factors Comprising the Control Environment a. Communication and enforcement of integrity and ethical values b. Commitment to competence

c. Participation by those charged with governance d. Management’s philosophy and operating style e. Organizational structure f. Assignment of authority and responsibility g. Human resources policies and procedures 335. Entity’s Risk Assessment Process Risk assessment is the identification, analysis and management of risks pertaining to the preparation of financial statements. 336. Sources of Risks due to Change a. b. c. d. e. f.

Changes in operating environment New personnel New or revamped information systems Rapid growth New technology New business models, products or activities g. Corporate restructurings h. Expanded foreign operations i. New accounting pronouncements 337. Information System It consists of infrastructure (physical and hardware components), software, people, procedures and data. 338. Objectives of Information System Relevant to Financial Reporting a. Initiate, record, process and report entity transactions (as well as events and conditions) and to maintain accountability for the related assets, liabilities and equity; b. Resolve incorrect processing of transactions (e.g., automated suspense files and procedures followed to clear suspense items out on a timely basis); c. Process and account for system overrides or bypasses of controls;

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY d. Transfer information from transaction processing systems to the general ledger; e. Capture information relevant to financial reporting for events and conditions other than transactions, such as the depreciation and amortization of assets and changes in the recoverability of accounts receivables; and f. Ensure information required to be disclosed by the applicable financial reporting framework is accumulated, recorded, processed, summarized and appropriately reported in the financial statements. 339. Business Processes An entity’s business processes are the activities designed to develop, purchase, produce, sell and distribute an entity’s products and services; ensure compliance with laws and regulations; and record information, including accounting and financial reporting information. 340. Objectives of Business Processes Relevant to Financial Reporting a. Identify and record all valid transactions. b. Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting. c. Measure the value of transactions in a manner that permits recording their proper monetary value in the financial statements. d. Determine the time period in which transactions occurred to permit recording of transactions in the proper accounting period. e. Present properly the transactions and related disclosures in the financial statements. 341. Control Activities

These are the policies and procedures that help ensure that management directives are carried out. Major Categories of Internal Control Procedures 343. Performance Review In a performance review, management uses accounting and operating data to assess performance, and it then takes corrective action. a. Comparing actual performance (or operating results) with budgets, forecasts, prior period performance, or competitors’ data to measure the extent to which targets are being met; b. Investigating performance indicators based on operating or financial data, such as quantity or purchase price variances or the percentage of returns to total orders; and c. Reviewing functional or activity performance, such as the performance of manager responsible for a bank’s consumer loans with some standard, such as economic statistics or targets. 344. Information Processing Controls These are policies and procedures designed to require authorization of transactions and to ensure the accuracy and completeness of transaction processing. a. Proper authorization of transactions and activities b. Segregation of duties c. Adequate documents and records d. Regulated access to assets e. Independent checks on performance 345. Physical Controls a. The physical security of assets, including adequate safeguards such as secured facilities over access to assets and records; b. The authorization for access to computer programs and data files; and c. The periodic counting and comparison with amounts shown on control records.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY ***

346. Monitoring of Controls It is the process that an entity uses to assess the quality of internal control over time. It involves assessing the design and operation of controls on a timely basis and taking corrective action as necessary. 347. Objective of the Study of Internal Control The whole point of studying internal control is to reasonably asses control risk. The auditor must consider the design of controls, whether they have been placed in operation, and, if they are in use, their effectiveness. 348. Design of Controls It refers to the controls that have been established. 349. Effectiveness of Controls It refers to how the controls actually function. Types of Control Activities that Relate to Financial Statement Assertions 351. Existence/Occurrence Procedures that require documentation, approvals, authorization, verification and reconciliations. 352. Completeness Procedures that ensure that all transaction that occur are recorded such as accounting for a numerical sequence of documents. 353. Rights and Obligations Procedures that ensure that the entity has a right to assets or an obligation to pay arising from the transaction (e.g., issuance of sales invoice and keeping of acknowledged delivery receipt).

Procedures that ensure that a proper price is charged and that mathematical accuracy are present in recording and in developing the accounting records and the financial statement (e.g., use of price list). 355. Presentation and Disclosure Procedures that indicate that a review has been made to ascertain that a transaction has been recorded in the proper account and that financial statement disclosures have been reviewed by competent personnel (e.g., chief accountant). ***

356. Documentation of Understanding of Internal Control a. b. c. d. e.

Internal Accounting Questionnaire Flowcharts Narrative Description Internal Control Checklist Decision Tables

Control

357. Summary of Internal Control Documentation Requirements Assessed Level of Control Risk Document Understanding of Internal Control Obtained to Plan the Audit? Document Assessed Level of Control Risk? Document the Basis for the Control Risk Assessment?

Maximum

Below the Maximum

Yes

Yes

Yes

No

No

Yes

354. Valuation or Measurement “We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 358. Implications of Assessment of Control Risk at Maximum Level If the controls are initially not considered effective or not cost efficient: a. Assess control risk at maximum (100%). b. Set acceptable risk of overreliance on internal control at maximum (100%). c. Perform no tests of controls. d. Use low risk of incorrect acceptance (decrease detection risk). e. Perform extensive substantive testing. 359. Ways of Performing Extensive Substantive Testing a. Nature – Using more effective substantive tests (more persuasive). b. Timing – Performing substantive tests at year end. c. Extent – Increasing the extent of substantive tests by selecting a larger sample size.

360. Implications of Assessment of Control Risk at Below the Maximum Level If the controls are initially considered effective: a. Reduce control risk. b. Reduce acceptable risk of overreliance on internal control. c. Perform test of controls. d. Increase acceptable risk of incorrect acceptance (increase detection risk). e. Reduce planned substantive tests. 361. Ways of Reducing Planned Substantive Tests a. Nature – Using less persuasive (less effective) substantive tests b. Timing – Performing substantive tests at interim date c. Extent – Decreasing the extent of substantive test by selecting a smaller sample size

362. Tests of Controls These are performed to obtain audit evidence about the effectiveness of the (1) design of the accounting and internal control systems, that is, whether they are suitably designed to prevent or detect and correct material misstatements; and (2) operation of the internal controls throughout the period. 363. Relationship Between the Assessed Level of Control Risk and the Extent of Test of Control Required The lower the assessment of control risk, the more support the auditor should obtain that accounting and internal control systems are suitably designed and operating effectively.

364. Determining the Necessary Level of Detection Risk The higher the assessment of inherent and control risk, the more audit evidence the auditor should obtain from the performance of substantive procedures; thus, reducing detection risk, and therefore audit risk, to an acceptably low level. 365. Reportable Conditions Specifically, these are matters coming to the auditor’s attention that, in his judgment, should be communicated to the audit committee because they represent significant deficiencies in the design or operation of the internal control structure, which could adversely affect the organization’s ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements. Examples: a. Deficiencies in internal control structure design b. Failures in the operation of the internal control structure 366. Form and Content of Report on Conditions a. Preferably in writing. b. If communicated orally, the auditor should document the communication by

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY appropriate memoranda or notations in the working papers. c. Should be able to meet the following:  Indicate that the purpose of the audit was to report on the financial statements and not to provide assurance on the internal control structure;  Include the definition of reportable conditions; and  Include the restriction on distribution: The report should state that the communication is intended solely for the information and the use of the audit committee, management, and others within the organization.

367. Causes of Misstatements in the Financial Statements a. Fraud b. Error 367. Fraud Fraud, in the context of auditing and financial reporting, is the intentional or reckless conduct, acts or emissions that result in material misstatements in the financial statements. Forms of Fraud 369. Fraudulent Financial Reporting (Management Fraud) It occurs when there is an intentional misstatement of amounts or disclosures in the financial statements with the intent to deceive users of those statements. The following are some examples: a. Manipulation, falsification (including forgery) or alteration of accounting records or supporting documentation

from which the financial statements are prepared; b. Misrepresentation in, or intentional omission from, the financial statements of events, transactions or other significant information; and c. Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation or disclosure. 370. Misappropriation of Assets (Employee Fraud) It occurs when an employee knowingly lies, deceives or steals from a company with the intent to obtain benefits or compensation of some type. The following are some examples: a. Embezzling receipts; b. Stealing physical assets or intellectual property; c. Causing an entity to pay for goods or services not received; and d. Using an entity’s assets for personal use. *** 371. Factors Contributing to Commitment of Fraud a. Incentive or pressure to commit fraud b. Perceived opportunity to do so c. Rationalization of the act 372. Responsibility for the Prevention and Detection of Fraud The primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and management. 373. Responsibilities of the Auditor An auditor conducting an audit in accordance with PSAs is responsible for obtaining reasonable assurance that the financial statements taken as a while are free from material misstatement, whether caused by fraud or error. 374. Risk Assessment

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY In planning the audit, the auditor should assess the risk that fraud and error may cause the financial statements or contain material misstatements and should inquire of management as to any fraud or significant error which has been discovered. 375. Detection Based on the risk assessment, the auditor should design audit procedures to obtain reasonable assurance that misstatements arising from fraud and error that are material to the financial statements taken as a whole are detected. Consequently, the auditor seeks sufficient appropriate evidence that fraud and error which may be material to the financial statements have not occurred or that, if they have occurred, the effect of fraud is properly reflected in the financial statements or the error is corrected. 376. Likelihood of Detecting Fraud and Error The likelihood of detecting errors ordinarily is higher than that of detecting fraud, since fraud is ordinarily accompanied by acts specifically designed to conceal its existence. 377. Inherent Limitations of an Audit An audit is subject to the unavoidable risk that some material misstatement of the financial statements will not be detected, even though the audit is properly planned and performed in accordance with PSA. The following are some helpful points for further understanding: a. Fraud ordinarily involves acts designed to conceal it (e.g., collusion, forgery, deliberate failure to record transactions, or intentional misrepresentations being made to the auditor). b. Certain levels of management may be in a position to override controls that would prevent similar frauds by other employees. 378. Fraud Risk Factors These are the factors that make it more likely that fraud will occur is occurring in a

business. For a deeper understanding, it is recommended that you read about some examples of fraud risk factors in your textbook. Some Methods Used in Misappropriation of Assets 380. Skimming This refers to the act of taking cash “off the top” of the daily receipts (including receipt for receivable A) of a business without recording them and officially reporting a lower total collection. Examples are: a. When a cashier in a retail store does not ring up a transaction and takes the cash; and b. When an employee who has access to cash receipts maintains accounts receivable records can record a sale at an amount lower than the invoice amount. When the customer pays, the employee takes the difference between the invoice and the amount recorded as receivable. 381. Lapping This technique is used to conceal the fact that cash has been collected; the shortage in one customer’s account is covered with a subsequent payment made by another customer. 382. Kiting It involves counting the cash twice by using the float in the banking system. *** 383. Float It is the gap between the time the check is deposited or added to an account and the time the check clears or is deducted from the account it was written on.

384. Error An accounting error is a non-fraudulent and unintentional discrepancy in financial documentation. Types of accounting errors include: a. Error of omission – a transaction is not recorded.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY b. Error of commission – a transaction that is calculated incorrectly. c. Error of principle – a transaction that is treated not in accordance with generally accepted accounting principles (GAAP). 385. Procedures When Errors or Irregularities are Suspected When an auditor detects factors that increase audit risk at the financial statement level, he or she should respond to such elevated risk by altering the: a. Engagement staffing (i.e., assigning more experienced personnel), b. Extent of staff supervision, c. Degree of professional skepticism, and/or d. Overall strategy for the expected conduct and scope of the engagement. 386. Reporting of Fraud and Error Fraud to Management The auditor should communicate factual findings to management as soon as practicable if the auditor suspects fraud may exist, even if the potential effect in the financial statements would be immaterial, or fraud or significant error is actually found to exist. In most cases involving fraud, it would be appropriate to report the matter to a level in the organization structure of the entity above and responsible for the persons believed to be implicated. When those persons ultimately responsible for the overall direction of the entity are doubted, the auditor would ordinarily seek legal advice to assist in the determination of procedures to follow. 387. Reporting of Fraud or Error to Users of the Auditor’s Report on the Financial Statements The findings regarding fraud or error shall be reflected and expressed in the auditor’s opinion if such were left uncorrected and unadjusted or the auditor is precluded by the entity from obtaining sufficient appropriate evidence.

388. Reporting of Fraud and Error to Regulatory and Enforcement Authorities The auditor’s duty of confidentiality would ordinarily preclude reporting fraud or error to a third party. However, in certain circumstances, the duty of confidentiality is overridden by statute, law or by courts of law (e.g., BSP requirements for external auditors of banks). 389. Documentation This shall include: a. The significant decisions reached during the discussion among the members of the engagement team regarding the susceptibility of the entity’s financial statements to material misstatement due to fraud; and b. The identified and assessed risks of material misstatement due to fraud at the financial statement level and assertion level. 390. Withdrawal from the Engagement If, as a result of a misstatement resulting from fraud or suspected fraud, the auditor encounters exceptional circumstances that bring into question the auditor’s ability to continue performing the audit, the auditor shall: a. Determine if there is a legal responsibility to report the matter to the person or persons who made the audit appointment or, in some cases, to regulatory authorities; b. Consider whether it is appropriate to withdraw from the engagement, where withdrawal from the engagement is legally permitted; and c. If the auditor withdraws, discuss with the following the auditor’s withdrawal and the reasons for the withdrawal:  Appropriate level of management and those charged with governance; and/or  If there is a legal requirement, Person or persons who made the

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY appointment or, in some cases, to regulatory authorities. 391. Management Representations Regarding Internal Control The auditor shall obtain written representations from management that: a. It acknowledges its responsibility for the design, implementation and maintenance of internal control to prevent and detect fraud; b. It has disclosed to the auditor the results of its assessment of the risk that the financial statements may be materially misstated as a result of fraud; c. It has disclosed to the auditor its knowledge of fraud or suspected fraud affecting the entity involving:  Management;  Employees who have significant roles in internal control; or  Others where the fraud could have a material effect in the financial statements; and d. It has disclosed to the auditor its knowledge of any allegations of fraud, or suspected, affecting the financial statements communicated by employees, former employees, analysts, regulators or others. 392. Client’s Illegal Acts Determination of the legality or illegality of specific client acts is normally beyond the scope of an independent auditor’s professional competence and generally should be left to the lawyers. The auditor however should be alert throughout their audit for information that raises a question regarding the possibility of illegal acts. If the auditors have knowledge of dishonest or clearly illegal activity by the client, they should attempt to assess the impact of the actions on the financial statements. A legal counsel or specialist may have to be consulted.

393. Corporate Governance It is the system by which business corporations are directed and controlled. It is the process by which the owners and creditors of an organization exert control and require accountability of the resources entrusted to the organization. 394. Aspects of Business Where Accountability is Required by Owners a. Financial performance b. Financial transparency c. Stewardship and protection of resources d. Quality of internal controls e. Composition of the board of directors and the nature of its activities f. Management incentive systems being aligned with the stockholders’ best interests Parties Involved in Corporate Governance 396. Stockholders They provide effective oversight through election of board members, approval of major initiatives such as buying or selling stocks and annual reports on management compensation from the board. 397. Board of Directors It is the major representative of stockholders to ensure that the organization is ran according to the organization’s charter and that there is proper accountability. Some of the specific activities of the board are: a. selecting management, b. reviewing management performance and determining compensation, c. declaring dividends, d. approving major changes such as mergers, approving corporate strategy, and e. overseeing accountability activities.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 398. Management It is responsible for the operations (ensuring that the organization is managed effectively) and accountability (providing accurate and timely accountability to shareholders and other stakeholders. Some of the specific activities of the management are: a. b. c.

d. e.

Formulating strategy and risk management, Implementing effective internal controls, Developing financial and other reports to meet public, stakeholder and regulatory requirements, Managing and reviewing operations, and Implementing an effective ethical environment.

399. Audit Committees of the Board of Directors They provide oversight of the internal and external audit and the process of preparing the annual financial statements and public reports on internal control. Some of their specific activities are: a. Selecting the external audit firm, b. Approving any non-audit work performed by the audit firm, c. Selecting and/or approving the appointment of the Chief Audit Executive (Internal Auditor), d. Reviewing and approving the scope and budget of the internal audit function, and e. Discussing audit findings with internal auditor and external auditor and advising the board (and management) on specific actions that should be taken. 400. Board of Accountancy (Regulator) It is responsible for the setting of: a. Accounting and auditing standards dictating underlying financial reporting and auditing concepts; and b. Setting the expectations for audit and accounting quality.

401. Securities and Exchange Commission (Regulator) Its role is to ensure the accuracy, timeliness and fairness of public reporting of financial and other information for public companies. 402. External Auditors They perform audits of company financial statements to ensure that the statements are free of material misstatements including misstatements that may be due to fraud. 403. Internal Auditors They perform audits of companies for compliance with company policies and laws, audits to evaluate the efficiency of operations, and periodic evaluation and tests of controls.

Major Corporate Governance Failures Resulting to Financial Reporting Frauds 405. Enron Covered up financial problems by: a. Shifting debts to off-statement of financial position entities (see no. for further information); b. Recognizing revenue on impaired assets by selling them to special-purpose entities that they controlled; c. Engaging in round-tripping trades (see no. for further information); and d. Numerous other related party transactions. 406. WorldCom Decreased expenses revenues through the following:

and

increased

a. Recorded bartered transactions as sales (e.g., trading the right to use telecommunication lines in one part of the world to similar rights to another part of the world); b. Used restructuring reserves established through acquisitions to decrease

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY expenses (i.e., over accrued reserves upon acquiring a company and later “releasing” those reserves to decrease expenses of future periods; and c. Capitalizing telecommunication line costs (e.g., rentals paid to other phone companies). 407. Lucent Enhanced quarterly revenues by “channel stuffing” which involves increasing sales at the end of the quarter at amounts greater than customers could actually take. Customers were informally given a very large “grace” period in which they could pay for the goods, or return the goods. 408. Parmalat Company siphoned cash off of subsidiaries through complex scheme that: a. Overstated cash and included the false recording of cash ostensibly held at major banks; and b. Understated debt by entering into complex transactions with off-shore subsidiaries in tax-haven places such as the Caribbean. 409. HealthSouth Recorded fictitious revenue across its 250 clinics and hospitals. Some of the billings actually went to the government for Medicare reimbursement. A wide variety of schemes were used including: a. Billing group psychiatric sessions as individual sessions (i.e., with ten people in a group the company billed for ten individual sessions instead of one group session); and b. Using adjusting journal entries to both reduce expenses and enhance revenues. 410. Adecco Overstated revenue by holding the books open for 20-35 days after the end of the year to record sales from the subsequent period as current period sales.

411. Dell Misstated operated earnings by categorizing a rebate from Intel to Dell if Dell promised not to buy chips from a competitor. Net income was not misstated, but operating earnings were misstated by a material amount. *** 412. Off-Statement of Financial Position Entities Off-balance-sheet entities are assets or debts that do not appear on a company's balance sheet. In a clean and clear example, a parent company can set up a subsidiary company and spin it off by selling a controlling interest (or the entire company) to investors. Such a sale generates profits for the parent company from the sale, transfers the risk of the new business failing to the investors and lets the parent company remove the subsidiary from its balance sheet. Too often, however, off–balance-sheet entities are used to artificially inflate profits and make firms look more financially secure than they actually are. The parent company lists proceeds from the sale of these items as assets but does not list the financial obligations that come with them as liabilities.

413. Round-Tripping Trades These are trades where the assets sold are found returning to the original owner (e.g., Enron) after initially recognizing sales and profits. Why the Auditing Profession was Partly Blamed for the Recent Corporate Failures 415. Arthur Levitt “Auditors are the public watchdogs in the financial reporting process. We rely on auditors to put something like the good housekeeping of approval on the information investors receive. The integrity of that information must take priority.” 416. Arthur Wyatt

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY “Practicing professionals should place the public interest above the interests of clients, particularly in a process designed to develop standards expected to achieve fair presentation… Unfortunately, the auditor is often a participant in aggressively seeking loopholes.” *** 417. Relationship Between Corporate Governance and Risk to the Auditor Good governance is important to the conduct of an audit for one very simple reason: companies with good corporate governance are less risky to audit. Many audit firms are not willing to accept potential audit clients unless the clients demonstrate a strong commitment to good corporate governance. 418. Relationship Between Corporate Governance and Non-Audit Services Regarding this, governance issues remain important in accepting those non-audit clients especially for internal audit work. 419. Importance of the Audit Committee One of the characteristics of good and effective corporate governance is the creation of an audit committee which will oversee the accounting and financial processing of the company and the financial statements audit. Here is a summary of the oversight of the audit committee: a. Financial reporting processes  Financial reporting  Internal controls over financial reporting b. Management of credit, market liquidity, operation, legal and other risk management activities c. Audit functions  External auditors  Internal auditors 420. Summary of Principles of Good Corporate Governance and Best Practice Recommendations

a. Lay solid foundations for management and oversight; b. Structure the board to add value; c. Promote ethical and responsible decision-making; d. Safeguard integrity and financial reporting; e. Make timely and balanced disclosure f. Respect the rights of shareholders g. Recognize and manage risk h. Encourage enhanced performance i. Recognize the legitimate interest of stakeholders

PHASE II: RISK RESPONSE Phase II-A: Designing Overall Responses and Further Audit Procedures to Develop Appropriate Responses to the Assessed Risk of Material Misstatement 423. Objective of Risk Response Phase It is to obtain sufficient appropriate evidence to reduce audit risk to an acceptably low level. 424. Overall Responses These include: a. b. c. d. e. f.

Professional skepticism Level of staff assigned Ongoing staff supervision Evaluate accounting policies Nature / timing / extent and unpredictability of planned procedures Other further procedures

425. Further Audit Procedures Audit procedures are the methods or acts that auditors use to gather evidence to determine the validity of financial statement assertions. The types of audit procedures are categorized as follows: a. Test of controls (see no. 362 for further information)

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY b. Substantive procedures (see no. 326 for further information) 426. Purpose of Application of Audit Procedures The auditor applies tests of control or compliance tests when the purpose is to see whether prescribed accounting control procedures are being followed. This evaluation identifies the control procedures that can be relied on in performing restricted substantive tests. Substantive tests are applied when the auditor’s purpose is to see whether the peso amount of an account is properly stated. Thus, there is relationship between the amount of reliance and the amount of additional work that will be needed. Types of Compliance Tests 428. No Trail This type does not leave a visible trail in the supporting documents of the performance of control procedures by the client’s employee. For instance, the auditor makes inquiries and observation of office personnel and routines to determine how control procedures are performed and who performed them.

b. Tests of balances 432. Analytical Review Procedures Analytical types of tests involve study and comparison of relationships among accounting data and related information. They identify unusual fluctuations for investigation and focus on the rationale of relationship. Auditing standards require the application of analytical procedures at the planning and overall final review stages of audits. The auditors may also decide to use them during the audit as substantive tests to provide evidence as to the reasonableness of the specific account balances. For related information, see no. 277. *** 433. Tests of Transactions These are tests of the processing of individual transactions by inspection of the documents and accounting records involved in processing. 434. Tests of Balances These are tests applied directly to the details of balances in general ledger accounts. 435. Common Analytical Procedures

429. Documentary Trail This type leaves a visible trail in the supporting documents. Hence, the auditor inspects the documents supporting a particular type of transaction to whether a control procedure, such as approval or other checking, was performed and who performed it as indicated by signatures or initials. Types of Substantive Tests 431. Tests of Details This type of substantive test involves obtaining evidential matter on the items (or details) involved in an account balance or class of transactions. Tests of details are also referred to as follows: a. Tests of transactions

a.

b.

c.

d.

Comparison of current financial information from prior periods (e.g., compare inventory levels for the current year and the of prior years) Comparison of current financial information with anticipated data (e.g., compare research and development expense to the budgeted amount) Comparison of current financial information with known or predictable relationships (e.g., compare interest expense to the average outstanding balance of interest-bearing debt) Comparison of current financial information with industry information (e.g., compare client’s gross profit percentage to published industry averages)

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY e.

Comparison of current financial information with current nonfinancial information (e.g., compare production records in units to sales)

436. Audit Techniques These are the basic tools or means employed to obtain audit evidences. The application of these techniques constitutes the audit procedures. Common Audit Techniques 438. Count a. Application – counting of inventory, cash, securities, unmatured promissory notes (to establish existence and where applicable, ownership and condition of assets) b. Assertion substantiated – physical existence 439. Confirm a. Application – obtaining information directly of details of account balances (to verify validity and accuracy of account balances and other information with outside parties) b. Assertion substantiated – existence, rights and obligations 440. Inquire a.

b.

Application – obtaining client’s representation letter; explanations to many diverse questions raised during the audit (to obtain knowledge) Assertion substantiated – completeness

441. Examine, Inspect, Review, Trace, Verify and Vouch a. Application – examining (or vouching) paid checks, vendor’s invoices, approved client documents (vouchers, purchase

orders, receiving reports), titles, contracts and other documentary materials (to verify the validity and propriety of accounting treatment of transactions and account balances and compliance with internal control) b. Assertion substantiated – occurrence. Measurement 442. Observe, Test and Verify a. Application – observing the taking of physical inventories by client personnel; of actual operation of internal control (to determine compliance with prescribed procedures) b. Assertion substantiated – existence 443. Extend and Foot a.

b.

Application – rechecking clerical determinations by client (to verify the accuracy of computations and transfer of information made by client) Assertion substantiated – measurement

444. Compare and Trace a. Application – comparing current period account balances or operating data with similar information for prior periods and investigation of unusual data relationship (to disclose and determine the reasons for significant changes) b. Assertion substantiated – completeness *** 445. Assertions in the Audit of Financial Statements These are the implicit or explicit claims and representations made by the management responsible for the preparation of financial statements regarding the appropriateness of the various elements of financial statements and disclosures. Types of Financial Statement Assertions Relating to Classes of Transactions

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

446. Occurrence Transactions recognized in the financial statements have occurred and relate to the entity. Example: Salaries and wages expense has been incurred during the period in respect of the personnel employed by the entity. 447. Completeness All transactions that were supposed to be recorded have been recognized in the financial statements. Example: Salaries and wages cost in respect of all personnel have been fully accounted for. 448. Accuracy Transactions have been recorded accurately at their appropriate amounts. Example: Salaries and wages cost has been calculated accurately. Any adjustments such as tax deduction at source have been correctly reconciled and accounted for. 449. Cut-Off Transactions have been recognized in the correct accounting periods. Example: Salaries and wages cost recognized during the period relates to the current accounting period. Any accrued and prepaid expenses have been accounted for correctly in the financial statements. 450. Classification Transactions have been classified and presented fairly in the financial statements. Example: Salaries and wages cost has been fairly allocated between:  Operating expenses incurred in production activities;  General and administrative expenses; and  Cost of personnel relating to any self-constructed assets other than inventory.

Types of Financial Statement Assertions Relating to Assets, Liabilities and Equity Balances at the Period End 452. Existence Assets, liabilities and equity balances exist at the period end. Example: Inventory recognized in the statement of financial position exists at the period end. 453. Completeness All assets, liabilities and equity balances that were supposed to be recorded have been recognized in the financial statements. Example: All inventory units that should have been recorded have been recognized in the financial statements. Any inventory held by a third party on behalf of the audit entity has been included in the inventory balance.

454. Rights and Obligations The entity has the right to ownership or use of the recognized assets, and the liabilities recognized in the financial statements represent the obligations of the entity. Example: Audit entity owns or controls the inventory recognized in the financial statements. Any inventory held by the audit entity on account of another entity has not been recognized as part of inventory of the audit entity. 455. Valuation Assets, liabilities and equity balances have been valued appropriately. Example: Inventory has been recognized at the lower of cost and net realizable value in accordance with IAS 2 Inventories. Any costs that could not be reasonably allocated to the cost of production (e.g., general and administrative costs) and any abnormal wastage has been excluded from the cost of inventory. An acceptable valuation basis has been used to value inventory cost at the period end (e.g., FIFO, average cost, etc.).

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY Types of Financial Statement Assertions Relating to Presentation and Disclosure 457. Occurrence Transactions and events disclosed in the financial statements have occurred and relate to the entity. Example: Transactions with related parties disclosed in the notes to financial statements have occurred during the period and relate to the audit entity. 458. Completeness All transactions, balances, events and other matters that should have been disclosed have been disclosed in the financial statements. Example: All related parties, related party transactions and balances that should have been disclosed have been disclosed in the notes to financial statements. 459. Classification and Understandability Disclosed events, transactions, balances and other financial matters have been classified appropriately and presented clearly in a manner that promotes understandability of information contained in the financial statements. Example: The nature of related party transactions, balances and events has been clearly disclosed in the notes to financial statements. Users of the financial statements can clearly determine the financial statement captions affected by the related party transactions and balances can easily ascertain their financial effect. 460. Accuracy and Valuation Transactions, events, balances and other financial matters have been disclosed accurately at their appropriate amounts. Example: Related party transactions, balances and events have been disclosed accurately at their appropriate amounts. ***

461. Extent of Testing

The auditor must decide the extent of testing or the number of items to audit. For example, when auditing cash receipts, an auditor may decide to examine every cash disbursement or only a sample of them. The sufficiency of the evidence needed determines the number of items to test. 462. Timing of Testing Another decision that the auditor must make is when to perform each audit procedure. Because an audit usually begins sometime during the fiscal year being audited and ends one to three months after the end of the fiscal year, a long period of time for performing the procedure is available. 463. Interim Work Audit procedures performed before yearend are referred to as interim work. Performing tests at interim dates help complete the audit in a timely manner. However, problems arise when business conditions rapidly change and/or the auditor was not able to assess correctly the predictability of the account balances at year-end. 464. Year-End Work Audit procedures performed between yearend and the completion of the audit are referred to as year-end work. There is less risk in performing tests within this timeframe since no further transactions will affect the account balances (except for adjusting events after the reporting period). 465. Nature of Testing The selection of particular procedures to achieve specific audit objectives is influenced by the following considerations: a. The nature and materiality of the particular component of the financial statements (account balance or class of transaction); b. The nature of the audit objective to be achieved; c. The reliance that can be placed on internal control structure;

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY d. The relative risk of material errors or irregularities; e. The kinds and competence of available evidence; and f. The expected efficiency and effectiveness of possible audit procedures.

466. Audit Evidence It refers to all the information used by the auditor in arriving at the conclusions on which the audit opinion is based, and includes both information contained in the accounting records underlying the financial statements and other information. 467. Factors Influencing the Auditor’s Judgment as to What is Sufficient Appropriate Audit Evidence a. Auditor’s assessment of the nature and level of inherent risk at both the financial statement level and the account balance or class of transaction level; b. Nature of the accounting and internal control systems and the assessment of control risk; c. Materiality of the item being examined; d. Experience gained during previous audits; e. Results of audit procedures, including fraud or error which may have been found; and f. Source and reliability of information available.

478. Factors that Determine the Competence or Appropriateness of Evidence a. Relevance of the evidence to the particular assertion being tested; b. Objectivity of the evidence; c. Qualifications of the provider of the evidence; and

d. Timeliness of the evidence. 479. Hierarchy of Evidential Matter Competence (Strongest to Weakest)

as

to

a. An auditor’s direct personal knowledge, obtained through physical observation and his or her own mathematical computations, is generally considered the most competent evidence. b. Documentary evidence obtained directly from independent external sources (external evidence) is considered competent. c. Documentary evidence that has originated outside the client’s data processing system but which has been received and processed by the client (external-internal evidence) is generally considered competent. However, the circumstances of internal control quality are important. d. Internal evidence consisting of documents that are produced, circulated and finally stored within the client’s information system is generally considered low in competence. However, internal evidence is used extensively when it is produced under satisfactory conditions of internal control. Sometimes, internal evidence is the only kind available. e. Verbal and written representations given by the client’s officers, directors, owners and employees are generally considered the least competent evidence. Such representations should be corroborated with other types of evidence, 480. Factors that Determine the Amount of Evidence to be Gathered (Sufficiency) a. Materiality (e.g., Peso amount) of the item in question; b. Relative risk of the item (e.g., cash due to its liquidity); and

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY c. Cost in relation to the benefit obtained from obtaining more evidence (may not be used as sole basis). Procedures for Obtaining Audit Evidence 482. Inspection It involves the examination of records, documents or tangible assets. 483. Physical Examination and/or Physical Count It is performed to determine the existence and qualitative characteristics of tangible assets. 484. Confirmation It is a specific type of inquiry referring to a process of obtaining representation of information or of an existing condition directly from a third party. 485. Inquiry Inquiry involves seeking both financial and nonfinancial information from knowledgeable persons inside or outside the entity. Inquiries may include formal written inquiries addressed to third parties to informal oral inquiries addressed to persons inside the entity. 486. Written Representation It is a written statement by management provided to the auditor to confirm certain matters or to support other audit evidence. Written representations in this context do not include financial statements, the assertions therein, or supporting books and records. A written representation provides that the audit evidence is all the information used by the auditor in arriving at the conclusions on which the audit opinion is based. 487. Observation It consists of looking at a process or procedure being performed by others. 488. Recalculation

It consists of checking the mathematical accuracy of source documents and accounting records or of performing independent calculations. 489. Reperformance It is the auditor’s independent execution of procedures and controls that were originally performed as part of the entity’s internal control, either manually or through the use of CAATs, for example, reperforming the aging of accounts receivable. 490. Analytical Procedures These consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. Kinds of Confirmation 492. Positive External Confirmation Request It asks the respondent to reply to the auditor in all cases either by indicating the respondent’s agreement with the given information, or by asking the respondent to fill in information. A response from this type of request is ordinarily expected to provide reliable audit evidence. However, a respondent may reply to the confirmation request without verifying that the information is correct. The auditor may reduce this risk by using positive confirmation requests that do not state the amount (or other information) on the confirmation request, but ask the respondent to fill in the amount or furnish other information. On the other hand, use of this type of “blank” confirmation request may result in lower response rates because additional effort is required of the respondents. 493. Negative External Confirmation Request It asks the respondent to reply only in the event of disagreement with the information provided in the request. However, when no response has been received to a negative confirmation request, the auditor remains aware that there will be no explicit evidence that the intended third parties have received the

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY confirmation requests and verified that information contained therein is correct. *** 494. More Procedures

Information

Regarding

the

supporting documents disbursement).

(cash

Sources of Confirmation for Certain Accounts Audit

a. Analyze – to identify and classify items for further study (account transactions). b. Compare – to observe similarities and differences between related items (beginning balances with last year’s audit figure). d. Confirm – to communicate with outside parties to authenticate internal evidence (accounts receivable; cash in bank; accounts payable). e. Count – to enumerate a characteristic (cash; inventory) f. Examine – to review critically (authoritative document such as invoices and checks). g. Extend – to add items located in the same row. h. Foot – to add items located in the same column. i. Inspect – to scrutinize or critically examine a document (certificate of stock). j. Interrelate – to show relationship (interest expense with liabilities) k. Observe – to watch or test a client (inventory count). l. Reconcile – to establish agreement between separate sources of information (cash balance per ledger with cash balance per bank statement). m. Test – to sample (cash transactions). n. Trace – to follow a transaction through the steps of the system (bookkeeping procedures). o. Verify – to prove accuracy of numbers or existence of amount (rent income against lease contract). p. Vouch – to prove accuracy of accounting entries by tracing to

496. Assets a. b. c. d.

Cash in Bank – Bank Accounts Receivable – Customer Notes Receivable – Maker Inventory out on Consignment – Consignee e. Inventory Held in Public Warehouse – Public warehouse f. Cash Surrender Value of Life Insurance – Insurance company 497. Liabilities a. b. c. d. e.

Accounts Payable – Creditor/supplier Notes Payable – Lender Advances from Customers – Customer Mortgages Payable – Mortgagee Bonds Payable – Issuer

498. Owners' Equity b. Shares Outstanding – Registrar and transfer agent 499. Other Information a. b. c. d.

Insurance Coverage Contingent Liabilities Bond Indenture Agreement Collateral Held by Creditors

500. Evidence about Accounting Estimates Accounting estimate means an approximation of the amount of an item in the absence of a precise means of measurement. The auditor should adopt one or a combination of the following approaches in the audit of an accounting estimate: a. Review and test the process used by the management; b. Use an independent estimate for comparison with that prepared by management; or

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY c. Review subsequent events confirm the estimate made.

which

501. Related Parties The term related parties refers to the client entity and any other party with which the client may deal, where one party has the ability to influence the other to the extent that one party to the transaction may not pursue its own separate interests. 502. Related Party Transaction It refers to any transaction between the company and related parties (except for normal compensation arrangements, expense allowances, and similar transactions arising in the ordinary course of business).

504. Reasons for the Use of Sampling a. The nature and materiality of the balance or class does not demand a 100% audit; b. A decision must be made about the balance or class; and c. The time and cost to audit 100% of the population would be too great. 505. Testing Procedures Which Do Not Involve Sampling a. Tests performed on 100% of the items within a population (e.g., large value, low volume accounts) b. Inquiry and observation c. Analytical procedures

501. Evidence for Related Party Transactions Since transactions with related parties are not conducted at arm’s length, the auditors should be aware that the economic substance of these transactions may differ from their form. Common methods of identifying related parties include making inquiries of management and reviewing SEC filings, stockholders’ listings, and conflict-ofinterest statements obtained by the client from its executives.

506. Sampling Risk This refers to the risk that the auditors’ conclusion based on a sample might be different from the conclusion they would reach if they examined every item in the entire population. 507. Non-Sampling Risk This arises from factors that cause the auditor to reach an erroneous conclusion for a reason not related to the size of the sample (e.g., the auditor might use inappropriate procedures or the auditor might misinterpret evidence and fail to recognize an error).

502. Audit Sampling It is defined as the application of a compliance or substantive procedure to less than 100% of the items within an account balance or class of transactions to enable the auditor to obtain and evaluate evidence of some characteristic of the balance or class to form or assist in forming a conclusion concerning that characteristic.

Selecting Items for Testing to Gather Audit Evidence

503. Sampling It is a process whereby information is gained concerning the characteristics of population (universe or field) of items by means of an examination of only a portion of the items composing that population.

509. Selecting All Items a. b. c.

d.

More common for substantive procedures than tests of control. Population composed of small number of large value items. Used when both inherent and control risk are high and other means do not provide sufficient appropriate evidence. Also applicable when the repetitive nature of a calculation or other process

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY performed by a computer information system makes a 100% examination cost effective. 510. Selecting Specific Items Specific items selected may include: a. b. c. d.

High value or key items All items over a certain amount Items relevant to specific information Items involved in a procedure

511. Audit Sampling a. b.

May use either nonstatistical or statistical sampling or both. Statistical sampling allows for the quantification of sampling risk; nonstatistical sampling does not. Sampling Techniques

513. Attribute Sampling Technique It is used when an auditor is interested in measuring a qualitative feature, such as the presence or absence of internal control procedure. 514. Variables Sampling Technique It is used by an auditor during substantive testing. This provides an estimate of a Peso range within which the true audited value of the population lies. Sample Risks to Be Considered in Performing Tests of Controls 516. Risk of Overreliance It is the risk that the sample supports reliance on internal control when this reliance is unjustified. 517. Risk of Underreliance It is the risk that the sample does not support reliance on internal control when the true compliance rate suggests that the auditor should rely on internal control.

Sample Risks to Be Considered in Performing Substantive Tests 519. Risk of Incorrect Rejection or Alpha Risk It is the risk that the sample supports the conclusion that the recorded account balance is materially misstated when it is not materially misstated. 520. Risk of Incorrect Acceptance or Beta Risk It is the risk that the sample supports the conclusion that the recorded account balance is not materially misstated when it is materially misstated (detection risk). 521. Factors to Be Considered in the Design of Sampling Procedures a. b. c. d. e. f.

Audit objectives Population Risk and assurance Tolerable error Expected error in the population Stratification

522. Audit Objectives The auditor first considers the specific objectives to be achieved and the combination of audit procedures which is likely to best achieve those objectives. Consideration of the nature of the audit evidence sought and possible error conditions or other characteristics relating to that audit evidence will assist the auditor in defining what constitutes an error and what population to use for sampling. 523. Population It is important for the auditor to ensure that the population is: a. Appropriate to the objective of the sampling procedure (e.g., test for overstatement of accounts payable – population: accounts payable listing; test for understatement of accounts payable – population: subsequent disbursements, unpaid invoices,

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY suppliers’ statements, unmatched receiving reports, etc.). b. Complete (e.g., conclusions cannot be drawn about all vouchers for the period unless the auditor is satisfied that all vouchers have in fact been filed). 524. Risk and Assurance a. Audit risk  Inherent risk  Control risk  Detection risk b. Sampling risk  Risk of overreliance  Risk of underreliance  Risk of incorrect rejection  Risk of incorrect acceptance c. Non-sampling risk 525. Tolerable Error This is the maximum error in the population that the auditor would be willing to accept and still conclude that the result from the sample has achieved his audit objective. 526. Relationship Between Tolerable Error and Required Sample Size The smaller the tolerable error, the larger sample size the auditor will require (inverse relationship). 527. Expected Error in the Population This assessment is based on the auditor’s prior knowledge or the examination of a small number of items from the population. The following factors should be considered in determining the expected error in the population: a. Error levels identified in previous audits, b. Changes in client procedures, and c. Evidence available from his evaluation of the system of internal control and from results of analytical review procedures. 528. Stratification

It is the process of dividing a population into subpopulations, that is, a group of sampling units which have similar characteristics (often monetary value). The reduction in variability within each stratum results in a smaller overall sample size. Examples: a. Account balance or class of transactions stratified by monetary value to allow greater audit effort to be directed to the larger value items; and b. Population stratified according to a particular characteristic that indicates a higher risk of error such as the stratification by age of accounts receivable. 529. Value Weighted Sampling In this method, the auditor first divides the population on the basis of monetary value, for example high value, mid value and low value. And then he or she selects more items from high value item group as compared to others. 530. Sample Size In determining the sample size, the auditor should consider whether sampling risk is reduced to an acceptably low level. Sample size is affected by the level of sampling risk the auditor is willing to accept. The lower the risk the auditor is willing to accept, the greater the sample size will need to be. 531. Examples of Factors Influencing the Sample Size for Tests of Control a. The more assurance the auditor intends to obtain from the operating effectiveness of controls, the lower the auditor’s assessment of the risk of material misstatements will be, and the larger the sample size will need to be. b. The lower the tolerable rate of deviation, the larger the sample size needs to be. c. The higher the expected rate of deviation, the larger the sample size needs to be so that the auditor is in a position to make a reasonable estimate of the actual rate of deviation.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY d. The greater the level of assurance that the auditor desires that the results of the sample are in fact indicative of the actual incidence of deviation in the population, the larger the sample size needs to be. 532. Examples of Factors Influencing Sample Size for Tests of Details a. The higher the auditor’s assessment of risk of material misstatement, the larger the sample size needs to be. b. The more the auditor is relying on other substantive procedures to reduce to an acceptable level the detection risk regarding a particular population, the less assurance the auditor will require from sampling and, therefore, the smaller the sample size can be. c. The greater the level of assurance that the auditor requires that the results of the sample are in fact indicative of the actual amount of misstatements in the population, the larger the sample size needs to be. d. The lower the tolerable misstatement, the larger the sample size needs to be. e. The greater the amount of misstatement the auditor expects to find in the population, the larger the sample size needs to be in order to make a reasonable estimate of the actual amount of misstatement in the population. f. When there is a wide range (variability) in the monetary size of items in the population, it may be useful to stratify the population. When a population is appropriately stratified, the aggregate sample sizes from the strata generally will be less than the sample size that would have been required to attain a given level of sampling risk, had one sample been drawn from the whole population.

533. Summary of the Steps Related to Sampling to Be Followed in the Risk Response Phase a. Selecting the sample using appropriate sampling method and sample size; b. Performing the Audit Procedure; c. Evaluation of Sample Results; d. Analysis of Errors in the Sample; e. Projection of Errors; and f. Assessing Sampling Risk. Audit Sampling Plans

Audit Sampling Attributes Sampling in Tests of Control Statistical

Nonstatistical

Regular or Classical Discovery Sequential or Stop or Go

Variables Sampling in Substantive Tests of Details Statistical

Probability or Proportional to Size

Nonstatistical

Classical Mean per Unit Difference Estimation Ratio Estimation Regression

534. Statistical Sampling Plan This is a sampling technique in which an auditor uses the laws of probability to select and evaluate a sample. When using statistical sampling, auditors must select a random sample, which means every item in the population must have equal chance of being included in the sample. Variations of Statistical Sampling Plan 536. Random Sampling A simple random sample is a sample that is selected in such a way that every item in a population has an equal chance of being selected.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY This is accomplished by using a printed table of random numbers or computer software that generates random numbers. 537. Systematic Sampling In using this method, the auditor counts through the population and selects items on the basis of a sampling interval which is determined by dividing the number of physical items in the population by sample size. 538. Stratified Random Sampling The auditor groups the population into subpopulations, or strata that are similar in amount or characteristic. Samples are then drawn from each stratum using one of the random selection methods. 539. Sampling with Probability Proportional to Size The probability of an item being selected under this method is directly proportional to its Peso amount. *** 540. Nonstatistical Sampling Plan These plans rely exclusively on subjective judgment to determine sample size and to evaluate sample results. Variations of Nonstatistical Sampling Plan 541. Haphazard Sampling A haphazard sample consists of sampling units without any conscious bias that is without any special reason for including or omitting items from the sample. 542. Block Selection A block sample consists of all items in a selected time period, numerical sequence or alphabetical sequence (e.g., all cash disbursement transactions in the first week of June). This method cannot be generally relied upon to efficiently produce a representative sample.

543. Judgmental Sampling Under this method, the auditor selects large or unusual items from the population and uses some other judgmental criterion for selection. Obviously, this selection method has a conscious bias and cannot be considered a representative selection method. *** 544. Logic of Tests of Controls Recall that there are two main aspects of internal control: design and operation. It is only the latter that is being subjected to tests of control. Based on the auditor's understanding of accounting and internal control systems, the auditor identifies the characteristics or attributes that indicate performance of a control, as well as possible deviation conditions which indicate departures from adequate performance. The presence or absence of attributes can then be tested by the auditor. 545. Evidence of Performance Audit sampling for tests of control is generally appropriate when the application of control leaves evidence of performance (e.g., initials of the credit manager on a sales invoice indicating credit approval). 546. Steps in the Application of Attributes Sampling to Test of Controls a. Determine the control to be tested or audit objective of the test. b. Define the attributes and deviation conditions. c. Define the population to be sampled and the sampling unit. d. Specify the risk of assessing control risk too low (overreliance) and the tolerable deviation rate. e. Estimate the expected population deviation rate. f. Determine the sample size. g. Select the sample. h. Perform the test of control procedures on sample items.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY i. j.

Evaluate the sample results. Document the sampling procedure.

547. Determine the Control to Be Tested or Audit Objective of the Test Example: The objective is to test the effectiveness of internal control over payments for purchases of merchandise which requires the matching of receiving reports with purchase invoices as a step for the authorization of such payments. 548. Attributes These are characteristics that provide evidence that an internal control procedure was actually performed.

549. Deviation It occurs when a sample item does not have one or more of the identified attributes. 550. Define the Attributes and Deviation Conditions Example: The following table shows the attributes and corresponding deviation conditions for the internal control of matching receiving reports with purchase invoices. Attribute Deviation a. Any purchase a. Any purchase invoice is supported by invoice is not a receiving document. supported by a receiving document. b. Any purchase b. Any purchase invoice is supported by invoice is supported by a receiving document a receiving document where the latter is that is applicable to applicable only to the another invoice. former. c. Any purchase c. Any difference invoice and the between the purchase receiving document invoice and the supporting it have a receiving document as matching information to quantities shipped. as to quantities

shipped. 551. Define the Population to Be Sampled and the Sampling Unit Example: The client prepares a serially numbered voucher for every purchase of materials. The receiving report and purchase invoice are attached to each voucher. Therefore, the sampling unit for the test is an individual voucher. Since the test of controls is being performed during the interim period, the population to be tested consists of 6,350 vouchers (assumed) for purchases of materials during the first 10 months of the year under audit. If at any point the auditor determines that the physical representation of the population (the 6,350 vouchers) has omitted vouchers that should be included in the first 10 months, the auditor should also test those vouchers. 552. Risk of Assessing Control Risk Too Low It is the risk that the actual deviation rate (deviations detected / sample size) exceeds the tolerable deviation rate (also known as risk of overreliance). 553. Specifying the Risk of Assessing Control Risk too Low The lower the risk percentage assigned to this, the tighter it is for the internal control to pass the compliance test. And since the results of tests of controls play a major role in determining the nature, timing and extent of other audit procedures, auditors usually specify a low level of acceptable risk of assessing control risk too low (5-10%). 554. Specifying the Tolerable Deviation Rate Auditors specify this based on the following: a. The lower the planned assessment level of control risk, the lower the tolerable deviation rate; and b. The higher the degree of assurance desired from the evidential matter in the sample, the lower the tolerable deviation rate.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 555. Estimation of the Expected Population Deviation Rate The following are the common bases for estimating the expected population deviation rate: a. Sample from prior years, as documented in working papers; b. Experience with similar tests on other audit engagements; or c. By examining a small pilot sample. 556. Determining the Initial Sample Size In determining the sample size, following factors shall be considered:

the

a. Acceptable level of sampling risk b. Planned reliance on internal control c. Allowable rate of deviation (tolerable error) d. Likely rate of population deviation (expected error) e. Required confidence level (risk of assessing control risk too low) f. Number of items in the population Moreover, the sample size can be determined by the use of a statistically-based formula (usually to create a table of statistical sample sizes) or through the exercise of professional judgment objectively applied to the circumstances.

560. Performing the Tests of Control Procedures on Sample Items When testing the sample items, an auditor examines each sample item for the attributes of interest. Each item will be classified as to whether it contains a deviation from the prescribed internal control procedure. The auditor performing the test should also be alert for evidence of any unusual matters, such as evidence of fraud or related party transactions. 561. Compliance Test Risk Matrix 562. Evaluating the Sample Results After performing the sampling plan, the auditor summarizes and evaluates the results by following these steps: a. Determine the sample deviation rate. b. Determine the upper deviation rate and the allowance for sampling risk. c. Compare the upper deviation rate and the tolerable rate of deviation and evaluate the effectiveness of a control accordingly. d. Consider qualitative information such as evidence of deliberate manipulation or circumvention of internal control. e. Reach an overall conclusion.

557. Selection of the Sample After determining the initial sample size, the auditor should select a random sample from the population.

563. Sample Deviation Rate Formula: Sample Deviation Rate = Number of Deviations Observed / Sample Size

558. Sampling with Replacement It means that after an item has been selected for inclusion in the sample, it is placed back in the population so that it is subject to selection again. Id an item is selected twice because the random number is drawn twice, the item must be included twice.

564. Upper Deviation Rate It is basically the sample deviation rate adjusted for the effects of sampling risk. Formula: Upper Deviation Rate = Sample Deviation Rate + Allowance for Sampling Risk

559. Sampling without Replacement It requires the selected item be included in the sample only once.

565. Allowance for Sampling Risk It is determined from the standard tables showing maximum deviation rates at specific levels of risk of overreliance.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 566. Evaluation of the Effectiveness of a Control Under the Statistical Sampling Plan

the auditor would assess control risk to be maximum.

a. If upper deviation rate is less than or equal to the tolerable deviation rate, it is implied that a control is effective and the results would support assessing control risk below the maximum or 100%. b. If the upper deviation rate is greater than the tolerable deviation rate, it would suggest that a control is not effective and the result would support assessing control risk at maximum level or 100%.

568. Evidence of Deliberate Manipulation or Circumvention of the Internal Control Structure It is important for the auditor to consider qualitative information such as this kind of evidence. The existence of such matter would greatly affect the subsequent portions of the audit.

567. Evaluation of the Effectiveness of a Control Under a Nonstatistical Sampling Plan In this type of application, sampling deviation rate is compared with tolerable rate or expected population deviation rate. a. If the sampling deviation rate is less than or equal to the tolerable rate or expected population deviation rate, internal control is considered effective and would support assessing control risk below maximum. b. If the sampling deviation rate is greater than the tolerable rate or expected population deviation rate, the control is not considered effective and therefore a. Sales clerk receives It triggers the start of purchase order from the sales process. customer. b. A sales order is Sales orders shall be prepared by the sales preprinted, clerk in eight (8) prenumbered, and copies. numerically controlled. c. Two (2) copies of the sales order are sent to the customer.

569. Conclusion of the Evaluation of Sample Results The auditor must relate the assessed control risk to detection risk for each financial statement assertion.

570. Logic of Substantive Procedures Substantive procedures are concerned with amounts and are of two types: analytical procedures and tests of details of transactions and balances. The purpose of substantive procedures is to obtain audit evidence to detect material misstatements in the financial statements. Types of Variable Sampling Plan Techniques for Substantive Procedures

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY Phase II-B: Implementing Responses to Assessed Risk of Material Misstatement to Reduce Audit Risk to an Acceptably Low Level Tests of Controls for Sale Transactions 5. Existence / Occurrence Recorded sales are for shipments actually made to customers. Controls a. Recording of sales is supported by customer orders, sales orders approved by the credit department, and approved and executed shipping documents. b. A clerk independent of accounts receivable prepares and mails monthly statements to customers for all trade accounts receivable and follows up on any complaints.

Potential Misstatements Sales that did not occur may be recorded.

Tests of Controls Examine approved customer order, sales order, shipping document, and copy of sales invoice for a sample of entries in the sales journal.

Errors in recording sales may not be detected.

Observe procedure and examine follow-up files.

5. Completeness All sales transactions that occurred are recorded. Controls a. Prenumbered shipping documents are accounted for to determine that a sales invoice is prepared for all shipments. b. Prenumbered sales invoices are accounted for to determine that all sales are recorded. c. Procedures to ensure timely recording of sales and proper cut-off are established.

Potential Misstatements Goods may be shipped but not billed.

Unrecorded sales may exist.

Sales transactions may recorded in the wrong period.

Tests of Controls Observe procedure. Examine copy of invoices to a sample of shipping documents.

Observe procedure. Examine entries for a sequence of sales invoices to sales journal. be Inquire how procedures are followed, observe procedures being followed and inspect report on last shipments.

5. Rights and Obligations Sales recorded represent only sales transactions. Controls Potential Misstatements a. Clerk checks sales order and Consignment transactions may be sales invoice for terms to recorded as sales. determine that transaction is a sale other than a consignment.

Tests of Controls Observe procedures.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

5. Valuation / Measurement Sales are correctly billed and recorded. Controls a. For all goods shipped, goods are counted and descriptions and quantities are compared to quantities and descriptions on sales orders and shipping documents prior to shipping. b. Customer credit is approved by a responsible official prior to merchandise shipment. c. Sales invoices are checked for:  Proper pricing  Mathematical accuracy  Terms

Potential Misstatements More or fewer goods may have been shipped than ordered. Customer returns may occur.

Tests of Controls Observe procedure. For a sample, examine signature on documents evidencing performance.

Accounts receivable uncollectible.

be

Examine sales order for selected transactions.

Sales/accounts receivable may be overstated or understated.

Inquire about the updating and use of approved price lists. For a sample of invoices, examine signature indicating performance of task. Observe procedure. Foot subsidiary ledger.

may

d. The accounts receivable Likelihood of errors in accounts subsidiary ledger is balanced receivable increases. to the general ledger control account regularly.

5. Presentation and Disclosure Sales and accounts receivable are recorded to result in presentation and disclosure in accordance with PFRS. Controls a. An independent review is made of account coding for recorded sales.

Potential Misstatements Revenues may be misclassified.

Tests of Controls Observe procedure. For a sample of invoices, recheck account coding.

Tests of Controls for Cash Receipt Transactions 5. Existence / Occurrence Recorded receipts represent actual collections of cash from customers. Controls Potential Misstatements a. A trustworthy employee Cash receipts may prepares a prelisting of cash misappropriated.

be

Tests of Controls Observe whether a prelisting is prepared and inquire of preparer

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY receipts before further processing. b. A validated deposit slip is obtained for daily deposits and compared to the cash receipts summary. c. Duties of handling cash receipts are segregated from posting to accounts receivable. d. A bank reconciliation is prepared monthly by a person not involved in handling cash, accounts receivable, or general ledger records.

about the procedures followed. Cash receipts may be recorded that were not deposited.

For a sample of entries in the cash receipts journal, reconcile the total to validated deposit tickets.

Cash may be misappropriated and lapping may occur.

Observe separation of duties and inquire of personnel about their responsibilities. Examine bank reconciliations and determine that preparer does not have conflicting duties.

Bank reconciliations may cover shortages.

5. Completeness / Rights and Obligations All receipts are processed and recorded. Controls a. Prelisting of cash receipts and cash register procedures are monitored. b. Checks are restrictively endorsed upon receipt. c. Cash receipts are deposited intact daily.

Potential Misstatements Cash may be misappropriated.

or

Tests of Controls Observe monitoring and inquire of prelister and cash register operator about procedures. Examine undeposited checks for endorsement. Observe the procedure and inquire of personnel who perform the procedure. For selected day, trace totals from cash receipts journal to cash summary and validated deposit ticket.

d. A daily cash summary is prepared and reconciled to total of prelisting and over-thecounter receipts and the cash receipts journal. e. The cash receipts journal total is independently reconciled to the total posted to accounts receivable.

Cash may be misappropriated.

Credits posted to customers’ accounts may be overstated or understated.

Observe the procedure and inquire of personnel who perform the procedure.

Cash may be misappropriated. Cash may be unrecorded misappropriated.

5. Valuation / Measurement Debits to cash and credits to accounts receivable are valued at amounts received. Controls Potential Misstatements a. Cash receipts are recorded at A customer may be given credit the amount received. for an amount greater than payment. b. A responsible person approves A customer may take a larger cash discounts taken. discount than appropriate.

Tests of Controls For a sample of entries in cash receipts journal, examine remittance advices. For a sample of entries in cash receipts journal, examine

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY remittance advices for approval of discount taken. 5. Presentation and Disclosure Cash receipt transactions are recorded to result in presentation and disclosure in accordance with PFRS. Controls Potential Misstatements a. A supervisor approves account Entries may be made to wrong classification made in accounts. journalizing.

Tests of Controls Observe procedure. Examine approvals by supervisor.

Tests of Controls for Purchase Transactions 5. Existence / Occurrence Recorded acquisitions are for items that were acquired. Controls a. Approval of acquisitions is evidenced by signature on the purchase order. b. A purchase requisition, purchase order; receiving report, and vendor’s invoice are filed in support of each acquisition. c. Documents are cancelled so they cannot be reused.

Potential Misstatements Purchases that did not occur may be recorded.

Tests of Controls Examine approval signature.

Purchases that did not occur may be recorded.

Observe procedure or examine file of documents.

Documents may be reused, and Examine cancellations acquisitions may be recorded documents. twice.

on

5. Completeness Acquisitions that occurred are recorded. Controls Potential Misstatements a. Receiving records are Purchases may be unrecorded. prenumbered and accounted for. b. Vouchers are prenumbered Purchases may be unrecorded. and accounted for.

Tests of Controls Observe procedure. Account for a numerical sequence. Observe procedure. Account for a numerical sequence.

5. Rights and Obligations Recorded acquisitions are the entity’s purchases and liabilities. Controls a. Receiving reports are prepared

Potential Misstatements Purchases that are not legitimate

Tests of Controls Observe procedure.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY by persons having access only to a blind copy of purchase order details. Consigned goods are readily identified.

business purchases may be recorded and paid, or consigned goods may be recorded as a purchase.

5. Valuation / Measurement Acquisitions are recorded for the proper amounts. Controls a. Invoice amounts are verified by reference to purchase orders and receiving reports, and mathematics on invoice is rechecked.

Potential Misstatements Client could overpay for goods or services.

Tests of Controls Examine voucher for signature indicating performance.

5. Presentation and Disclosure Acquisitions are recorded to result in presentation and disclosure in accordance with PFRS. Controls Potential Misstatements a. Chart of accounts adequately Purchases may be charged to describes accounts to be wrong accounts. debited. Account coding is assigned by one person and checked by another.

Tests of Controls Examine chart of accounts. Examine signature of employee performing check.

Tests of Controls for Cash Payment Transactions 5. Existence / Occurrence Recorded cash payments occurred. Controls a. Authorized individual signs and promptly mails checks after reviewing documentation. b. A review is made by a person not responsible for handling disbursements that checks are processed on a timely basis.

Potential Misstatements Checks may be written but not issued or released.

Tests of Controls Observe procedure. Examine documents.

Checks may be written but not issued or released.

Observe procedure. Inquire about procedures being followed.

6. Completeness All cash payments made are recorded. Controls Potential Misstatements a. Checks are prenumbered and Checks may be issued but not

Tests of Controls Observe procedure. Account for

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY accounted for. b. Independent reconciliation is monthly.

recorded. bank Account may not reconcile or performed discrepancy may not be disclosed.

sequence. Observe that person preparing bank reconciliation is independent of cash handling. Inspect reconciliation.

5. Rights and Obligations All cash payments made are for obligations of the entity. Controls Potential Misstatements a. Check signer who is Unauthorized payments may be independent of voucher made. preparation examines supporting documentation before signing checks.

Tests of Controls Observe procedure.

5. Valuation / Measurement Debits to various accounts and credits to cash are valued at proper amounts. Controls Potential Misstatements a. Amounts (including discounts Improper amounts may be paid taken) and calculations on because of math errors or vendors’ invoices are incorrect discounts. independently verified.

Tests of Controls Observe procedure. Examine signature on invoice.

5. Presentation and Disclosure Cash payments are recorded to result in presentation and disclosure in accordance with PFRS. Controls Potential Misstatements a. Chart of accounts adequately Payments may be credited to describes accounts to be used, wrong accounts. and account coding is assigned to one person and checked by another.

Tests of Controls Observe procedure. Examine chart of accounts. Examine signature of employee performing checks.

Tests of Controls for Payroll Transactions 5. Existence / Occurrence Recorded payroll transactions occurred. “We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY Controls a. Chart of accounts adequately describes accounts to be used, and account coding is assigned to one person and checked by another. b. Payroll checks are signed and distributed by a person not in personnel, payroll accounting, or supervisor of operations.

Potential Misstatements Payments may be credited to wrong accounts.

Tests of Controls Observe procedure. Examine chart of accounts. Examine signature of employee performing checks.

Payroll may include fictitious or former employees.

Observe separation of duties.

5. Completeness All payroll earned by employees is recorded. Controls Potential Misstatements a. Payroll checks are Paychecks may be issued but not prenumbered and accounted recorded. for in the bank reconciliation by a person independent of the payroll function.

Tests of Controls Observe procedures. Examine bank reconciliation.

5. Rights and Obligations Recorded payroll transactions are for services received. Controls a. Employees record their time using a time clock but record no other employee’s name. b. Supervisors approve time cards before submitting them to payroll accounting.

Potential Misstatements Employees may be paid for hours they did not work.

Tests of Controls Observe procedure.

Employees may be paid for hours they did not work.

Examine signature on cards.

5. Valuation / Measurement Payroll transactions are recorded for the proper amounts. Controls a. Payroll calculations are verified. b. Control totals of hours worked are determined independently

Potential Misstatements Paychecks may be for wrong amounts. Employees may be paid for hours they did not work.

Tests of Controls Examine payroll register for signature indicating verification. Examine reconciliation.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY of payroll accounting and compared to the hours for which payment is recorded. 5. Presentation and Disclosure Payroll transactions are recorded to result in presentation and disclosure in accordance with PFRS. Controls Potential Misstatements a. Account codes assigned are Wages expense may be charged reviewed by appropriate levels to wrong accounts. of management.

Tests of Controls Examine chart of accounts. Examine signature of employee performing check.

Tests of Controls for Production Transactions 5. Existence / Occurrence Recorded production transactions occurred. Controls a. A materials requisition is prepared by operating personnel and signed by a warehouse custodian when goods are transferred to production. b. Labor tickets are used by production employees for recording labor.

Potential Misstatements Transactions that did not occur may be recorded.

Tests of Controls Observe segregation of duties and examine approval signatures.

Fictitious time may be assigned to jobs.

Examine labor tickets.

5. Completeness / Rights and Obligations All production transactions that occurred are recorded. Controls a. Production orders are prenumbered and accounted for to determine that all production is recorded. b. Materials requisition are prenumbered and accounted for by an accounting clerk. c. Time charged on labor tickets is reconciled to employee time cards.

Potential Misstatements Completed production may not be recorded.

Tests of Controls Observe procedure and account for a numerical sequence of production orders.

Goods may be issued but not recorded.

Observe procedure and account for a numerical sequence of materials requisitions. Observe procedure.

Time may be worked in production but not recorded.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 5. Valuation / Measurement Production transactions are recorded by the proper amounts. Controls a. Values for transactions are based on a bill of materials, approved labor tickets and rates for labor, and predetermined overhead rates. b. Overapplied or underapplied overhead is reviewed periodically, and rates are adjusted as necessary.

Potential Misstatements Values may not be based on cost incurred.

Tests of Controls Trace values to bill of materials, time cards, and overhead rates.

Finished goods may be assigned with incorrect value.

Examine signature performance.

indicating

5. Presentation and Disclosure Production transactions are recorded to result in presentation and disclosure in accordance with PFRS. Controls a. Chart of accounts adequately describes accounts to be used, and account coding is independently checked.

Potential Misstatements Costs may be assigned to wrong accounts.

Tests of Controls Examine chart of accounts. Examine signature of employee performing check.

Tests of Controls for Inventory Warehousing Transactions 5. Existence / Occurrence Recorded inventory warehousing transactions occurred. Controls Potential Misstatements a. A copy of a receiving report Fictitious receipts may be signed by a receiving clerk is recorded. used by inventory accounting to record receipt of goods. b. A materials requisition is Fictitious issues may be recorded. prepared and signed by appropriate operating personnel.

Tests of Controls Observe separation of duties and examine approval signature on receiving report. Observe separation of duties and examine approval signature on materials requisition.

5. Completeness All inventory warehousing transactions that occurred are recorded. Controls Potential Misstatements a. Receiving reports and Goods may be received or issued materials requisitions are but not recorded. prenumbered and accounted for by a clerk in inventory

Tests of Controls Observe procedure and account for a numerical sequence of receiving reports to determine that all have been recorded.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY accounting. b. An inventory clerk signs a copy of the receiving report after counting goods transferred to his or her area. c. Access to inventory is limited to personnel responsible for its custody.

Errors may be recorded in the quantity of goods transferred.

Observe procedure. Examine signature on receiving reports.

Goods may be issued but not recorded.

Observe procedures.

5. Rights and Obligations Inventory warehousing transactions are for goods that belong to the entity. Controls Potential Misstatements Tests of Controls a. Goods received on Goods on consignment may be Inquire about and observe the consignment are labeled and treated as inventory. procedure. separated from goods the entity owns. 6. Valuation / Measurement Inventory warehousing transactions are recorded for proper amounts. Controls Potential Misstatements a. Costs assigned to work in Inventory may be misvalued. process and finished goods are set by procedures that are reviewed and periodically evaluated. Mathematical accuracy is tested.

Tests of Controls Inquire about and observe evidence of standards setting, review standards and testing of standards.

7. Presentation and Disclosure Inventory warehousing transactions are recorded to result in presentation and disclosure in accordance with PFRS. Controls a. Chart of accounts adequately describes accounts to be used, and account coding is

Potential Misstatements Receipt or issue may be charged or credited to wrong accounts.

Tests of Controls Examine chart of accounts. Examine signature of employee performing check.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY assigned to one person and checked by another. 6. Audit Documentation It means the record of audit procedures performed, relevant audit evidence obtained, and conclusions the auditor reached. It is also known as working papers or work papers. 6. Audit File It means one or more folders or other storage media, in physical or electronic form, containing the records that comprise the audit documentation for a specific engagement. 6. Experienced Auditor He or she is an individual (whether internal or external to the firm) who has practical audit experience, and a reasonable understanding of audit processes, PSAs and applicable legal and regulatory requirements, the business environment in which the entity operates, and auditing and financial reporting issues relevant to the entity’s industry. 6. Primary Objective of Audit Documentation Its objective is preparing sufficient and appropriate audit documentation on a timely basis to help enhance the quality of the audit and to facilitate review and evaluation of the audit evidence obtained and conclusions reached before the auditor’s report is finalized. 6. Types of Working Papers a. b. c. d. e.

Audit administrative working papers Working trial balance and lead schedule Supporting schedules and analysis Adjusting and reclassifying entries Audit memoranda and documentation of corroborating information

6. Audit Administrative Working Papers These are working papers designed to aid the auditors in planning and administration of engagements. These include audit plans and programs, internal control questionnaires and flowcharts, engagement letters, and time budgets.

Types of Audit Programs (See no. 288 for definition.) 6. Standard All-Purpose Audit Program It lists standard practices applicable to almost every engagement. 6. Tailor-Made Audit Program It lists the procedures to be followed on a specific audit engagement, indicating any departure from normal practices and specifying the extent of the tests of transactions. 6. Modified Standard Form Audit Program It is a reprinted program that outlines the usual audit procedures common to most businesses and provides space for an auditor to indicate other specific procedures applicable to the business under examination. *** 6. Working Trial Balance Also called as the backbone of the working papers, it is a list of the accounts in the client’s general ledger with columns that, as a minimum include unadjusted amounts directly from the client’s accounting records, proposed adjusting entries, and adjusted (audited) amounts. 6. Lead or Top Schedule It is a working paper that shows the grouping of related account balances. Each line item on the trial balance is supported by a lead schedule, containing the detailed accounts from the general ledger making up the line item total. Each detailed account on the lead schedule is, in turn, supported by appropriate supporting schedules evidencing the audit work performed and the conclusions reached. 6. Supporting Schedules These are the detailed schedules prepared by auditors in support of specific amounts on the

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY financial statements (e.g., cash count sheet for cash on hand balance) 6. Accounts Analysis This working paper shows the activity during the period in a particular statement of financial position account. It starts with the beginning balance, shows the transactions (additions and reductions) that occurred during the period, and concludes with the ending balance. 6. Summary of Adjusting Entries Adjusting entries are corrections of material errors in the accounting records discovered by the auditor. These entries must be approved by the client because management has primary responsibility for the fair presentation of the statement. 6. Summary of Reclassifying Entries Reclassifying entries are made in the statements to present accounting information properly, even when the general ledger balances are correct (e.g., material credit customer balances in accounts receivable subsidiary ledger to be reclassified to advances from customers). 6. Audit Notes This is the working paper used to note items of work to be done that cannot be completed by following the usual sequence of audit procedures. This is also used to record questions concerning the audit investigation. 6. Outside Documentation These are composed of documentation gathered by auditors, such as confirmation replies, and copies of client agreements. They are indexed (labeled and arranged) and interfiled (filed together) and procedures are indicated on them in the same manner as on the other schedule. Main Divisions of Audit Working Papers 6. Current Audit File

The current year working paper file is designed to support the assertions embodied in the financial statements. 6. Permanent File Working papers in permanent files contain information of continuing interest to the auditor. These are intended to contain data of a historical or continuing nature pertinent to the current examination. These files provide a convenient source of information about the audit that is of continuing use from year to year. Other Files Maintained 6. Tax Files These files contain information relevant to a client’s current and past income tax and other business tax obligations. They serve as basis for preparing current year’s returns and performing other tax-related services such as amending prior year returns or representing the client’s tax assessment case. 6. Correspondence File This file contains all correspondence or letters to, from or in behalf of a client. *** 6. Ownership and Custody of Working Paper All working papers made by a CPA in public practice and his staff, except those submitted to a client shall be treated confidential and privileged and remain property of such CPA in the absence of a written agreement between the CPA and the client, to the contrary, unless such documents are required to be produced through subpoena issued by any court, tribunal, or government regulatory or administrative body.

PHASE III: REPORTING Phase III-A: Evaluating the Audit Evidence Obtained to Determine What Additional Audit Work (If Any) Is Required

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

Matters Addressed by the Evaluation of Audit Evidence 6. Materiality The auditor shall assess whether the amounts established for overall and performance materiality are still appropriate in the context of the entity’s actual financial results. If a lower materiality than that initially set is appropriate, the auditor is required to determine: a. Whether it is necessary to revise performance materiality; and b. Whether the nature, timing and extent of further audit procedures remain appropriate. 6. Risks The auditor shall determine whether in the light of the audit findings, the assessed risks of material misstatement at the assertion level is appropriate. If not, the risk assessments would be revised and further planned audit procedures modified. 6. Misstatements The auditor shall determine the effect on the audit of identified misstatements and whether there is a need to perform additional audit procedures. Revisions to the audit strategy and detailed audit plans may be required when: a. The nature or circumstances of identified misstatements indicate that other misstatement(s) may exist that, when aggregated with known misstatements, could exceed performance materiality; or b. The aggregate of identified and uncorrected misstatements close to or exceeds performance materiality. 6. Fraud The auditor, through the performance of analytical procedures shall assess whether previously unrecognized risks of material misstatement due to fraud are present. Also, he or

she shall determine whether the misstatements are indicatives of fraud.

identified

6. Evidence The auditor shall determine whether sufficient appropriate evidence has been obtained to reduce detection risk to an acceptably low level. He or she shall consider whether there is a need for further procedures to be performed. 6. Analytical Procedures The auditor shall assess whether the analytical procedures performed at the final review stage of the audit: a. Corroborate the audit findings; or b. Identify previously unrecognized risks of material misstatements. Factors to Be Considered in Evaluating the Sufficiency and Appropriateness of Audit Evidence 6. Materiality of Misstatements Is a misstatement in the assertion being addressed significant, and what is the likelihood of it having a material effect (individually or combined with other potential misstatements) on the financial statements? 6. Management Responses Is management responsive to audit findings, and how effective is the internal control in addressing risk factors? 6. Quality of Information Are the sources of available information reliable and appropriate for supporting the audit conclusions? 6. Persuasiveness Is the audit convincing?

evidence

persuasive

or

6. Previous Experience What has been the previous experience in performing similar procedures and were any misstatements identified?

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

6. Results of Performed Audit Procedures Do the results of performed audit procedures support the objectives, and is there is any indication of fraud or error? 6. Understanding the Entity Do the evidence obtained support or contradict the results of the risk assessment procedures (which were performed to obtain an understanding of the entity and its environment, including internal control)? *** 6. Communication with Those Charged with Governance The auditor shall communicate on a timely basis with those charged with governance the responsibilities of the auditor in relation to the financial statements audit, including that: a. The auditor is responsible for forming and expressing an opinion on the financial statements that have been prepared by management with the oversight of those charged with governance; and b. The audit of the financial statements does not relieve management or those charged with governance of their responsibilities.

6. Matters to Be Considered in Completing the Audit (Post-Audit Responsibilities) a. Related party transactions (see nos. 501-503) b. Subsequent events review c. Letters of inquiry / review of contingent liabilities d. Evaluating going concern status (see no. 285) e. Management representation f. Analytical procedures (see nos. 277 & 432)

g. Evaluating findings, formulating an opinion and drafting the auditor’s report 6. Subsequent Events The term is used to refer to both events occurring between period end and the date of the auditor’s report, and facts discovered after the date of the auditor’s report. Types of Subsequent Events 6. Adjusting Subsequent Events These are events that provide further evidence about conditions that existed at the statement of financial position date. Some examples are: a. Loss on receivables resulting from the bankruptcy of a major customer that was in a deteriorating condition at yearend. b. Settlement of litigation for an amount different from an estimate at year-end. 6. Non-Adjusting Subsequent Events These are events that are indicative of conditions that arose subsequent to period end. Some examples are: a. Sale of a bond or capital stock issue. b. Loss of plant or inventories as a result of fire or flood. Responsibilities of the Auditor Regarding Subsequent Events 6. Events Occurring Up to the Date of the Auditor’s Report The auditor should perform procedures designed to obtain sufficient appropriate evidence that all events up to the date of the auditor’s report that may require adjustment of, or disclosure in, the financial statements have been identified. 6. Facts Discovered After the Date of the Auditor’s Report and Before the Financial Statements Are Issued

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY The auditor ordinarily has no responsibility to perform procedures or make inquiry of subsequent events after the date of the report. However, when after the date of the auditor’s report but before the date the financial statements are issued, a fact becomes known to the auditor that, had it been known to the auditor at the date of the auditor’s report, may have caused the auditor to amend the auditor’s report, the auditor shall: a. Discuss the matter with management and, where appropriate, those charged with governance. b. Determine whether financial statements need amendment and, if so, inquire how management intends to address the matter in the financial statements. 6. Procedures If Management Decides to Amend the Financial Statements Resulting from Discovery of an Adjusting Subsequent Event After the Date of the Auditor’s Report and Before the Financial Statements Are Issued a. Carry out the audit procedures necessary in the circumstances or the amendment. b. Extend the audit procedures to the date of the new auditor’s report; and c. Provide a new auditor’s report on the amended financial statements. The new auditor’s report shall not be dated earlier than the date of approval of the amended financial statements. 6. Contingent Liability It is defined as: a. A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise; or b. A present obligation that arises from past events but is not recognized because:





It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or The amount of the obligation cannot be measured with sufficient reliability.

6. Summary of Accounting Treatments for Loss Contingencies Chance of Material Loss Remote: The chance that the future event will occur is slight. Reasonably possible: The chance that the future event will occur is more than remote but less than likely. Probable: The future event is likely to occur.

Required Financial Disclosure None

Disclose in a note.

If able to estimate, adjust. If unable to estimate, disclose in a note.

6. Audit Inquiry Letter to Client’s Lawyer Also called a lawyer’s letter, it is sent by the auditor to the client’s lawyer as a primary means of corroborating the information management provides about litigation, claims, and assessments. 6. Pending Litigations Claims and Assessments These are situations in which a claimant has stated that it has suffered a loss and plans to seek remuneration, as well as situations in which a claimant has filed a lawsuit. 6. Unasserted Claim It is a potential legal claim that has not yet been made by a claimant (e.g., a manufacturer knowingly selling a faulty automobile may have unasserted claims from accident victims who have not yet filed them). 6. Management Representation Letter

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY It is a form letter written by a company's external auditors, which is signed by senior company management. The letter attests to the accuracy of the financial statements that the company has submitted to the auditors for their analysis. 6. Purposes of the Client Letter of Representation a. It impresses upon management its responsibility for the assertions in the financial statements. b. It provides written representation to the auditor in support of oral responses from management to inquiries about various aspects of the audit.

The auditor shall express an unmodified opinion when the auditor concludes that the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. 7. Modified Opinion The auditor shall modify the opinion in the auditor’s report if he or she: a. Concludes that, based on the audit evidence obtained, the financial statements as a whole are not free from material misstatements; or b. Is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole are free from material misstatements.

6. Consideration of Omitted Procedures After the Report Date Procedures to follow when an auditor discovers that an audit procedure was deemed necessary but was omitted: a. Assess importance of omitted procedure to support previously expressed opinion. If omission of procedure impairs present ability support report and persons are relying on it, action is necessary. b. Perform omitted procedures. If unable consult lawyer. c. If evidence supports previously issued report, auditor has no further responsibility. d. If evidence would have affected the previously issued report, follow procedures to prevent further reliance on report.

Phase III-B: Forming an Opinion Based on Audit Findings and Preparing the Auditor’s Report Forms of Opinion 6. Unmodified Opinion

Contents of the Auditor’s Report 6. Title The auditor’s report shall have a title that clearly indicates that it is the report of an independent auditor. Example: “Independent Auditor’s Report” 6. Addressee The auditor’s report shall be addressed, as appropriate, based on the circumstances of the engagement. Example: “To the shareholders of ABC Company” 6. Auditor’s Opinion The first section of the auditor’s report shall include the auditor’s opinion and shall have the heading “Opinion”. Example: “In our opinion, the accompanying financial statements present fairly, in all material respects, … in accordance with (the applicable financial reporting framework).” 6. Basis for Opinion The auditor’s report shall include a section directly following the Opinion section, with the heading “Basis for Opinion”.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

6. Going Concern Where applicable, a going concern qualification shall be included in the auditor’s report. A going concern qualification means an opinion of an independent accounting firm auditor that there is substantial doubt regarding the entity's ability to continue into the future, generally defined as the following year. 6. Key Audit Matters Key audit matters are those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period. Key audit matters are selected from matters communicated with those charged with governance. 6. Responsibilities of Management and Those Charged with Governance The auditor’s report shall include a section with a heading “Responsibilities of Management for the Financial Statements”. In some jurisdictions, the appropriate reference may be to those charged with governance (instead of being specifically to management). 6. Auditor’s Responsibilities for the Audit of the Financial Statements The auditor’s report shall include a section with the heading “Auditor’s Responsibilities for the Audit of the Financial Statements”. 6. Other Reporting Responsibilities If the auditor addresses other reporting responsibilities in the auditor’s report in the financial statements that are in addition to the auditor’s responsibilities under the ISAs, these other reporting responsibilities shall be addressed in a separate section in the auditor’s report with a heading titled “Report on Other Legal and Regulatory Requirements” or otherwise as appropriate in the content of the section. 6. Name of the Engagement Partner

The name of the engagement partner shall be included in the auditor’s report for audits of complete sets of general-purpose financial statements of listed entities unless, in rare circumstances, such disclosure is reasonably expected to lead to a significant personal security threat. 6. Signature of the Auditor The auditor’s report shall be signed either in the name of the audit firm, the personal name of the auditor or both, as appropriate for the particular jurisdiction. 6. Auditor’s address The auditor’s report shall name the location in the jurisdiction where the auditor practices. 6. Date of the Auditor’s Report The auditor’s report shall be dated no earlier than the date on which the auditor has obtained sufficient appropriate audit evidence on which to base the auditor’s opinion on the financial statements. 6. Supplementary Information Presented with the Financial Statements Supplementary information refers to information presented with the audited financial statements even though it is not required by the applicable financial reporting framework. Such information shall be covered by the auditor’s opinion if through the auditor’s professional judgment, the supplementary information is an integral part of the financial statements due to its nature or how it is presented.

6. Pervasiveness It is the term used, in the context of misstatements, to describe the effects on the financial statements of misstatements or the possible effects on the financial statements of misstatements, if any, that are undetected due to an inability to obtain sufficient appropriate audit evidence.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 6. Pervasive Effects on the Financial Statements a. Those that are not confined to specific elements, accounts or items of the financial statements; b. Those, if so confirmed, that represent or could represent a substantial proportion of the financial statements; or c. Those, in relation to disclosures, are fundamental to users’ understanding of the financial statements. Types of Modified Opinions 6. Qualified Opinion The auditor shall express a qualified opinion when: a. The auditor, having obtained sufficient appropriate evidence, concludes that misstatements, individually or in aggregate, are material, but not pervasive, to the financial statements; or b. The auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, but the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be material but not pervasive. 6. Adverse Opinion The auditor shall express an adverse opinion when the auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements, individually or in aggregate, are both material and pervasive to the financial statements. 6. Disclaimer of Opinion The auditor shall disclaim an opinion when the auditor is unable to obtain sufficient appropriate evidence on which to base the opinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive. ***

6. Summary of Types Modified Opinions

Nature of Matter Giving Rise to the Modification

Auditor’s Judgment about the Pervasiveness of the Effects or Possible Effects on the Financial Statements Material but Material and Not Pervasive Pervasive Qualified Adverse opinion opinion

Financial statements are materially misstated Inability to Qualified obtain opinion sufficient appropriate audit evidence

Disclaimer opinion

of

6. Management-Imposed Limitations If, after accepting the engagement, the auditor becomes aware that management has imposed a limitation on the scope of the audit that the auditor considers that it is likely to result in the need to express a qualified opinion or disclaim an opinion on the financial statements, the auditor shall request that management remove the limitation. 6. Refusal by the Management to Remove Limitation If management refuses to remove the limitation, the auditor shall communicate the matter to those charged with governance and determine whether it is possible to perform alternative procedures to obtain sufficient appropriate audit evidence. 6. Options When there is Inability to Obtain Sufficient Appropriate Evidence a. Qualify the opinion if the possible effects of undetected material misstatements are not pervasive; or b. If the possible effects of undetected material misstatements are pervasive:

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY 



Resign from the audit, where practicable and not prohibited by law or regulation; or If resignation from the audit before issuing the auditor’s report is not practicable or possible, disclaim an opinion on the financial statements.

Form and Content of the Auditor’s Opinion When the Opinion Is Modified 6. Auditor’s Opinion When an auditor modifies the audit opinion, the auditor shall use the heading “Qualified Opinion,” “Adverse Opinion,” or “Disclaimer of Opinion,” as appropriate, for the opinion paragraph. The following are some phrases indicative of the types of modification in the auditor’s opinion: a. Qualified Opinion – “Except for the matter(s) described in the Basis for Qualified Opinion paragraph, the financial statements present fairly, in all material respects, the… in accordance with the applicable financial reporting framework.” b. Adverse Opinion – “Because of the matter(s) described in the Basis for Adverse Opinion paragraph, the financial statements do not present fairly the… in accordance with the applicable financial reporting framework.” c. Disclaimer of Opinion – “Because of the significance of the matter(s) described in the Basis for Disclaimer of Opinion paragraph, the auditor has not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion; and, accordingly, the auditor does not express an opinion on the financial statements.” 6. Description of Auditor’s Responsibility When the Auditor Expresses a Qualified or Adverse Opinion When the auditor expresses a qualified or adverse opinion, the auditor shall amend the description of the auditor’s responsibility to state

that the auditor believes that the audit evidence the auditor has obtained is sufficient and appropriate to provide a basis for the auditor’s modified audit opinion. 6. Description of Auditor’s Responsibility When the Auditor Disclaims an Opinion When the auditor disclaims an opinion due to an inability to obtain sufficient appropriate audit evidence, the auditor shall amend the introductory paragraph of the auditor’s report to state that the auditor was engaged to audit the financial statements (e.g., “Our responsibility is to express an opinion on the financial statements based on conducting the audit in accordance with International Standards on Auditing. Because of the matter(s) described…” 6. Communication with Those Charged with Governance Regarding the Modification of Auditor’s Opinion When the auditor expects to modify the opinion in the auditor’s report, the auditor shall communicate with those charged with governance the circumstances that led to the expected modification and the proposed wording of the modification.

6. Electronic Data Processing (EDP) It is simply the collecting, processing, and distributing of information through the use of an electronic digital computer to achieve a desired result. Computer Hardware Components 6. Central Processing Unit (CPU) It consists of the main storage unit, the arithmetic and logic unit and the control unit. Additionally, the CPU controls the input and output devices. 6. Main Storage Unit (Memory) It is used to temporarily store programs and data for processing.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

6. Arithmetic and Logic Unit Arithmetic tasks (addition, subtraction, multiplication, and division), comparisons, and other types of data transformations are accomplished by the arithmetic and logic unit. The data and instructions needed for the operation are called from the computer’s main storage. After the operation, the results are returned to the main storage unit. 6. Control Unit It unit regulates the activities of the other units and devices by retrieving machine language instructions from the main storage units and then interpreting the instructions. Next, the control unit generates the signals and commands that cause the other units and devices to perform their operations at the appropriate times. 6. Input Device It permits the computer to receive both data and instructions for processing (e.g., keyboard, mouse, optical disk drive, etc.). 6. Output Device It returns information from the computer to the user (e.g., printer, monitor, optical disk authoring device, etc.). *** 6. Software It is a series of programs or routines that provide instructions for operating the computer. There are two broad categories of computer software – application programs (e.g., Microsoft Excel, Google Chrome, Etc.) and systems software (Microsoft Windows, MacOS, etc.). 6. Computer Installations These are the facilities where the computer hardware and personnel are located. Types of Computer Installations 6. In-House or Captive Computer

The organization owns or leases the equipment and hires the necessary trained personnel to program, operate, and control the various applications processed with the equipment. 6. Service Bureau Computer The computer is used by an independent agency which rents computer time and provides programming, key-punching, and other services. 6. Time-Sharing Under this system, the organization acquires a keyboard device capable of transmitting and receiving data and, by agreement, the right to use a central computer facility. This facility will furnish service to several users at the same time. The user company does most of its own programming and treats the computer as though the company were the only one using it. 6. Facilities Management This is the latest type of computer service arrangement to be developed. It falls somewhere between the captive computer and the service bureau categories. Under facilities management, the organization needing computer services may lease or purchase the necessary hardware and install it on its own premises. Then by negotiation, an outside contractor with the necessary staff of programmers and operators agrees to manage the facility. *** 6. Batch Data processing It is an efficient way of processing high volumes of data is where a group of transactions is collected over a period of time. Data is collected, entered, processed and then the batch results are produced. An example is payroll and billing systems. 6. Direct Random-Access Data Processing Instead of processing transactions in batches, the data is processed as the transactions are entered into the system. It is also known as real-time data processing.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY

6. Database Processing A database is a set of interconnected files that users can access to obtain specific information. A database eliminates the need for separate, and often repetitive, application-specific files (e.g., files for payroll and files for personnel information are maintained interconnectedly). 6. Control in Small Computer Environments Small computer environments refer to the use of micro- and minicomputers in data processing. No matter how small the computer may become, the control objectives remain the same. Segregation of duties becomes especially difficult in small computer environments because one individual may perform all recordkeeping (processing) as well as maintain other nonrecordkeeping responsibilities. Some of the points of emphasis in this environment are: a. Security over software and/or data is more critical than security over hardware (which can easily be replaced). b. Independent verification of the applications being processed ion the small computer system should be made to prevent the system from being used for personal projects. c. Centralized authorization to purchase hardware and software should be required to ensure that “fly-by-night” equipment and “garage-developed” software are not purchased and that corporate-wide discounts can be obtained. 6. Distributed Systems These represent a network of remote computer sites each having a small computer connected to the main computer system. Distributed systems reduce the load on the main computer by transferring edit or simple processing function to the remote sites.

a. Documents are not maintained in readable form. b. Processing of transactions is more consistent. c. Duties are consolidated. d. Reports can be generated easily. Major Types of Computer Fraud 6. Salami Technique Computer programs are modified to inappropriately round off calculations to the benefit of the fraud perpetrator. The amounts available from rounding are then placed in an account controlled by the perpetrator. In some of the most famous cases, the payment of centavos of interest detoured from bank accounts amounted to thefts of millions of Pesos. 6. Trojan Horse It is an unauthorized program placed within an authorized one. Trojan horses typically are designed to wait until a specific time, when they act and then erase all evidence of their existence. For example, a Trojan horse can be used to destroy important data and then destroy itself. Fired employees have used Trojan horses to destroy their employer’s data. 6. Virus Programs These are programs with unauthorized information or instructions. They can spread by the electronic transfer of information between systems or the physical exchange of media, such as disks carried from one system to another. 6. Trapdoors These are unauthorized entry points into programs or databases. Through a trapdoor, individuals can change data or instructions without approval.

6. Auditor’s Responsibilities with Respect to Internal Control Over EDP Systems

6. Impact of Computers on Accounting Systems “We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY The auditor’s responsibilities with respect to internal control over EDP systems remains the same as with manual systems, that is to obtain an understanding adequate: a. To aid in planning and the remainder of the audit; and b. To assess control risk. 6. Effects of Computer Systems in the Study of Internal Control Computer systems may: a. Result in transaction trails that exist for a short period of time or only in computer readable form; b. Include program errors that cause uniform mishandling of transactions (clerical errors become less frequent); c. Include computer controls that need to be relied upon instead of segregation of functions; d. Involve increased difficulty in detecting unauthorized access; e. Allow increased management supervisory potential resulting from more timely reports; f. Include less documentation of initiation and execution of transactions; and g. Include computer controls that affect the effectiveness of related manual control procedures that use computer output. Types of Internal Control Over EDP Activities 6. General Controls These are controls that affect multiple application systems (e.g., payroll, accounts payable, and accounts receivable). 6. Application Controls These are specialized controls that relate to specific application instead of multiple applications. 6. Categories of General Controls

a. Organizational and operation controls b. Systems development and documentation controls c. Hardware and systems software controls d. Access controls e. Data and procedural controls 6. Organizational and Operation Controls Controls: a. Segregate functions between the EDP department and user departments. b. Do not allow the EDP department to initiate or authorize transactions. c. Segregate functions within the EDP department. Key Functions Within the EDP Department 6. Systems Analyst He or she is responsible for analyzing the present user environment and requirements and recommending the specific changes which can be made, recommending the purchases of new system, and designing a new EDP system. 6. Applications Programmer He or she is responsible for writing, testing, and debugging the application programs from the specifications (whether general or specific) provided by the systems analyst. 6. Systems Programmer He or she is responsible for implementing, modifying, and debugging the software necessary for making the hardware work (e.g., operating system, telecommunications monitor and the database management system). 6. Operator He or she is responsible for the daily computer operations of both the hardware and the software. 6. Data Librarian He or she is responsible for the custody of the removable media (i.e., magnetic tapes or disks),

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY and for maintenance of program and system documentation. 6. Quality Assurance This function is established primarily to ensure that new systems under development and old systems being changed are adequately controlled and that they meet the users’ specifications and follow department documentation standards. 6. Control Group It acts as a liaison between users and the processing center. This group records input data in a control log, follows the progress of processing, distributes output, and ensures compliance with control totals. 6. Data Security It is responsible for maintaining the integrity of the online access control security software. Passwords and IDs are issued to users and follow up is done on all security violations. 6. Database Administrator He or she is responsible for maintaining the database and restricting access to the database to authorized personnel. 6. Network Technicians Using line monitoring equipment, they can see each key stroke made by any user. This group must have strict accountability controls. 6. Systems Development and Documentation Controls Controls: a. User departments must participate in systems design. b. Each system must have written specifications which are reviewed and approved by management and by user departments. c. Both users and EDP personnel must test new systems.

d. Management, users, and EDP personnel must approve new systems before they are placed into operation. e. All master and transaction file conversion should be controlled to prevent unauthorized changes and to verify the results on a 100% basis. f. After a new system is operating there should be proper approval of all program changes. g. During the change process, programmers should not have access to live data files or production programs. h. Proper documentation standards should exist to assure continuity of the system. Hardware and Systems Software Controls 6. Parity Check A special bit is added to each character stored in the memory that can detect if the hardware loses a bit during the internal movement of a character similar to a check digit. 6. Echo Check During the sending and receiving of characters, the receiving hardware repeats back to the sending hardware what it received and the sending hardware automatically resends any characters that it detects were received incorrectly. 6. Diagnostic Routines Hardware or software supplied by the manufacturer check the internal operations and devices within the computer system. These routines are often activated when the system is booted up. 6. Boundary Protection Most CPUs have multiple jobs running simultaneously (multiprogramming environment). To ensure that these simultaneous jobs cannot destroy or change the allocated memory of another job, the system contains boundary protection controls. 6. Periodic Maintenance

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY The system should be examined periodically (often weekly) by a qualified service technician. Such service can help to prevent unexpected hardware failures.

The board is programmed with a unique “key” that makes data unreadable to anyone who might intercept a data transmission. Data and Procedural Controls

Physical Access Controls 6. Limited Physical Access The physical facility that houses EDP equipment, files, and documentation should have controls to limit access only to authorized individuals (e.g., guard, automated key cards, manual key locks, etc.). 6. Visitor Entry Logs Any individual entering a secure are must be either pre-approved by management and waring an ID badge or authorized by an appropriate individual, recorded in a visitor’s log, and escorted while in the secure area. Electronic Access Controls 6. Access Control Software (User Identification) The most used electronic access control is a combination of a unique identification code and a confidential password. Passwords should be either reissued periodically or periodically expire and force users to change their password to ensure that only the individual that is assigned to the account has access to it. 6. Call Back It is a specialized form of user identification that is used in highly sensitive systems. In a call back system, the user dials up the system, identifies him/herself, and is disconnected from the system. Then either (1) an individual manually looks up the authorized telephone number for the individual or (2) the system automatically looks up the authorized telephone number of that individual, calls back the individual, and reestablishes communications. 6. Encryption Boards

6. Operations Run Manual It specifies, in detail, the “how to’s” for each application to enable the computer operator to respond to any errors that may occur. 6. Backup-and-Recovery To ensure the preservation of historical records and the ability to recover from an unexpected error, files created within EDP are backed up in a systematic manner. 6. Processing Control It should be monitored by the control group to ensure that processing is completed in a timely manner, all hardware errors have been corrected, and output has been properly distributed. 6. File Protection Ring It is a processing control to ensure that an operator does not use a magnetic tape as a tape to write on when it actually has critical information on it. If the ring is on the tape, data can be written on the tape. 6. Internal and External Labels External labels are paper labels, attached on a reel of tape or other storage medium which identify the file. Internal labels perform the same function through the use of machine-readable identification in the first record of a file. The use of labels allows the computer operator to determine whether the correct file has been selected for processing. Application Controls for Input 6. Input Controls a. Input data should be properly authorized and approved.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY b. The system should verify all significant data fields used to record information (editing the data). c. Conversion of data into machine-readable form should be controlled and verified for accuracy. d. Movement of data between processing steps and departments should be controlled. e. The correction of errors and resubmission of corrected transactions should be reviewed and controlled. 6. Preprinted Form Information is pre-assigned to a place and a format on the input form used. The form reduces the possibility that computer input operators will miss or ignore input data recorded by users. This control is used when large quantity of repetitive data is inputted. 6. Check Digit An extra digit is added to an identification number to detect certain types of data transmission or transportation errors. It is used to verify that the number was entered into the computer system correctly. 6. Control, Batch, or Proof Total A total of one numerical field for all the records of a batch that normally would be added (e.g., total sales persons). 6. Hash Totals A total of one field for all the records of a batch where the total is a meaningless total for financial purposes (e.g., a mathematical sum of account numbers added together). 6. Record Count A control total used for accountability to ensure all the records received are processed. 6. Reasonableness and Limit Tests These tests determine if amounts are too high, too low, or unreasonable (e.g., for a field that indicates auditing exam scores, a limit check would

test for scores over 100). A reasonableness check is similar to a validity check (see no. ). 6. Memo Driven Input If input is being entered into a CRT, then the operator should be greeted by a menu and prompted as to the proper response to make [e.g., What scored did you get on the Auditing part of the CPA Exam (75-100)?]. 6. Field Checks Checks that make certain only numbers, alphabetical characters, special characters, and proper positive and negative signs are accepted into a specific data field where they are required. 6. Validity Check A check which allows only “valid transactions or data to be entered into the system (e.g., field accepting “male” or “female” response only). 6. Missing Data Check If blanks exist in input data where they should not (e.g., an employee’s division number), an error message would result. 6. Field Size Check If an exact number of characters is to be inputted, an error message would result if the number of characters inputted is less than or greater than the requirement. 6. Logic Check It ensures that illogical combinations of inputs are not accepted into the computer (e.g., the field total for raw material is validated by footing price times quantity). Application Controls for Processing 6. Processing Controls a. Control totals should be produced and reconciled with input control totals – proof of batch totals.

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY b. Controls should prevent processing the wrong file and detect errors in file manipulation – label checks. c. Limit and reasonableness checks should be incorporated into programs to prevent illogical results such as reducing inventory to a negative value. d. Run-to-run totals should be verified at appropriate points in the processing cycle. This ensures that records are not added or lost during the processing runs. 6. Checkpoint / Restart Capacity If a particular program requires a significant amount of time to process, it is desirable to have software within the application that allows the operator the ability to restart the application at the last checkpoint passed as opposed to restarting the entire application. 6. Error Resolution Procedure Individual transactions may be rejected during processing as a result of the error detection controls in place. There should be complementary controls that ensure those records are corrected and reentered into the system. Logging of errors in a suspense file of “suspended” transactions is often used to control error resolution. Application Controls for Output 6. Output Controls a. Output control totals should be reconciled with input and processing control totals. b. Output should be scanned and tested by comparison to original source documents. c. Systems output should be distributed only to authorized users. 6. Control Total The user of the application will frequently give the operator the expected result of processing ahead of time to allow the operator to verify that processing was completed properly to notify the user if the totals did not agree. 6. Limiting the Quantity of Output and Total Processing Time

Time restraints and output page generation constraints are often automated within the job being run to ensure that, if processing is being done in error, the job will not utilize resources needlessly. 6. Error Message Resolution Following each job, the system provides technical codes indicating the perceived success of the job run. The operator should be trained to recognize these codes and take appropriate action detailed in the operations run manual.

6. Computer Information System It is a system composed of people and computers that processes or interprets information. 6. Review of the CIS If the client uses CIS, the auditor must be capable of understanding the entire system to evaluate the client’s internal control. The auditor’s primary concern therefore is to determine whether the system provides reasonable assurance that errors and irregularities have been and will be prevented or detected on a timely basis by employees in the course of their normal activities. 6. Compliance Testing of CIS Controls After reviewing the CIS controls, the auditor attempts to gather evidence to provide reasonable assurance that the prescribed controls are functioning properly. Types of Compliance Tests Applicable to CIS Environments 6. Auditing Around (without Using) the Computer It means the auditor does not use the computer to perform tests, select samples, etc. If there is an adequate audit trail, the auditor can do the following: a. Examine for evidence of controls (i.e., error logs, batch control records, etc.); b. Trace transactions using printouts to follow input documents through final report; and

“We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel

AUDITING THEORY c. Process sample transactions manually and compare with the printouts. 6. Auditing Through (with the Use of) Computer The auditor can use a computer program (provided by the client or prepared by the auditor) to examine data files and perform many of the clerical tasks previously performed by a junior auditor. Substantive Testing of Computer-Based Records 6. Substantive Testing without Using the Computer Printouts are used to test the correctness of accounts and as a basis from which samples will be selected for further testing or confirmation. 6. Substantive Testing with the Use of a Computer Auditor uses a program written to gain access to the computer-based records. Once access has been achieved, the auditor can use the computer to perform those procedures which are clerical in nature. ***

d. Examining records which meet criteria specified by the auditor (e.g., property acquisitions in excess of P10,000) e. Selecting audit samples f. Comparing data that exist on separate files g. Summarizing data h. Comparing data obtained through other audit procedures with client records i. Identify weaknesses in internal control j. Prepare flowcharts of client transaction cycles and of client programs k. Prepare graphic displays of data for easier analysis l. Correspondence (e.g., engagement letters, representation letters, attorney’s letters) 6. Test Data A set of dummy transactions is developed by the auditor and processed by the client’s computer programs to deter

6. Sources of Programs Used for Substantive Testing of Computer-Based Records a. Auditor written programs b. Auditee programs – coded by the company’s own programmer to meet the auditor’s needs. This will require additional precautions on the part of the auditor. c. Utility programs – provided by software vendors and used to obtain data. d. Generalized computer audit programs – offer audit-oriented functions for use in accessing and testing records. Audit Techniques Using Computers 6. Audit Software Some of the audit procedures that may be performed by generalized audit software include: a. Testing client calculations b. Making additional calculations c. Extracting data from client files “We waste our time waiting for the ideal path to appear. But it never does. Because we forget that paths are made by walking, not waiting. And no, you should not feel more confident before you take the next step. Taking the next step is what gradually builds your confidence.” - Marcandangel