INTRODUCTION TO AUDITING

Auditing, Defined:

Auditing is “a systematic process of objectively obtaining and evaluating 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 the interested users.”

Two processes of auditing:

a. Investigative process – involves the systematic gathering and evaluation of evidence as a
basis for determining whether assertions made by responsible person correspond with the
established criteria
b. Reporting process – involves communicating the audit opinion to interested users

Important Concepts:
1. Systematic process – auditing involves structured/logical series of sequential steps or
procedures known as the audit process

2. Objectively obtaining and evaluating evidence – auditing involves gathering and

evaluating sufficient appropriate audit evidence that will support the auditor’s opinion
 Objectivity refers to the combination of impartiality, intellectual honesty and
freedom from conflicts of interest.
 Audit evidence is the information obtained by the auditor in arriving at the
conclusions on which the audit opinion is based.

3. Assertions about economic actions and events – assertions are the subject matter
of auditing
 In the context of audit of financial statements, assertions are representations of
management, explicit or otherwise, that are embodied in the financial statements.
Assertions include the accounts, balances/amounts and disclosures appearing on the
face of the financial statements (and in the notes to financial statements) and which
the management claims to be free of misstatements.
 Audit evidence gathered and evaluated by the auditor may support or contradict the
assertions of management.

4. Established criteria – the standards or benchmarks that are needed to judge the
validity of the assertions on the financial statements
 In the context of audit of financial statements, the established criteria are the
applicable financial reporting framework (for example, the PFRS).

5. Ascertain the degree of correspondence between assertions and established

criteria – The auditor’s objective is to determine whether the assertions conform with
established criteria, that is, whether the financial statements are prepared, in all material
respects, in accordance with the applicable financial reporting framework (such as the
PFRS).

6. Communicating the results to the interested users – The ultimate objective of

audit is the communication of audit findings/opinion on the fairness of the financial
statements to interested users.
 Communicating results is achieved through issuance of a written audit report which
contains the audit opinion (or disclaimer of opinion).
 Interested users are the wide variety of financial statements users who rely on
the auditor’s opinion such as the stockholders, creditors, potential investors and
creditors, management, government agencies, and the public (in general).

FS audit is an Assurance Engagement:

Financial statements audit engagement is an assurance engagement because it provides a
reasonable (high but not absolute) level of assurance that the subject matter conforms in all material
respects with identified suitable criteria. It has the elements of an assurance engagement as follows:
1. Three Party Relationship:
a. Practitioner: Independent or External auditor
b. Responsible party: Client’s management
c. Intended users: Users of financial statements
2. Subject matter: Assertions/Financial statements of the client company
 3. Criteria: Applicable financial reporting framework / GAAP in the Philippines (PFRS)
4. Sufficient appropriate evidence: Auditor obtains sufficient appropriate audit evidence as a
basis for audit conclusion/opinion
5. Written Assurance Report: Independent auditor’s report contains the audit conclusion/opinion

Need for Independent Audit of Financial Statements:

The primary economic reason for an audit of financial statements is the demand by external users
for reliable or fairly stated financial statements that they will use in making economic decisions. Thus,
the market for auditing services is driven by demand by external financial statements users.

An audit can help reduce information risk , that is, the risk that the financial statements that will
be used for decision-making are materially misleading, unreliable or inaccurate.

Four conditions/reasons that gave rise to a demand for independent audit of financial
statements:
a. Potential conflict of interest between users and preparers of the financial
information can result in biased information – Client management may not be
objective in financial reporting. It may provide impressive but biased, unrealistic, or
misleading financial statements to obtain benefits that it seeks. On the other hand,
financial statement users need unbiased, realistic, or reliable financial statements.
b. Remoteness of users – Users do not have access to entity’s records to personally
verify the reliability of the financial information.
c. Complexity of subject matter requires expertise – Expertise is often required for
information preparation and verification. Users of financial statements are not
equipped with the necessary skills, competence, and knowledge of complexities of
accounting and auditing to determine whether the financial statements are reliable.
d. Consequence for decision making – Financial statements are used for important
decisions that involve significant amount of money. If a decision is based on
misleading financial information, it could have substantial financial or economic
consequences on decision makers.

Another condition that gave rise to demand for audit of financial statements is the
stewardship or agency theory which means that management wants the credibility
an audit adds to the financial statement to enhance stewardship of the financial
statement and to lessen the owner’s mistrust of the management.

Elements of Theoretical Framework of Auditing:

Auditing concepts and standards are based on the following postulates and assumptions which
form part of the elements of theoretical framework of auditing:

1. An audit benefits the public. – the primary beneficiary of reliable financial statements are
the wide variety of users (intended users)
2. Financial data and statements to be audited are verifiable. – if financial statements are
not verifiable, there can be no audit
 Financial statements or data are verifiable if two or more qualified individuals, working
independently, each reach essentially similar conclusions.
3. The auditor should always maintain independence with respect to the client whose
financial statements are subject to audit . – audit opinion and the audit report would be of
little or no value if auditor is not independent
4. Effective internal control system reduces the possibility of errors and fraud
affecting the financial statements. – Internal control affects the reliability of the financial
statements. The stronger the internal control is, the lesser the possibility of errors and fraud,
and consequently, the more reliance on internal control can be placed or assurance that it can
generate reliable accounting data and financial statements.
5. 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 auditors who examine the data but such conflicts must be resolve since both must be
interested in fairness of the financial statements.
6. Consistent application of GAAP results in fair presentation of FS. – The criterion in
financial statement audit is an identified or applicable financial reporting framework, which is
usually the PFRS.
7. 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.

Examples of Instances Requiring Independent Financial Statements Audit:

 Application for a bank loan
 Establishing credit worthiness for purchase of merchandise, equipment, or other assets
 Reporting financial position, operating results, and cash flows to absentee owners (stockholders
or partners)
 SEC requirements:
 Issuance of securities by a corporation
 Annual FS by a corporation with securities listed on a stock exchange or traded over the
counter
 Sale of a business (such as merger) requires due diligence audit
 Termination of a partnership
 Preparation of income tax returns
 Establishing losses from fire, theft and burglary
 Bankruptcy and insolvency cases

Audit of Financial Statements:

Audit of financial statements is the objective examination of financial statements to enable the
auditor to express an opinion on whether the financial statements are prepared, in all material respects,
in accordance with an applicable financial reporting framework.

Synonyms:
Audit of financial statements is sometimes called:
 Independent audit because in an audit of financial statements the auditor is
independent of the client subject to audit.
 External audit because it is performed by an external auditor who is not an employee
of the client subject to audit.
 Financial audit

Various descriptions:
Independent auditing has been described in a variety of ways, as follows:
 It involves objective examination of and reporting on financial statements prepared by
management
 It is a discipline which attests to the results of accounting and other functional
operations and data.
 It lends credibility to the financial statements.
 It provides increased assurance to users as to the fairness of the financial statements.
 Its essence is to determine whether the client’s financial statements are fairly stated.
 It enhances the degree of confidence of interested users in the financial statements.
 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 intended users in the financial
statements. Such purpose 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.

Overall Objectives of the Independent Auditor:

a. To obtain reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud or error.

 Reasonable assurance means high, but not absolute, level of assurance

 Reasonable assurance is the basis for the auditor’s opinion. Reasonable assurance is
achieved when the auditor has obtained sufficient appropriate audit evidence to reduce
audit risk to an acceptably low level.

b. To report on the financial statements and to communicate such report in accordance with the
auditor’s findings.

Auditor’s opinion and reasonable assurance:

The auditor's opinion, as expressed in the auditor’s report, enhances the credibility of the
 financial statements by providing a reasonable assurance that the financial statements are fairly
presented or free from material misstatement.

Audit opinion is based on whether reasonable assurance is obtained:

1. When reasonable assurance is obtained: Auditor shall express an unqualified opinion
2. When reasonable assurance cannot be obtained: The auditor is required to:
a. Express a qualified opinion in the auditor’s report
b. If qualified opinion is insufficient in the circumstances:
 Disclaim an opinion or
 Withdraw from the engagement, where withdrawal is legally permitted

Audit Opinion and Audit Report:

Audit opinion:

 In a financial statement audit, the auditor obtains sufficient appropriate audit evidence to be
able to draw conclusions on which to base that opinion. The auditor’s opinion is on the fairness
of the audited financial statements.
 The auditor's opinion helps establish the credibility of the financial statements.

Auditor’s report:
 the primary product of an audit engagement
 the end product of the audit process
 a written report that contains auditor’s opinion about the fairness of the FS
 the medium through which the auditor communicates the results of his or her work

Example of Standard Independent Auditor’s Report (pls. refer to PSA 700; pls. memorize)

Importance of audit opinion/audit report:

 It lends credibility to the FS.
 It provides increased assurance (reasonable assurance) to users as to the fairness of the FS.

An FS audit is:
 NOT a certification or guarantee as to accuracy or fairness of the FS.
 NOT an assurance as to future viability of the entity.
 NOT an assurance as to efficiency or effectiveness of the client’s business operations.
 NOT attestation as to the financial strength of an entity, the wisdom of its management
decisions, or the risk of doing business with it.

Scope of an Audit of Financial Statements:

 The auditor’s opinion on the financial statements deals with whether the financial statements are
prepared, in all material respects, in accordance with the applicable financial reporting
framework.
 The auditor’s opinion or the audit of financial statements is:
 NOT an assurance as to future viability of the entity.
 NOT an assurance as to efficiency or effectiveness with which client’s management has
conducted the affairs of the entity.
 NOT attestation as to the financial strength of an entity, the wisdom of its management
decisions, or the risk of doing business with it.
 NOT a certification or guarantee as to accuracy or fairness of the financial statements.
 When an applicable law or regulation requires an auditor to provide opinions on other specific
matters (such as the effectiveness of internal control, or the consistency of a separate
management report with the financial statements) the auditor would be required to undertake
further work if he had additional responsibilities to provide such opinions.

Financial Statements:
 Financial statements are a structured representation of historical financial information
(including related notes which comprise a summary of significant accounting policies and other
explanatory information), intended to communicate an entity’s economic resources or obligations
at a point in time or the changes therein for a period of time in accordance with a financial
reporting framework.
 The term “financial statements” ordinarily refers to a complete set of financial statements, but
can also refer to a single financial statement.
End Products of Audit Engagement:
a. Independent auditor’s report – the primary product of audit engagement
b. Certain other communication and reports – other communication and reporting responsibilities
to users, management, those charged with governance, or parties outside the entity, in relation
to matters arising from the audit (as may be required by the PSAs or by applicable laws or
regulations)
Examples:
 Communication with those charged with governance
 Auditor’s responsibilities relating to fraud in an audit of financial statements

Management Responsibility for the Financial Statements:

An audit in accordance with PSAs is conducted on the premise that management and, where
appropriate, those charged with governance have acknowledged and understand that they have
responsibility over the financial statements.

Management responsibility over the financial statements includes:

1. Responsibility for the preparation and presentation of the financial statements in accordance with
the applicable financial reporting framework which includes:
a. Identification of applicable financial reporting framework, in the context of any relevant laws
or regulations
b. Preparing the financial statements in accordance with that framework
c. Adequate description of that framework in the financial statements
d. Making reasonable accounting estimates
e. Selecting and applying appropriate accounting policies
2. Responsibility for designing, implementing and maintaining internal control that is relevant or
necessary to enable the preparation of financial statements that are free from material
misstatement, whether due to fraud or error, and
3. Responsibility to provide the auditor with:
a. All information (such as records, documentation and other matters) that are relevant to the
preparation and presentation of the financial statements
b. Any additional information that the auditor may request from management for the purpose of
the audit; and
c. Unrestricted access to persons within the entity from whom the auditor determines it
necessary to obtain audit evidence.

Auditor’s responsibility vs. client management’s responsibility:

 The client management, with oversight from those charged with governance, has the
responsibility for the preparation and presentation of the financial statements in
accordance with the applicable financial reporting framework. In other words, the
management is primarily responsible for the fairness of the financial statements.
 The auditor’s responsibility for the financial statements is confined to the expression of
opinion on them. The audit of the financial statements does not relieve management or
those charged with governance of their responsibilities over the financial statements
because the auditor merely audits the financial statements.
 However, an auditor may make suggestions on the form and content of financial
statements or may draft statement.

Applicable Financial Reporting Framework:

Applicable financial reporting framework means the financial reporting framework adopted by
management (and, where appropriate, those charged with governance) in the preparation of the financial
statements that is acceptable in view of the nature of the entity and the objective of the financial
statements, or that is required by law or regulation.

The applicable financial reporting framework often encompasses financial reporting standards
established by:
 An authorized or recognized standards setting organization (such as PFRSC)
 Legislative or regulatory requirements

Other sources of applicable financial reporting framework:

 The legal and ethical environment (including statutes, regulations, court decisions, and
professional ethical obligations in relation to accounting matters)
 Published accounting interpretations of varying authority issued by standards setting,
professional or regulatory organizations
  Published views of varying authority on emerging accounting issues issued by standards setting,
professional or regulatory organizations
 General and industry practices widely recognized and prevalent; and
 Accounting literature

Where conflicts exist between the financial reporting framework and the sources from which
direction on its application may be obtained, or among the sources that encompass the financial
reporting framework, the source with the highest authority prevails.

Financial reporting frameworks encompass primarily the financial reporting standards established by
an organization that is authorized or recognized to promulgate standards to be used by entities for
preparing general purpose financial statements are often designed to achieve fair presentation, for
example, International Financial Reporting Standards (PFRSs).

Basic Distinction between Auditing and Accounting:

 Auditing involves verification of FS and its fairness of presentation while accounting involves
preparation and presentation of FS
 Accounting precedes auditing because without FS there could be no FS audit.
 Auditing begins when accounting ends.
 The end product of the accounting process is a set of FS while the end product of the audit
process is an auditor’s report.
 An auditor must be proficient/expert in accounting (since the auditor will use GAAP in
evaluating the fairness of the FS) as well as in auditing (specifically in accumulation and
interpretation of audit evidence); an accountant need not be proficient in auditing
 Separate disciplines: Auditing is a separate discipline or field of study
 With different frameworks/foundations:
 Accounting – Framework for Preparation of FS
 Auditing – a) Philippine Framework for Assurance Engagements, and b) Framework of
Philippine Standards on Auditing
 Auditing – governed by GAAS; Accounting – governed by GAAP/PFRS
 Dissimilar bodies of knowledge (accounting – GAAP; auditing – GAAS)

Requirements Relating to an Audit of Financial Statements:

1. Relevant ethical requirements – The auditor shall comply with relevant ethical requirements,
including those pertaining to independence, relating to financial statement audit engagements.

Relevant ethical requirements ordinarily comprise:

a. Code of Ethics for Professional Accountants in the Philippines (the Code of
Ethics) promulgated by the Board of Accountancy

Compliance with the Code of Ethics is necessary in order to ensure the highest quality
of performance and to maintain public confidence in the profession and in the context of
audit of financial statements, maintain public confidence in the auditor’s work.

(1) Part A of the Code of Ethics – establishes the fundamental principles of professional
ethics relevant to the auditor when conducting an audit of financial statements and
provides a conceptual framework for applying those principles
The fundamental principles of professional ethics are:
a) Integrity
b) Objectivity
c) Professional competence and due care
d) Confidentiality, and
e) Professional behavior
(2) Part B of the Code of Ethics – illustrates how the conceptual framework is to be
applied in specific situations
(3) Independence
 It is in the public interest that the auditor be independent of the entity subject to
the audit.
 The auditor’s independence from the entity safeguards the auditor’s ability to form
an audit opinion without being affected by influences that might compromise that
opinion.
 Independence enhances the auditor’s ability to act with integrity, to be objective
and to maintain an attitude of professional skepticism.
 Independence requirements comprise of both:
a) Independence of mind
b) Independence in appearance
b. National requirements that are more restrictive
c. Philippine Standard on Quality Control (PSQC) – require the CPA firm to establish
and maintain its system of quality control designed to provide it with reasonable assurance
that the firm and its personnel comply with relevant ethical requirements, including those
pertaining to independence

2. Professional skepticism – The auditor shall plan and perform an audit with professional
scepticism recognizing that circumstances may exist that cause the financial statements to be
materially misstated.

Professional skepticism is an attitude that includes a questioning mind, a critical

assessment of validity of audit evidence, and being alert to conditions which may indicate
possible misstatement due to error or fraud.

Professional skepticism is necessary to the critical assessment of audit evidence.

This includes:
a. Questioning contradictory audit evidence
b. Considering the reliability of documents and responses to inquiries and other information
obtained from management and those charged with governance
c. Considering the sufficiency and appropriateness of audit evidence obtained in the light of the
circumstances (for example, in the case where fraud risk factors exist and a single document,
of a nature that is susceptible to fraud, is the sole supporting evidence for a material financial
statement amount)

Professional skepticism includes being alert to:

 Audit evidence that contradicts other audit evidence obtained.
 Information that brings into question the reliability of documents and responses to
inquiries to be used as audit evidence.
 Conditions that may indicate possible fraud.
 Circumstances that suggest the need for audit procedures in addition to those
required by the PSAs.

The auditor may accept records and documents as genuine unless the auditor has reason to
believe the contrary. In cases of doubt about the reliability of information or indications of
possible fraud, the PSAs require that the auditor investigate further and determine what
modifications or additions to audit procedures are necessary to resolve the matter.

Maintaining professional skepticism throughout the audit is necessary to reduce the risks of:
 Overlooking unusual circumstances.
 Over generalizing when drawing conclusions from audit observations.
 Using inappropriate assumptions in determining the nature, timing and extent of the
audit procedures and evaluating the results thereof.

The auditor cannot be expected to disregard past experience of the honesty and integrity of
the entity’s management and those charged with governance. Nevertheless, a belief that
they are honest and have integrity does not relieve the auditor of the need to maintain
professional skepticism in conducting the audit.

3. Professional judgement – The auditor shall exercise professional judgment in planning and
performing an audit of financial statements.

Professional judgment is essential to the proper conduct of an audit. This is because

interpretation of relevant ethical requirements and the PSAs and the informed decisions required
throughout the audit cannot be made without the application of relevant knowledge and
experience to the facts and circumstances.

Professional judgment is necessary on decisions about:

 Materiality
 Audit risk
 Nature, timing and extent of audit procedures used to meet the requirements of the
PSAs and gather audit evidence
  Evaluating whether sufficient appropriate audit evidence has been obtained
 Evaluation of management’s judgments in applying the entity’s applicable financial
reporting framework.
 Drawing of conclusions based on the audit evidence obtained (for example, assessing
the reasonableness of the estimates made by management in preparing the financial
statements)

The distinguishing feature of the professional judgment expected of an auditor is that it is

exercised by an auditor whose training, knowledge and experience have assisted in
developing the necessary competencies to achieve reasonable judgments.

The exercise of professional judgment in any particular case is based on the facts and
circumstances that are known by the auditor. Consultation on difficult or contentious matters
during the course of the audit, both within the engagement team and between the
engagement team and others at the appropriate level within or outside the firm assist the
auditor in making informed and reasonable judgments.
Professional judgment can be evaluated based on whether the judgment reached reflects a
competent application of auditing and accounting principles and is appropriate in the light of,
and consistent with, the facts and circumstances that were known to the auditor up to the
date of the auditor’s report.

Professional judgment needs to be exercised throughout the audit. It also needs to be

appropriately documented. In this regard, the auditor is required to prepare audit
documentation sufficient to enable an experienced auditor, having no previous connection
with the audit, to understand the significant professional judgments made in reaching
conclusions on significant matters arising during the audit. Professional judgment is not to be
used as the justification for decisions that are not otherwise supported by the facts and
circumstances of the engagement or sufficient appropriate audit evidence.

4. Sufficiency and appropriateness of audit evidence and audit risk – 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.

a. Sufficiency and appropriateness of audit evidence

Audit evidence includes information used by the auditor in arriving at the conclusions
on which the auditor’s opinion is based. Audit evidence includes both:
 Information contained in the accounting records underlying the financial statements and
 Other information

Sufficiency is the measure of the quantity of audit evidence. Sufficiency is influenced

or affected by:
(1) The auditor’s assessment of the risks of misstatement (the higher the assessed risks, the
more audit evidence is likely to be required) and
(2) The quality of such audit evidence (the higher the quality, the less may be required)

Appropriateness is the measure of the quality of audit evidence; that is, its relevance
and its reliability in providing support for the conclusions on which the auditor’s opinion is
based. The reliability of evidence is influenced by its source and by its nature, and is
dependent on the individual circumstances under which it is obtained.

Whether sufficient appropriate audit evidence has been obtained 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, is a matter of professional judgment.

Note:
• Audit evidence is necessary to support the auditor’s opinion and report.
• It is cumulative in nature and is primarily obtained from audit procedures performed
during the course of the audit.
• Audit evidence comprises both information that supports and corroborates
management’s assertions, and any information that contradicts such assertions.
• Most of the auditor’s work in forming the auditor’s opinion consists of obtaining and
evaluating audit evidence.
• The sufficiency and appropriateness of audit evidence are interrelated.
 • Obtaining more audit evidence, however, may not compensate for its poor quality.

Sources of audit evidence:

a. Primarily obtained from audit procedures performed during the course of the audit
b. May be obtained from other sources such as:
• Previous audits (provided the auditor has determined whether changes have
occurred since the previous audit that may affect its relevance to the current
audit) or
• A firm’s quality control procedures for client acceptance and continuance
• The entity’s accounting records
• An expert employed or engaged by the entity
• In some cases, the absence of information (for example, management’s refusal to
provide a requested representation) is used by the auditor, and therefore, also
constitutes audit evidence.

b. Audit risk

Audit risk is the risk that the auditor expresses an inappropriate opinion when the
financial statements are materially misstated. Audit risk is a function of the risks of material
misstatement and detection risk.

Audit risk does not include the risk that the auditor might express an opinion that the
financial statements are materially misstated when they are not. Audit risk is a technical
term related to the process of auditing; it does not refer to the auditor’s business risks
such as loss from litigation, adverse publicity, or other events arising in connection with
the audit of financial statements.

Risk of material misstatements is the risk that the financial statements are materially
misstated prior to audit. Risk of material misstatement may exist at two levels:
1. Overall financial statement level – refer to risks of material misstatement that relate
pervasively to the financial statements as a whole and potentially affect many assertions
2. Assertion level – refer to risks of material misstatement that relate to classes of
transactions, account balances, and disclosures

Risk of material misstatement at the assertion level has two components:

(a) Inherent risk – the susceptibility of an assertion about a class of transaction,
account balance or disclosure to a misstatement that could be material, either
individually or when aggregated with other misstatements, before consideration of
any related controls
(b) Control risk – the risk that a misstatement that could occur in an assertion about a
class of transaction, account balance or disclosure and that could be material, either
individually or when aggregated with other misstatements, will not be prevented, or
detected and corrected, on a timely basis by the entity’s internal control

Control risk is a function of the effectiveness of the design, implementation and

maintenance of internal control by management to address identified risks that
threaten the achievement of the entity’s objectives relevant to preparation of the
entity’s financial statements. However, internal control, no matter how well
designed and operated, can only reduce, but not eliminate, risks of material
misstatement in the financial statements, because of the inherent limitations of
internal control. Accordingly, some control risk will always exist.

Risks of material misstatement at assertion level (inherent risk and control risk) are
the entity’s risks; they exist independently of the audit of the financial statements. Such
risks are assessed in order to determine the nature, timing and extent of further audit
procedures necessary to obtain sufficient appropriate audit evidence. This evidence
enables the auditor to express an opinion on the financial statements at an acceptably
low level of audit risk. The assessment of risks is a matter of professional judgment,
rather than a matter capable of precise measurement.

Detection risk is the risk that the procedures performed by the auditor to reduce audit risk
to an acceptably low level will not detect a misstatement that exists and that could be
material, either individually or when aggregated with other misstatements.
 Detection risk relates to the nature, timing and extent of the auditor’s procedures that
are determined by the auditor to reduce audit risk to an acceptably low level. It is therefore
a function of the effectiveness of an audit procedure and of its application by the auditor.

For a given level of audit risk, the acceptable level of detection risk bears an inverse
relationship to the assessed risks of material misstatement at the assertion level. For
example, the greater the risks of material misstatement the auditor believes exists, the
less the detection risk that can be accepted and, accordingly, the more persuasive the
audit evidence required by the auditor.

The following matters assist to enhance the effectiveness of an audit procedure and of its
application and reduce the possibility that an auditor might select an inappropriate audit
procedure, misapply an appropriate audit procedure, or misinterpret the audit results:
• Adequate planning
• Proper assignment of personnel to the engagement team
• The application of professional scepticism, and
• Supervision and review of the audit work performed

Detection risk, however, can only be reduced, not eliminated, because of the inherent
limitations of an audit. Accordingly, some detection risk will always exist.

5. The auditor shall conduct an audit in accordance with PSAs

 PSAs contain basic audit principles and essential procedures together with related
guidance in the form of explanatory and other material which the auditor should follow

An audit in accordance with PSAs includes:

a. Compliance with PSAs relevant to the audit
1) Compliance 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)

Complying with relevant requirements means the auditor shall comply with each
requirement of a PSA unless, in the circumstances of the audit:
a. The entire PSA is not relevant (for example, if an entity does not have an internal
audit function, nothing in PSA 610 is relevant)
b. The requirement is not relevant because it is conditional (implicit or explicit) and
the condition does not exist.
Examples of conditional requirements:
• The requirement to modify the auditor’s opinion if there is a limitation of
scope represents an explicit conditional requirement.
• The requirement to communicate significant deficiencies in internal control
identified during the audit to those charged with governance, which depends
on the existence of such identified significant deficiencies; and
• The requirement to obtain sufficient appropriate audit evidence regarding the
presentation and disclosure of segment information in accordance with the
applicable financial reporting framework, which depends on that framework
requiring or permitting

2) Having an understanding of the entire text of a PSA (including its application and other
explanatory material) to understand its objectives and to apply its requirements properly
3) Prohibition from the auditor from representing compliance with PSAs in the auditor’s
report when he has not complied with the requirements of PSAs relevant to the audit
b. The use of the objectives stated in relevant PSAs in planning and performing the audit to
achieve the overall objectives of the auditor.
 In using the objectives, the auditor is required to have regard to the interrelationships
among the PSAs. This is because the PSAs deal in some cases with general
responsibilities and in others with the application of those responsibilities to specific
topics.

The auditor is required to use the objectives to evaluate whether sufficient appropriate
audit evidence has been obtained in the context of the overall objectives of the auditor. If
as a result the auditor concludes that the audit evidence is not sufficient and appropriate,
then the auditor may follow one or more of the following approaches:
• Evaluate whether further relevant audit evidence has been, or will be, obtained as
a result of complying with other PSAs;
• Extend the work performed in applying one or more requirements; or
 • Perform other procedures judged by the auditor to be necessary in the
circumstances.

c. In addition, the auditor should also consider Philippine Auditing Practice Statements
(PAPSs). PAPSs provide interpretative guidance and practical assistance to auditors in
implementing the PSAs and to promote good practice in the accountancy profession.

Contents/Structure of the PSAs

a. Objectives – each PSA contains one or more objectives which provide a link between the
requirements and the overall objectives of the auditor
The objectives in individual PSAs serve to focus the auditor on the desired outcome of the PSA.
b. Requirements (requirements are expressed in the PSAs using “shall”) – the requirements of the
PSAs are designed to enable the auditor to achieve the objectives specified in the PSAs, and
thereby the overall objectives of the auditor
c. Related guidance in the form of application and other explanatory material that are designed to
support the auditor in obtaining reasonable assurance

Application and other explanatory material:

 It provides further explanation of the requirements of a PSA and guidance for carrying them
out
 It may explain more precisely what a requirement means or is intended to cover
 It may include examples of procedures that may be appropriate in the circumstances.
 While such guidance does not in itself impose a requirement, it is relevant to the proper
application of the requirements of an PSA.
 It may also provide background information on matters addressed in a PSA.
 It may include appendices which form part of the application and other explanatory material.
 When appropriate, it may include additional considerations specific to audits of smaller
entities and public sector entities.

PSAs may also contain:

 Introductory material – provides context relevant to a proper understanding of the PSA
Introductory material may include, as needed, such matters as explanation of:
a. The purpose and scope of the PSA (including how the PSA relates to other PSAs)
b. The subject matter of the PSA
c. The respective responsibilities of the auditor and others in relation to the subject matter of
the PSA
d. The context in which the PSA is set
 Definitions – a description of the meanings attributed to certain terms for purposes of the PSAs
 Assist in the consistent application and interpretation of the PSAs
 Not intended to override definitions that may be established for other purposes, whether in
law, regulation or otherwise

The Glossary of Terms relating to PSAs contains a complete listing of terms defined in the
PSAs. It also includes descriptions of other terms found in PSAs to assist in common and
consistent interpretation and translation.

Nature of the PSAs

The PSAs, taken together, provide the standards for the auditor’s work in fulfilling the
overall objectives of the auditor. The PSAs deal with the general responsibilities of the
auditor, as well as the auditor’s further considerations relevant to the application of those
responsibilities to specific topics.

The scope, effective date and any specific limitation of the applicability of a specific PSA
is made clear in the PSA. Unless otherwise stated in the PSA, the auditor is permitted to
apply a PSA before the effective date specified therein.

In performing an audit, the auditor may be required to comply with legal or regulatory
requirements in addition to the PSAs. The PSAs do not override law or regulation that
governs an audit of financial statements. In the event that such law or regulation differs
from the PSAs, an audit conducted only in accordance with law or regulation will not
automatically comply with PSAs.

Departure from a relevant requirement in a PSA:

 In exceptional circumstances wherein the auditor may judge it necessary to depart from a relevant
requirement in a PSA, the auditor shall perform alternative audit procedures to achieve the aim of that
requirement.

The need for the auditor to depart from a relevant requirement is expected to arise only where the
requirement is for a specific procedure to be performed and, in the specific circumstances of the audit,
that procedure would be ineffective in achieving the aim of the requirement.

The PSAs do not call for compliance with a requirement that is not relevant in the circumstances of
the audit.

b. As the basis for the auditor’s opinion, PSAs require the auditor to obtain reasonable assurance
about whether the financial statements as a whole are free from material misstatement, whether
due to fraud or error. 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.

Considerations Specific to Smaller Entities

For purposes of specifying additional considerations to audits of smaller entities, a “smaller entity”
refers to an entity which typically possesses qualitative characteristics such as:
1. Concentration of ownership and management in a small number of individuals (often a single
individual – either a natural person or another enterprise that owns the entity provided the
owner exhibits the relevant qualitative characteristics); and
2. One or more of the following:
a. Straightforward or uncomplicated transactions;
b. Simple record-keeping;
c. Few lines of business and few products within business lines;
d. Few internal controls;
e. Few levels of management with responsibility for a broad range of controls; or
f. Few personnel, many having a wide range of duties.

These qualitative characteristics are not exhaustive, they are not exclusive to smaller entities, and
smaller entities do not necessarily display all of these characteristics.

The PSAs refer to the proprietor of a smaller entity who is involved in running the entity on a day-to-
day basis as the “owner-manager.”

General Principles of Financial Statement Audit

1. The auditor should plan and perform the audit with an attitude of professional
skepticism recognizing that circumstances may exist that may cause the FS to be materially
misstated.

Because of the possibility that the FS may be materially misstated, the auditor should
conduct the audit with an attitude of professional skepticism. For example, the auditor would
ordinarily expect to find evidence to support management representations and not assume
they are necessarily correct.

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. In planning and performing the audit, the auditor neither assumes that the
management is honest nor assumes unquestioned honesty.

Concept of Reasonable Assurance:

Although an independent FS audit in accordance with PSAs lends credibility to the FS, such audit is
designed to provide only reasonable assurance , rather than absolute assurance, that the FS taken as a
whole are free from material misstatement, whether due to fraud or error. In other words, the level of
assurance provided by an audit of detecting a material misstatement is referred to as reasonable
assurance. Reasonable assurance means high, but not absolute, assurance.
 Reasonable assurance refers to the gathering of the audit evidence necessary for the auditor to
conclude that there are no material misstatements in the FS, taken as a whole. This concept
recognizes the existence of audit risk.

Notes on reasonable assurance:

 Reasonable assurance relates to the conclusion of the auditor that there are no material
misstatements in the FS taken as a whole.
 Reasonable assurance is achieved when the auditor has reduced audit risk to an acceptably low
level by designing and performing audit procedures to obtain sufficient appropriate audit
evidence to be able to draw reasonable conclusions on which to base an audit opinion.
 Reasonable assurance relates to the whole audit process.
 Absolute assurance in audit of FS is not attainable. Accordingly, the audit opinion is not a
guarantee or certification that the financial statements are free from material misstatements.

When reasonable assurance cannot be obtained and a qualified opinion cannot be expressed,
the auditor should:
 Disclaim an opinion, or
 Withdraw from the engagement (if legally permitted)

As the basis for the auditor’s opinion, PSAs require the auditor to obtain reasonable assurance about
whether the financial statements as a whole are free from material misstatement, whether

The level of assurance provided by an audit of detecting a material misstatement is referred to as

Reasonable assurance.

Inherent Limitations of an Audit

A45. The auditor is not expected to, and cannot, reduce audit risk to zero and cannot therefore obtain
absolute assurance that the financial statements are free from material misstatement due to fraud or
error. This is because there are inherent limitations of an audit, which result in most of the audit evidence
on which the auditor draws conclusions and bases the auditor’s opinion being persuasive rather than
conclusive. The inherent limitations of an audit arise from:
a. The nature of financial reporting –
• The preparation of financial statements involves judgment by management in applying the
requirements of the entity’s applicable financial reporting framework to the facts and
circumstances of the entity.
• Many financial statement items involve subjective decisions or assessments or a degree of
uncertainty, and there may be a range of acceptable interpretations or judgments that may
be made
• Consequently, some financial statement items are subject to an inherent level of variability
which cannot be eliminated by the application of additional auditing procedures. For example,
this is often the case with respect to certain accounting estimates. Nevertheless, the PSAs
require the auditor to give specific consideration to whether accounting estimates are
reasonable in the context of the applicable financial reporting framework and related
disclosures, and to the qualitative aspects of the entity’s accounting practices, including
indicators of possible bias in management’s judgments.

b. The nature of audit procedures – there are practical and legal limitations on the auditor’s ability
to obtain audit evidence
For example:

• There is the possibility that management or others may not provide, intentionally or
unintentionally, the complete information that is relevant to the preparation of the financial
statements or that has been requested by the auditor. Accordingly, the auditor cannot be
certain of the completeness of information, even though the auditor has performed audit
procedures to obtain assurance that all relevant information has been obtained.
• Fraud may involve sophisticated and carefully organized schemes designed to conceal it.
Therefore, audit procedures used to gather audit evidence may be ineffective for detecting
an intentional misstatement that involves, for example, collusion to falsify documentation
which may cause the auditor to believe that audit evidence is valid when it is not. The auditor
is neither trained as nor expected to be an expert in the authentication of documents.
• An audit is not an official investigation into alleged wrongdoing. Accordingly, the auditor is
not given specific legal powers, such as the power of search, which may be necessary for
such an investigation.
• The need for the audit to be conducted within a reasonable period of time and at a reasonable cost.

Timeliness of Financial Reporting and the Balance between Benefit and Cost

A48. The matter of difficulty, time, or cost involved is not in itself a valid basis for the auditor to omit an
audit procedure for which there is no alternative or to be satisfied with audit evidence that is less than
persuasive. Appropriate planning assists in making sufficient time and resources available for the conduct
of the audit. Notwithstanding this, the relevance of information, and thereby its value, tends to diminish
over time, and there is a balance to be struck between the reliability of information and its cost. This is
recognized in certain financial reporting frameworks (see, for example, the IASB’s “Framework for the
Preparation and Presentation of Financial Statements”). Therefore, there is an expectation by users of
financial statements that the auditor will form an opinion on the financial statements within a reasonable
period of time and at a reasonable cost, recognizing that it is impracticable to address all information that
may exist or to pursue every matter exhaustively on the assumption that information is in error or
fraudulent until proved otherwise.

A49. Consequently, it is necessary for the auditor to:

• Plan the audit so that it will be performed in an effective manner;
• Direct audit effort to areas most expected to contain risks of material misstatement, whether
due to fraud or error, with correspondingly less effort directed at other areas; and
• Use testing and other means of examining populations for misstatements.

A50. In light of the approaches described in paragraph A49, the ISAs contain requirements for the
planning and performance of the audit and require the auditor, among other things, to:
AUDITING
• Have a basis for the identification and assessment of risks of material misstatement at the
financial statement and assertion levels by performing risk assessment procedures and
related activities;21 and
• Use testing and other means of examining populations in a manner that provides a
reasonable basis for the auditor to draw conclusions about the population.

Other Matters that Affect the Inherent Limitations of an Audit

A51. In the case of certain assertions or subject matters, the potential effects of the inherent limitations
on the auditor’s ability to detect material misstatements are particularly significant. Such assertions or
subject matters include:
• Fraud, particularly fraud involving senior management or collusion. See ISA 240 for further
discussion.
• The existence and completeness of related party relationships and transactions. See ISA
55023 for further discussion.
• The occurrence of non-compliance with laws and regulations. See ISA 250.24 for further
discussion.
• Future events or conditions that may cause an entity to cease to continue as a going
concern. See ISA 570.25 for further discussion.

Relevant ISAs identify specific audit procedures to assist in mitigating the effect of the inherent
limitations.

A52. Because of the inherent limitations of an audit, there is an unavoidable risk that some material
misstatements of the financial statements may not be detected, even though the audit is properly
planned and performed in accordance with ISAs. Accordingly, the subsequent discovery of a material
misstatement of the financial statements resulting from fraud or error does not by itself indicate a failure
to conduct an audit in accordance with ISAs. However, the inherent limitations of an audit are not a
justification for the auditor to be satisfied with less than persuasive audit evidence. Whether the auditor
has performed an audit in accordance with ISAs is determined by the audit procedures performed in the
circumstances, the sufficiency and appropriateness of the audit evidence obtained as a result thereof and
the suitability of the auditor’s report based on an evaluation of that evidence in light of the overall
objectives of the auditor.

Limitations of Financial Statements Audit: (Reasons why absolute assurance in auditing is not
attainable or why reducing audit risk to zero is not attainable)
 Absolute assurance in auditing is not attainable because of inherent limitations in an audit that
affect the auditor’s ability to detect material misstatements. These limitations result from factors such
as:

1. Need for auditor’s judgment

The auditor’s work requires exercise of professional judgment such in the following matters:
 Identifying and addressing risk factors
 Deciding what evidence to gather
 Making decisions about materiality and audit risk
 Gathering and evaluating audit evidence (for example, in deciding the nature, timing and
extent of audit procedures)
 Evaluating management’s judgments in applying the entity’s applicable financial reporting
framework.
 Assessing the sufficiency and appropriateness of audit evidence
 Drawing of conclusions based on the evidence gathered
 Forming an opinion (the phrase “in our opinion” in the auditor’s report is intended to
inform that auditors based their conclusions on professional judgment)

2. Use of testing / sampling risk – An audit is conducted on a test basis or by examining only
sample of less than 100% of a population. This may introduce some risk that a misstatement will
not be detected.

3. Reliance on management representation – Some audit evidence must be obtained by

obtaining oral or written representations from management because many FS assertions
cannot be audited.

4. Inherent limitations of accounting and internal control – Although the auditor performs
audit procedures to detect material misstatements, such procedures may not be effective in
detecting misstatements resulting from the possibility of:
 management override of controls
 circumvention of internal control
 collusion among employees

5. Nature of audit evidence available – This is the fact that most of the evidence available to
the auditor is persuasive, rather than conclusive, in nature.

6. Undetected fraud – Fraud is specifically designed not to be detected. Thus, there is always
the possibility that fraud will not be detected.

7. Availability of audit evidence – Insufficient support may be available for drawing absolute
conclusions on specific assertions such as fair value estimates.

8. Other limitations may affect the persuasiveness of audit evidence available to draw
conclusions on particular assertions (for example, transactions between related parties).

Not a limitation of audit: Physical limitations of auditors due to fatigue and stress.

Concept of Materiality and Audit Risk

1. Materiality: the magnitude of misstatement or omission; the ability to influence the

economic decision of reasonable FS user

The auditor obtains and evaluates audit evidence to obtain reasonable assurance about
whether the FS are fair or are presented fairly, in all material respects , in accordance with the
applicable financial reporting framework.

When is a misstatement or omission material? It is material if it could influence the economic

decision of FS users. If it is probable that the judgment of a reasonable person would have
been changed or influenced by the omission or misstatement of information, then that
information is material.
 Meaning of the term "present fairly, in all material respects ": The auditor considers only
those matters that are significant to the FS users; the phrase refers to the auditors expression of
opinion

2. Audit Risk: the risk that audit opinion is inappropriate

 specifically, it is the risk that the auditor expresses an inappropriate (unqualified) audit
opinion when the FS are materially misstated
 concept of reasonable assurance acknowledges the existence of audit risk

General Types of Audit:

1. According to objectives or nature of assertion

a. Financial statement audit – an audit conducted to determine whether the financial

statements of an entity are fairly presented in accordance with an identified financial
reporting framework (or PFRS)

 An of financial statements is the type of audit most frequently performed by CPAs

(due to the widespread use of audited financial statements) on a fee basis and for
more than one client.
 Financial audit is also called:
 External audit – because it is performed by external auditors, whether individual
CPAs or CPA firms, who are not employees of the client
 Independent audit – because the auditor is independent of the client subject to
audit
 Financial audit

b. Compliance audit: a review of an entity’s degree of compliance with applicable laws and
rules/regulations or contracts; usually performed by government auditors
Examples: Examination conducted by:
i) BIR examiners: compliance of taxpayers with tax law, rules or regulations
ii) BSP examiners: compliance of banks with banking laws, rules or regulations
iii) COA auditors: compliance of government transactions/expenditures with the
requirements of applicable laws, rules or regulations

c. Operational audit involves a systematic review and evaluation of the specific operating
units (or procedures, methods or activities) of an organization in relation to specified
objectives for the purpose of measuring/assessing its performance in terms of efficiency
and effectiveness of operations, identifying opportunities for improvement and making
recommendations to improve performance (such as introduction of controls to reduce
waste).
 Also called performance audit or management audit
 Example: Evaluation of a company’s computerized accounting system
 Usually performed by internal auditors
 Efficiency relates to use of its resources, while effectiveness relates to accomplishing
objectives.

Internal auditor's responsibilities in operational audits:

In operational audits, the company's management is responsible for setting
operating standards. The internal auditor's responsibilities are to determine that:
a. Management has established such standards.
b. The standards are being met.
c. Deviations from established standards are being identified and corrected.
d. Corrective action has been taken.

Objective of operational auditing:

a. To assess performance in terms of efficiency and effectiveness of operations
(1) Effectiveness – To verify fulfillments of plans and sound business requirements
(2) Efficiency – To determine whether the entity is managing or utilizing its resources
economically and efficiently
b. To identify areas for improvement
c. To develop recommendations to improve performance (example of such as introduction
of controls to reduce waste)

Operational audit includes:

  Program or effectiveness audit : an audit to determine whether the entity has been
effective in achieving the desired results or benefits of the program or activity
 Economy audit: an audit to determine whether company objectives or goals are met
at a cost commensurate with the task
 Efficiency audit: whether company objectives or goals are met at the least or
minimal costs

Major differences between financial and operational auditing:

 The financial audit is oriented to the past whereas an operational audit concerns
performance for the future.
 The financial audit report is distributed to many readers whereas the operational
audit report goes to a few managers.
 Financial audits are limited to matters that directly affect the financial statements
whereas operational audits cover any aspect of efficiency and effectiveness.

2. According to types of auditor or their affiliation with the entity being examined:

a. External / Independent audit: performed by practitioners or independent CPAs who

offer their professional services for a fee to various clients on a contractual basis
 Independent or external auditors are not employees of the client
 External audit complements internal audit

b. Internal audit: audit performed by entity’s own employees known as internal auditors ;
internal auditors investigate and apprise the effectiveness and efficiency of operations and
internal controls of the firm

Internal auditing is defined as "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
bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management,
control, and governance processes."

Internal auditing includes the audit of:

 Financial and operating information;
 Compliance with policies, plans, procedures, laws, regulations, and contracts;
 The means of safeguarding assets and verifying their existence;
 The economy and efficiency with which resources are employed; and
 Operations or programs to ascertain whether results are consistent with established objectives
and goals and whether they are being carried out as prescribed.

Internal auditing is an appraisal control that measures and evaluates other controls. The increased
complexity and sophistication of business operations have required management to rely on this appraisal
control.

Internal auditors review the adequacy of the company's internal control system primarily to
ascertain whether the system provides reasonable assurance that the company's objectives and
goals will be achieved efficiently and economically. Efficient performance implies the use of minimal
resources to meet the company's objectives and goals. Economical performance is the
accomplishment of objectives and goals at a cost commensurate with the task.

Internal auditors assist in the prevention of fraud by examining and evaluating the system of internal
control.

Internal auditors are required to review the means employed by the company to safeguard its assets
from various types of losses such as those resulting from fire, theft, unscrupulous or illegal activities, and
exposure to the elements.

i) Internal auditing: 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. It 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.
 ii) Overall objective of internal auditing: to assist the members of the organization,
particularly management and board of directors, in the effective discharge of their
responsibilities; in short, to provide assistance to management or board of directors (it
serves the needs of management).

 Internal auditors usually perform operational audits

 Internal auditors usually focus on improving the efficiency and effectiveness of their
employer, unlike external auditors (public accounting firms) whose focus is the
fairness of the FS of their clients.

c. Government auditing: audit performed by government employees whose main concern

is to determine whether persons or entities comply with government laws, rules and
regulations

Scope of government audit: may extend beyond FS audit to include:

i) FS audit
ii) Performance audit (includes (a) program results (effectiveness) audit and (b) economy
and efficiency audit)
iii) Compliance audit

A governmental audit is typically designed to determine whether the auditee has complied with
applicable laws and regulations.

The types of audits conducted by the Commission on Audit (COA) are financial audit and performance audit.
Performance audits include economy, efficiency, and program audits. Included in the scope of financial
and performance audits is determining whether the entity has complied with applicable laws and
regulations.

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 auditor's report should
include the following:

1. The scope of the auditor's work in obtaining an understanding of the entity's internal control and
in his/her assessment of control risk.

2. The entity's significant controls including those that are established to ensure compliance
with laws and regulations that have a material impact on the financial
statements.

3. The conditions, including the identification of material weaknesses, identified as a result of the
auditor's work.

The Government Auditing Standards require auditors to prepare a written report on the entity's
internal control. This report should include the conditions, including the identification of material
weaknesses, discovered 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.

Government auditors are required to obtain an understanding of the possible financial statement effects of
laws and regulations having direct and material effects on amounts reported. Also, they are required to
make an assessment whether management has identified such laws that might have such effects.

The audit of a government program involves obtaining information about the costs, outputs,
benefits, and effects of the program. Auditors attempt to measure the accomplish ments and relative
success of the program based on the actual intent of the legislation that established the program.

Types of Auditors:
1. Independent auditors or external auditors – are CPA firms and individual practitioners who
perform audit services on contractual basis for more than one client
 Independent auditor – because the auditor is independent with respect to the client
whose FS are being audited; External auditor – the auditor is an outsider (not an employee
of the client)
 Practitioners perform operational audits and compliance audits as part of consultancy
services
2. Internal auditors – they are employed by the entity thus they are not independent. However,
to operate effectively, an internal auditor must be independent of the line functions of the entity.
Internal auditors perform operational and compliance audits.
3. Government auditors – employed in government agencies
 BIR examiners perform compliance audits
 BSP examiners perform compliance and operational audits
 COA auditors perform compliance and operational audits

The relationship between an external auditor and an internal auditor is that both of them use
basically an identical approach; however, there are differences in the application of auditing
techniques.

The audit committee is composed of outside directors who are independent of management. The
primary purpose is to assure that the directors are exercising due care and external and internal
auditors are independent of management.

The following are some of the audit committee's functions:

 Select the external auditors.
 Review the external auditor's overall audit plan.
 Evaluate the results of external and internal audits.
 Review the internal auditing work schedule, budget, etc.
 Meet regularly with the internal auditing director.
 The above functions should increase public confidence on the fair presentation of the
company's financial statements.

Acceptability of the Financial Reporting Framework

The auditor should determine whether the financial reporting framework adopted by management in
preparing the FS is acceptable. An acceptable financial reporting framework is what is referred to as the
“applicable financial reporting framework.” The auditor determines whether the financial reporting
framework adopted by management is acceptable in view of the nature of the entity (for example,
whether it is a business enterprise, a public sector entity or a not for profit organization) and the
objective of the FS.

In FS audit, financial reporting frameworks that are acceptable as valid criteria include:
1. Philippine Financial Reporting Standards (PFRSs)
2. Philippine Accounting Standards (PASs)
3. International Accounting Standards (IASs)
4. Other authoritative basis

Financial statements need to be prepared in accordance with one, or a combination of the above-cited
financial reporting framework.

Distinction: Types of audit according to objectives or nature of assertion/data

Point of FS Audit Compliance audit Operational audit

distinction
Primary objective To enable the auditor to express To determine To assess entity’s
an opinion on the fairness of the degree of performance (in terms
FS compliance of efficiency and
effectiveness)
Subject matter Assertion that the FS are Assertion that the Assertion that the
(Assertion) presented in accordance with organization has organization’s
identified financial reporting complied with laws, activities/operations
framework (GAAP) regulations and are conducted
specific procedures effectively and
efficiently in relation to
specified objectives
Established GAAP – Identified financial Applicable laws, Objectives (as set by
criteria reporting framework (as by regulations and the board of directors)
standard setting bodies) specific procedures
(as set by
authoritative
 bodies)
Sufficient Audit findings whether the FS Findings on degree Findings on
appropriate are in accordance with Identified of compliance assessment of
evidence / financial reporting framework performance /
outcome (GAAP) operations
Communication of Auditor’s report containing an Reports on the Recommendations or
results to opinion whether the FS are fairly degree of suggestions on how to
intended users presented in accordance with compliance with improve operations
identified financial reporting applicable laws,
framework (GAAP) regulations or
specific procedures
Users of audit Different groups for different Authoritative bodies Management of the
report purposes; wide variety of users that sets down the entity
(both internal and external regulations, rules
users) and procedures
Type of auditor Independent / external auditors Government Internal auditors
performing the – practitioners auditors
audit