CHAPTER 2 OVERVIEW OF AUDITING I. Review Questions 1.

One definition of auditing is that 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 assertions and established criteria and communicating the results to interested users. The Philippine Standards on uditing !PS " 1#$ %&ramewor' of Philippine Standards on uditing( states the objective of an audit as follows) %The objective of an audit of financial statements is to enable the auditor to e*press an opinion whether the financial statements are prepared in all material respects, in accordance with an identified financial reporting framewor'.( #. This apparent parado* arises from the distinction between the function of auditing and the function of accounting. The accounting function is the process of recording, classifying and summari+ing economic events to provide relevant information to decision ma'ers. The rules of accounting are the criteria used by the auditor for evaluating the presentation of economic events for financial statements and he or she must therefore have an understanding of generally accepted accounting principles !, P", as well as generally accepted auditing standards !, S". The accountant need not, and fre-uently does not, understand what auditors do, unless he or she is involved in doing audits, or has been trained as an auditor.

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Audits of Financial Stat ! nts Pu#"os To determine whether the financial statements are presented in accordance with , P. 0ifferent groups for different purposes 1 many outside entities. 2ighly standardi+ed

Co!"lianc Audits To determine whether the client is following specific procedures set by higher authority. uthority setting down procedures, internal or e*ternal 3ot standardi+ed, but very specific and usually objective

O" #ational Audits To evaluate whether operating procedures are efficient and effective. .anagement of organi+ation 2ighly nonstandard4 often very subjective

Us #s of Audit R "o#t Natu#

P #fo#! d $%& CPAs COA Audito#s 'IR Audito#s Int #nal Audito#s

lmost universally Occasionally 3ever &re-uently

Occasionally &re-uently 5niversally &re-uently

&re-uently &re-uently 3ever &re-uently

6. The major differences in the scope of audit responsibilities are) 1. 7P s perform audits in accordance with Philippine Standards on uditing of published financial statements prepared in accordance with identified and applicable Statements of &inancial ccounting Standards. #. 7O auditors perform compliance or operational audits in order to assure the 7ongress of the e*penditure of public funds in accordance with its directives and the law. 8. 9I: agents perform compliance audits to enforce the ta* laws as defined by 7ongress, interpreted by the courts, and regulated by the 9I: law. 6. Internal auditors perform compliance or operational audits in order to assure management or the board of directors that controls and policies are properly and consistently developed, applied and evaluated. ;. n independent audit is a means of satisfying the need for reliable information on the part of decision ma'ers. &actors of a comple* society which contribute to this need are) () # !ot n ss of info#!ation a. owners !stoc'holders" divorced from management b. directors not involved in day/to/day operations or decisions c. dispersion of the business among numerous geographic locations and comple* corporate structures 2) $ias and !oti* s of "#o*id #

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a. information will be biased in favor of the provider when his goals are inconsistent with the decision ma'er. +) *olu!inous data a. possibly millions of transactions computeri+ed systems b. multiple product lines c. multiple transaction locations processed daily via sophisticated

,) co!"l - -c.an/ t#ansactions a. new and changing business relationships lead to innovative accounting and reporting problems b. potential impact of transactions not -uantifiable, leading to increased disclosures <. The four primary causes of information ris' are remoteness of information, bias in motives of the provider, voluminous data, and e*istence of comple* e*change transactions. The three main ways to reduce information ris' are) 1. 5ser verifies the information itself. #. The users share the information ris' with management. 8. 2ave audited financial statements provided. The advantages and disadvantages of each are as follows)
Ad*anta/ s Us # * #ifi s info#!ation 1. 5ser obtains information desired. #. 5ser can be more confident of the -ualifications and activities of the person getting the information. 1. 3o audit costs incurred. Disad*anta/ s 1. 2igh cost of obtaining information. #. Inconvenience to the person providing the information because large number of users would be on premises. 1. 5sers may not be able to collect on losses.

Us #s s.a# info#!ation #is0 1it. !ana/ ! nt Audit d financial stat ! nts a# "# "a# d

1. .ultiple users obtain the information. #. Information ris' can usually be reduced sufficiently to satisfy users at reasonable cost. 8. .inimal inconvenience to management by having only one auditor.

1. .ay not meet needs of certain users. #. 7ost may be higher than the benefits in some situations, such as for a small company.

=. Information ris' is the possibility that information upon which a business decision is made is inaccurate. &our causes of information ris' are) remoteness of information, biases and motives of the provider,

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voluminous data, and comple* e*change transactions.

>. Three primary ways users of information can reduce information ris' are) users can verify the information themselves, users can share information ris' with management, and users can obtain audited financial statements. ?. &our factors that are li'ely to significantly reduce information ris' in the ne*t five to ten years are) technological advances, more companies will go on1line, reducing the ris' of investors obtaining outdated information, new accounting and auditing standards, and auditors will find more efficient and effective audit techni-ues. 1$. :efer to pages 6; and 6< of the te*tboo'. 11. report by an independent public accountant concerning the fairness of a company@s financial statements is commonly re-uired in the following situations) !1" pplication for a ban' loan. !#" Astablishing credit for purchase of merchandise, e-uipment, or other assets. !8" :eporting operating results, financial position, and cash flows to absentee owners !stoc'holders or partners". !6" Issuance of securities by a corporation. !;" nnual financial statements by a corporation with securities listed on a stoc' e*change or traded over the counter. !<" Sale of an ongoing business. !=" Termination of a partnership. 1#. To add credibility to financial statements is to increase the li'elihood that they have been prepared following the appropriate criteria, usually the relevant and applicable S& S. s such, an increase in credibility results in financial statements that can be believed and relied upon by third parties. 18. 9usiness ris' is the ris' that the investment will be impaired because a company invested in is unable to meet its financial obligations due to economic conditions or poor management decisions. Information ris' is the ris' that the information used to assess business ris' is not accurate. uditors can directly reduce information ris', but have only limited effect on business ris'. 16. n operational audit attempts to measure the effectiveness and efficiency of a specific unit of an organi+ation. It involves more subjective judgments than a compliance audit or an audit of financial statements because the criteria of effectiveness and efficiency of departmental performance are not as clearly established as are many laws and regulations or generally accepted accounting principles.

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The report prepared after completion of an operational audit is usually directed to management of the organi+ation in which the audit wor' was done. 1;. compliance audit is an audit to determine whether financial reports or other assertions are in compliance with established criteria. The necessary ingredients are verifiable data and the e*istence of standards established by an authoritative body. n operational audit, on the other hand, is a review of a department or other unit of a business or governmental organi+ation to measure the effectiveness and efficiency of operations. Internal auditors often perform operational audits as do auditors employed by the 7ommission on udit !7O " of the national government and public practitioners as part of their consultancy services.

1<. The first -uoted sentence overstates the case. lthough annual audits by 7P firms are universal practice for large corporations, they are not essential to many small businesses. The financial statements of large corporations go to many stoc'holders !often hundreds of thousands" who demand the assurance of reliability supplied through independent audits by 7P firms. .oreover the SA7 and the stoc' e*changes re-uire that listed companies have annual audits. &or a small business concern, the primary need for annual financial statements is to support an application for a ban' loan. If a small business does not need to borrow, or can obtain borrowed funds without providing audited statements, the cost of an audit may not be justified. Often a small business can obtain from a 7P firm speciali+ed services other than an audit, which are more useful and may cost less. A*amples are the review or compilation of financial statements, installation of a computer based accounting system, or a study of internal control. Thus, the second -uoted sentence, as well as the first, is too sweeping to be correct. decision not to have an audit is not always %false economy.( 1=. !a" n e*ample of possible bias on the part of the provider of financial information is the situation in which an individual or business entity applies for a ban' loan. In such circumstances, there is an incentive to overstate assets, income, and owner@s e-uity, and to overloo' or minimi+e liabilities. 0istortions of this type give the appearance of greater financial strength. !b" ban' loan officer may insist that a prospective borrower provide audited financial statements. This provides assurance that the data in the financial statements have been e*amined by independent competent persons.

II. Multiple Choice Questions 1. #. 8. 6. ;. d a a d !PS s" b <. =. >. ?. 1$. c b c b d 11. 1#. 18. 16. 1;. b a c c a 1<. 1=. 1>. 1?. #$. d a a d c #1. d

III. Comprehensive Cases

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Cas () a. The major advantages and disadvantages of a career as a 9I: agent, 7P , or an internal auditor are) Employment 'IR a/ nt Advantages 1. A*tensive training in individual, corporate, gift, trust, and other ta*es is available with concentration in area chosen. #. On/hand e*perience with sophisticated selection techni-ues. 1. A*tensive training in audit of financial statements, compliance auditing and operational auditing. #. Opportunity for e*perience in auditing, ta* counseling, and management consulting practices. 8. A*perience in a diversity of enterprises and industries with the opportunity to speciali+e in a particular industry. 1. A*tensive e*posure to all segments of the enterprise with which employed. #. 7onstant e*posure to one industry presenting opportunity for e*pertise in that industry. 8. Bi'ely to have e*posure to compliance, financial and operational auditing. Disadvantages 1. A*perience limited to ta*es. #. 3o e*perience with operational or financial statement auditing. 8. Training is not e*tensive with any business enterprise.

CPA

1. A*posure to ta*es and to the business enterprise may not be as in/depth as the 9I: agent or the internal auditor. #. Bi'ely to be less e*posed to operational auditing than is li'ely for internal auditors.

Int #nal Audito#

1. Bittle e*posure to ta*ation and the audit thereof. #. A*perience is limited to one enterprise, usually within one or a limited number of industries.

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b. Other auditing careers that are available are) 1. 7O auditor #. uditors within many of the branches of the government 8. uditors for many local government units Cas 2) The most li'ely type of auditor and the type of audit for each of the e*amples are) E-a!"l 1. #. 8. 6. ;. <. =. >. ?. 1$. 11. 1#. T%" of Audito# 7O 7P 4 Internal uditor Internal auditor4 7P 7P 7P 7O 7P 7O 7P 4 Internal uditor Internal auditor or 7P 7P or 7O 7P 4 9I: T%" of Audit 7ompliance Operational 7ompliance &inancial statements Ta* audit4 &S audit &inancial statements &inancial statements Operational audit &inancial statements Operational audit Operational audit 7ompliance

Cas +) a. The overriding objective of an independent audit is to provide reasonable assurance that the financial statements fairly reflect the economic substance of the transactions and events reflected in those statements. To this end, the auditor tests management@s assertions as embodied in the financial statements, and renders an opinion concerning fairness. Testing involves gathering and evaluating evidence relating to the assertions. The opinion assumes the form of an audit report formulated and issued at the conclusion of the e*amination. b. n independent audit may be beneficial to Byn 7ru+ in the following ways) 1. 7orrection of identified wea'nesses in the accounting system may improve the -uality of financial reporting4 #. The independent auditor may be able to assist Byn in improving physical safeguards over assets4 8. n independent audit may facilitate Byn@s efforts in raising new capital4 6. The audit may identify a need for improved budgeting and performance reporting, thus improving control over costs and revenues4 ;. lthough not designed for this purpose, the audit may disclose defalcations by employees4 <. To determine amounts receivable or payable under bonus, profit sharing, and pension plans4 lease agreements4 royalty agreements4 and other contracts and agreements4 =. To serve as an error andCor irregularity prevention device by ma'ing employees aware of audit coverage. Cas ,) Types of uditors and Services Performed

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To"ic 1 # 8 6 ; < = > ? 1$

T%" of Audito# 7P 7P Internal auditor4 7P 7O 9an' e*aminer 7P 7P Internal auditor4 7P 9I:4 7P 7P 4 7O

Class of Wo#0 udit of financial statements udit of financial statements Operational audit Operational audit 7ompliance audit .ngt. advisory services udit of financial statements Operational audit 7ompliance audit 7ompliance audit