Mindanao State University

College of Business Administration and Accountancy

DEPARTMENT OF ACCOUNTANCY
Marawi City

FUNDAMENTALS OF AUDITING
Accounting 151

NATURE OF AUDITING responsible person correspond with the established

Auditing is a systematic process by which a competent, criteria.
independent person objectively obtains and evaluates B. Reporting process – involves communicating the
evidence regarding assertions about economic actions audit opinion to interested users.
and events to ascertain the degree of correspondence
between those assertions and established criteria and ACCOUNTING VERSUS AUDITING
communicating the results to interested users (American Though related and often both conducted by CPAs,
Accounting Association). auditing and accounting are separate fields of study. Their
distinctions are as follows:
A. Auditing is a systematic process.
Auditing involves structured and logical series of Auditing Accounting
sequential steps or procedures. This is known as the Involves the verification of Involves the preparation and
audit process. financial statements as to its presentation of financial
B. An audit is conducted by a competent, fairness of presentation statements
independent person. Begins when accounting ends Precedes auditing
The auditor must be qualified to understand the
criteria used and the competence to know how The end product of the
The end product of the audit
and what evidence to accumulate to reach the accounting process is a
process is the independent
complete set of financial
proper conclusion. auditor’s report
statements
The auditor must also have an independent mental
attitude which involves impartial and objective The auditor must be both
thinking. proficient in accounting as
The accountant need not be
well as auditing, specifically in
C. An audit involves obtaining and evaluating and accumulating and
proficient in auditing
evidence about assertions regarding economic interpreting evidence
actions and events.
Accounting is governed by
Assertions are representations made by an auditee
Auditing is governed by the the generally accepted
about economic actions and events. These are the generally accepted auditing accounting standards (PFRSs)
subject matter of auditing. In the context of standards (PSAs) with the with the Philippine Framework
financial statements, assertions are representations PSAEs as its foundation for Financial Reporting as its
of the management, explicit or otherwise, that are foundation
embodied in the financial statements.
The auditor’s objective is to determine whether GENERAL TYPES OF AUDIT
these assertions are valid. To satisfy this objective, According to the Nature of Assertion or Date Being Audited
the auditor performs audit procedures and gathers
A. Financial statement audit – also known as
evidence that corroborates or refutes the
independent audit, independent financial
assertions.
statement audit, financial statement audit and
D. An audit is conducted objectively. financial audit, is conducted to determine whether
The auditor examines the bases for the assertions the financial statements of an entity are fairly
and judiciously evaluating the results without bias stated in accordance with an identified financial
or prejudice either for or against the individual or reporting framework. This type of audit is
entity making the representations. conducted by external auditors on a fee basis and
E. Auditors ascertain the degree of correspondence for more than one client.
between assertions and established criteria. The following are the basic characteristics of
Established criteria are needed to judge the validity financial statement audits:
of the assertions. These criteria are important  Auditors who perform financial statement
because they establish and inform the users of the audits are independent of management
basis against which the assertions have been and financial statement users.
evaluated or measured. In an audit, the auditor  Auditors base their opinions on a sample of
determines the degree by which the assertions the financial data rather than every item
conform to the established criteria. that makes up the financial statements.
F. Auditors communicate the audit results to various  Auditors obtain reasonable assurance
interested users. about whether the financial statements
are free of material misstatements. Auditors
The communication of audit findings, often referred
are never absolutely certain that financial
to as attestation, is the ultimate objective of any
statements are accurate.
audit. For the audit to be useful, the results must be
 Auditors express an opinion on the
communicated to interested users on a timely
financial statements as a whole and not on
basis. Interested users are those individuals who rely
the individual items within the financial
on the auditor’s findings which may include
statements.
stockholders, creditors, governmental agencies
 Auditors issue their report to a variety of
management and the general public. The
financial statement users.
communication of findings is achieved through a
written report. B. Compliance audit – involves a systematic review of
an organization’s procedures to determine
Processes of Auditing
whether the organization has adhered to specific
A. Investigative process – involves systematic procedures, rules or regulations set down by some
gathering and evaluation of evidence as a basis higher authority. This may be performed for a
for determining whether the assertions made by private business or a governmental unit. This type of

Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014 Page|1 of 4
 audit is usually performed by government auditors.
The following are the basic characteristics of a
compliance audit:
 The party employing the auditor frequently
determines the items audited and the
standards followed.
 The auditors are on the payroll of the entity
interested in determining whether the
standards are being met.
 The auditor’s reports are directed to an
official or department within the
organization that employs the auditor.
C. Operational audit – also known as management
audit or performance audit, involves a systematic
review and evaluation of the specific units (or
procedures, methods or activities) of an
organization in relation to specific objectives for the
purpose of measuring or assessing the effectiveness
and efficiency of its operations. It also includes
identifying opportunities for improvements and
making recommendations to improve performance
such as the introduction of controls to reduce
waste. This type of audit is often performed by
internal auditors.
Operational audits have the following important
characteristics:
 Auditors performing the audit are
independent of the activity they audit
though they are often on the payroll of the
entity whose operations are being
evaluated.
 The audit report is directed to an official or
department within the organization that
employs the auditor.
 The assertion is about the efficiency and
effectiveness of the performance of a
specific activity.
 The audit report frequently reports
problems or deficiencies identified during
the audit rather than reporting an overall
conclusion.
Internal Auditors Responsibility in Operational Audits
In operational audits, the company’s management
is responsible for setting operating standards. In
contrasts, the internal auditor’s responsibilities are
to determine that:
 Management has established such
standards.
 The standards are being met.
 Deviations from established standards are
being identified and corrected.
 Corrective action has been taken.
According to Types of Auditor Conducting the Audit
A. External audit – performed by practitioners or
independent CPAs who offer their professional
services for a fee to various clients on a contractual
basis.
B. Internal audit – performed by entity’s own
employees known as internal auditors who
investigate and appraise the effectiveness and
efficiency of operations and internal controls of the
firm. Internal auditing is an independent appraisal
function or control or activity established within an
entity to examine and evaluate its activities or
other controls as a service to the entity. It is an
independent, objective assurance and consulting
activity designed to add value and improve an
organization’s operations.
Internal auditing helps an organization to
accomplish its objectives by bringing a systematic
disciplined approach to evaluate and improve the
effectiveness of risk management, control and
governance processes. The increased complexity
and sophistication of business operations have
required management to rely on this appraisal
control.
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
Internal auditing includes the audit of the following:
 Financial and operating information.
 Compliance with policies, procedures,
plans, regulations and contracts.
 The means of safeguarding assets.
 The economy and efficiency with which
resources are employed.
 The operations or programs to ascertain
whether they are being carried out as
prescribed.
External and internal audits complement each
other.
C. Government audit – performed by government
employees whose main concern is to determine
whether persons or entities comply with government
laws, rules and regulations. Government auditing
usually covers the following areas:
 Financial audit.
 Compliance audit.
 Performance audit (which includes both
economy and efficiency audit and
program results audit)
The audit of a government program involves
obtaining information about the costs, outputs,
benefits and effects of the program. Auditors
attempt to measure the accomplishments and
relative success of the program based on the
actual intent of the legislation that established the
program.
TYPES OF AUDITORS
Auditors can be classified according to their affiliation with
the entity being examined:
A. Independent or external auditors – these are
independent CPAs who offer their professional
services to different clients on a contractual basis.
External auditors are the ones who generally
conduct financial statement audits. However,
external auditors perform operational auditing as
well as compliance auditing as part of their
management consultancy services.
B. Internal auditors – these are the entity’s own
employees who investigate and appraise the
effectiveness and efficiency of operations and
internal controls. The main function of internal
auditors is to assist the members of the organization
in the effective discharge of their responsibilities.
The internal auditor is therefore concerned with all
kinds of financial and other data generated for
both internal and external users. To be able to
operate effectively, an internal auditor must be
independent of the line functions of the
organization. Internal auditors generally perform
operational audits.
Both external and internal auditors basically use an
identical approach. However, there are
differences in the application of audit techniques.
C. Government auditors – these are government
employees whose main concern is to determine
whether persons or entities comply with government
laws and regulations. They include:
 BIR examiners perform compliance audit.
 BSP examiners perform operational audit
and compliance audit.
 COA auditors perform operational audit,
compliance audit and financial audit.
Government auditors are required to prepare a
written report on the entity’s internal control and
assessment of control risk made as part of a
financial statement audit. The report should include:
 The scope of the auditor’s work in
obtaining an understanding of the entity’s
internal control and in his assessment of
control risk.
 The entity’s significant controls including
those that are established to ensure
compliance with laws and regulations that
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 have a material impact on the financial
statements.
 The conditions, including the identification
of material weaknesses, identified as a
result of the auditor’s work.
However, the report should not give any form of
assurance on the design and effectiveness of the
entity’s internal control.
AUDIT OF FINANCIAL STATEMENTS
A financial statement audit is the objective or independent
examination of financial statements of an entity to enable
the auditor to express and opinion thereon, that is, whether
the financial statements are prepared in all material
respects, in accordance with an applicable financial
reporting framework. The entity subject to an audit of
financial statements may be profit-oriented or not,
irrespective of size and legal form. Financial statement
audits have been described in various ways as follows:
A. It involves the objective examination of and
reporting on financial statements prepared by
management.
B. It lends credibility to the financial statements;
provides increased assurance to the users as to the
fairness of the financial statements; enhances the
degree of confidence of interested users in the
financial statements.
C. It is a discipline that attests to the results of
accounting and other functional operations and
data.
D. Its essence is to determine whether the client’s
financial statements are fairly stated.
E. It provides reasonable assurance that the financial
statements fairly reflect the economic substance of
the transactions and events reflected in those
statements.
Purpose of an Audit of Financial Statements
The purpose of an audit is to enhance the degree of
confidence of interested users in the financial statements
which is achieved by the expression of an opinion by the
auditor on whether the financial statements are prepared
in all material respects, in accordance with an applicable
financial reporting framework.
Limitations of an Audit of Financial Statements
An audit is not a guarantee of the exactness of assertions in
the financial statements. An audit is not intended to, and
cannot, provide a guarantee or absolute assurance that
the financial statements are free from material
misstatements due to fraud or error. This is because there
are inherent limitations of an audit arising from:
A. The nature of financial reporting.
B. The nature of audit procedures.
C. The need for an audit to be conducted within a
reasonable period of time and at a reasonable
cost.
An audit is also necessarily limited by its scope and
objective. An audit only expresses as opinion on the
financial statements and does not express an opinion on
other matters such as:
A. The future viability of the entity.
B. The efficiency and effectiveness with which
management has conducted the affairs of the
entity.
C. The extent of compliance with all laws and
regulations that may be applicable to the entity.
AUDIT AS AN ASSURANCE ENGAGEMENT
An independent financial statement audit is an assurance
engagement as provides a reasonable level of assurance
that the subject matter conforms in all material respects
with identified suitable criteria. It exhibits all the elements of
an assurance engagement as follows:
A. A three party relationship – an audit involves three
parties namely the independent auditor
(practitioner), client’s management (responsible
party) and various uses of the financial statements
(intended users).
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
B. Appropriate subject matter – the subject matter of
an audit are historical financial information for
which the subject matter information are the
assertions embodied in the financial statements.
C. Suitable criteria – the criterion used in an audit is
the applicable financial reporting framework which
is the generally accepted accounting principles in
the Philippines (PFRSs).
D. Sufficient appropriate evidence – an auditor obtains
sufficient appropriate evidence as a basis for the
audit conclusion or opinion.
E. A written assurance report – the conclusion formed
by the auditor is contained in an independent
auditor’s report.
NEED FOR AN INDEPENDENT FINANCIAL STATEMENT AUDIT
The market for auditing services is driven by the demand by
external users for reliable, dependable or fairly stated
financial statements that they will use in making economic
decisions. Normally, independent financial statements are
required under the following instances:
A. Application for a bank loan.
B. Establishing credit worthiness for purchase of
merchandise, equipment or other assets.
C. Reporting financial position, financial performance
and cash flows to absentee owners.
D. Requirements of the regulatory agencies.
E. Sale of business such as a merger requires due
diligence audit.
F. Termination of a partnership.
G. Preparation of income tax returns.
H. Establishing losses from fire, theft and burglary.
I. Bankruptcy and insolvency cases.
Users’ demand for reliable financial statements is due to
information risk, that is, the risk that the information that will
be used in decision making is materially misleading,
inaccurate or unreliable. Financial statements are used for
important decisions that involve significant amount of
money. If a decision is based on materially misstated
financial statements, it could have substantial economic or
financial consequences on decision makers.
Several factors contribute to the existence of information
risk, including the following:
A. Remoteness of information users from information
providers.
B. Potential bias and motives of information providers.
C. Voluminous data.
D. Complex exchange transactions.
To reduce information risk, managements of businesses and
the users of their financial statements may adopt any or all
of the following approaches:
A. Allow users to verify information.
B. Let users share information risk with management.
C. Have the financial statements audited.
Another condition that gives rise to the demand for
financial statement audit is the stewardship or agency
theory. The theory states that management wants credibility
an audit adds to the financial statements to enhance
stewardship of the financial statements and lessen the
mistrust of owners towards the management.
THEORETICAL FRAMEWORK OF AUDITING
The audit function operates within a theoretical framework.
Below are selected postulates, assumptions or ideas that
support many auditing concepts and standards:
A. Audit function operates on the assumption that all
financial data are verifiable.
If financial statements are not verifiable, there can
be no audit. A data is verifiable if two or more
qualified individuals, working independently, each
reach essentially similar conclusions.
B. The auditor should always maintain independence
with respect to the financial statements audited.
The audit report and the audit opinion would be of
little or no value at all if the audit is not conducted
by an independent auditor.
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 C. There should be no long-term conflict between the
auditor and the client management.
Short-term conflicts may exist between the
management who prepare the data and the
auditor who examine the data but such must be
resolved since both are interested in the fairness of
financial statements.
D. Consistent compliance with applicable financial
reporting framework results in fair presentation of
financial statements.
E. Effective internal control system reduces the
possibility of errors and fraud affecting financial
statements.
Internal control affects the reliability of the financial
statements. The stronger the internal control is, the
lesser possibility for misstatements and
consequently, the more assurance it provides
about the reliability of accounting data and
financial statements.
F. What was held true in the past will continue to hold
true in the future in the absence of known
conditions to the contrary.
Experience and knowledge accumulated from
auditing a client in prior years can be used to
determine the appropriate audit procedures that
need to be performed.
G. An audit benefits the public.
The beneficiaries of reliable financial statements
are the wide variety of users including the general
public.
GENERAL PRINCIPLES GOVERNING THE AUDIT OF FINANCIAL
STATEMENTS (PSA 200)
PSA 200 provides the following guidelines when auditing
financial statements:
A. The auditor shall comply with relevant ethical
requirements, including those pertaining to
independence, relating to financial statement
audit engagements.
B. The auditor shall plan and perform an audit with
professional skepticism recognizing that
circumstances may exist that cause the financial
statements to be materially misstated.
C. To obtain reasonable assurance, the auditor shall
obtain sufficient appropriate audit evidence to
reduce audit risk to an acceptably low level and
thereby enable the auditor to draw reasonable
conclusions on which to base the auditor’s opinion.
D. The auditor shall exercise professional judgment in
planning and performing an audit of financial
statements.
E. The auditor shall comply with all PSAs relevant to
the audit. A PSA is relevant to the audit when the
PSA is in effect and the circumstances addressed
by the PSA exist.
F. The auditor shall not represent compliance with
PSAs in the auditor’s report unless the auditor has
complied with the requirements of PSA 200 and all
other PSAs relevant to the audit.
THE MANAGEMENT AND AUDITOR’S RESPONSIBILITY IN THE
CONDUCT OF AN AUDIT OF FINANCIAL STATEMENTS
Management’s Responsibility
An audit is conducted on the premise that management
and where appropriate, those charged with governance
have the responsibility for the preparation and presentation
of financial statements in accordance with the applicable
financial reporting framework. This responsibility includes the
design, implementation and maintenance of internal
control relevant to the preparation and presentation of
financial statements that are free from material
misstatements, whether due from fraud or error and to
provide the auditor with unrestricted access to all
information, records and documents relevant to the
financial statements.
Management refers to the person or persons with executive
responsibility for the conduct of the entity’s operations. On
the other hand, those charged with governance refers to
the person or persons or organization with responsibility for
overseeing the strategic direction of the entity and
obligations related to the accountability of the entity. This
includes overseeing the financial reporting process. For
some entities in some jurisdictions, those charged with
governance may include management personnel and vice
versa.
Auditor’s Responsibility
The auditor’s responsibility is to form and express an opinion
on the financial statements based on his audit. An audit of
financial statements does not relieve management of its
responsibilities.

COMPARISON AMONG THE DIFFERENT TYPES OF AUDITS

POINT OF DISTINCTION FINANCIAL STATEMENT AUDIT COMPLIANCE AUDIT OPERATIONAL AUDIT

To determine the degree of To assess the entity’s

To enable the auditor to express
compliance with established performance or operations in
Objective an opinion on the fairness of
laws, rules and regulations or terms of effectiveness and
financial statements
contracts efficiency

That the organization has That the organization's activities

Assertions made by the That the financial statements are
complied with laws, regulations are conducted effectively and
auditee fairly presented
or contracts efficiently

Financial reporting standards or

Laws, regulations, specific Objectives set by the board of
Established criteria other financial reporting
procedures and contracts directors
framework

An opinion about whether the Reports on the assessment of

financial statements are fairly
Content of the
presented in conformity with the
auditor's report applicable financial reporting
framework.
Reports on the degree of performance or operations
compliance with applicable including recommendations or
laws, regulations and contracts. suggestions on how to improve
operations.

Auditors who generally

External auditors Government auditors Internal auditors
perform
Authoritative bodies that sets
Wide variety of users both internal
Users of the report down the regulations, rules and Management of the entity
and external to the auditee
procedures

Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014 Page|4 of 4