2: Fundamentals of Auditing

Auditing

is an independent, systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events.

Auditing

Its primary purpose is to ascertain the degree of correspondence between those assertions and established criteria (such as accounting standards, laws, or regulations) and to communicate the results to intended users.

Auditing

provides credibility to financial information by ensuring that what is presented by management is free from material misstatement, whether due to fraud or error.

Accounting

involves recording, classifying, and summarizing financial transactions.

Auditing

involves verifying, evaluating, and expressing an opinion on the fairness of the financial information prepared by accountants.

Accounting

Process of identifying, measuring, recording, classifying, summarizing, and communicating financial transactions to produce financial statements.

Auditing

Independent examination of financial statements and records to express an opinion on whether they present a true and fair view.

Accounting

• Objective: To prepare and present financial information about an entity’s financial position and performance

• Nature of Work: Involves recording and reporting of financial data

• Timing: Performed on a continuous, day-to-day basis throughout the accounting period.

• Focus: Focuses on current financial transactions and preparation of statements.

• Dependence: Independent of auditing.

Auditing

• Objective: To verify the reliability, accuracy, and fairness of the financial information prepared by accountants

• Nature of Work: Involves verification, evaluation, and opinion on financial data

• Timing: Performed after accounting work is completed (periodically, e.g.,

  annually, quarterly).

• Focus: Focuses on checking past records and validating the correctness of financial statements.

• Dependence: Dependent on accounting records as the subject matter of examination.

Accounting

• End Product: Produces financial statements (Balance Sheet, Income Statement, Cash Flow Statement, etc.).

• Responsibility: Responsibility of management/accountants who maintain books of accounts.

• Standards Applied: Governed by Accounting Standards (e.g., IFRS, PFRS).

• Skills Required: Requires knowledge of bookkeeping, accounting principles, and financial reporting.

• Legal Requirement: Not always legally required (depends on entity’s needs).

Auditing

• End Product: Produces an audit report expressing an independent opinion.

• Responsibility: Responsibility of independent auditors who examine management’s financial reports.

• Standards Applied: Governed by Auditing Standards (e.g., ISAs).

• Skills Required: Requires knowledge of auditing techniques, internal controls, risk assessment, and professional skepticism.

• Legal Requirement: Statutory audit is mandatory for certain organizations (e.g., corporations, banks, public entities).

Key Elements of Auditing

1. Systematic and Independent Process

2. Obtaining and evaluating evidence

3. Assertions about economic actions and events

4. Degree of correspondence between those assertions and established criteria

5. Expression of Opinion and Communication of Results

Systematic Process

Auditing is not done randomly it follows a structured methodology based on professional standards (e.g., ISAs). Steps include planning, risk assessment, evidence-gathering, evaluation, and reporting.

Independent Process

Independence is the backbone of auditing. Auditors must be free from bias, conflicts of interest, and undue influence. Independence enhances credibility of the audit opinion. Without independence, an audit loses its value.

Independence of mind (actual independence), Independence in appearance (perceived independence)

2 Aspects of Independence

Independence of mind (actual independence)

ability to express a conclusion without being affected by outside pressures.

Independence in appearance (perceived independence)

ensuring that stakeholders see the auditor as impartial and objective.

Obtaining and evaluating evidence

Auditing involves a critical and detailed examination, not just casual checking. The scope includes:

• Financial Statements (balance sheet, income statement, cash flow statement, notes).

• Supporting records (journals, ledgers, vouchers, contracts, invoices).

• Disclosures (accounting policies, related party transactions, contingent liabilities).

Sufficient and appropriate audit evidence

Auditors form their opinion based on ____________________, not assumptions.

Evidences

It can be:

• Physical (inspection, observation, asset count).

• Documentary (invoices, contracts, board minutes).

• Analytical (ratio analysis, trend analysis).

• Testimonial (management representations, confirmations from third parties).

Evidence

• provides the foundation for the auditor’s opinion, ensuring reliability and defensibility.

• It allows the auditor to determine the support for assertions or representations.

Assertion

is a positive statement about an action, event, condition, or performance over a specified period of time.

Assertion

assertion is a claim or representation—either explicit or implicit—made by management about the recognition, measurement, presentation, and disclosure of items in the financial statements.

Types of Assertions: Assertions about Classes of Transactions and Events (Income Statement side)

1. Occurrence

2. Completeness

3. Accuracy

4. Cut-off

5. Classification

6. Presentation and Disclosure

Types of Assertions: Assertions about Account Balances (Statement of Financial Position side)

1. Existence

2. Rights and Obligations

3. Completeness

4. Valuation and Allocation

5. Presentation and Disclosure

Occurrence

Transactions recorded actually happened and pertain to the entity. Example: Recorded sales actually occurred.

Completeness

All transactions that should have been recorded are included. Example: No sales revenue has been omitted.

Accuracy

Transactions are recorded at the correct amounts. Example: Sales invoices match the amounts posted in the ledger.

Cut-off

Transactions are recorded in the correct accounting period. Example: December sales are not recorded in January.

Classification

Transactions are properly classified in the accounts. Example: Repairs are not wrongly classified as capital expenditures.

Presentation and Disclosure

Transactions are properly presented and disclosed in the financial statements.

Existence

Assets, liabilities, and equity balances actually exist. Example: The inventory shown in the books physically exists.

Rights and Obligations

The entity holds rights to assets and owes the liabilities. Example: The company has legal ownership of the building recorded.

Completeness

All assets, liabilities, and equity balances that should be recorded are included. Example: No liabilities are omitted from the balance sheet.

Valuation and Allocation

Balances are recorded at appropriate amounts and properly adjusted. Example: Accounts receivable are shown net of doubtful debts.

Presentation and Disclosure

Balances are properly presented and disclosed in the financial statements.

Degree of correspondence between those assertions and established criteria

This refers to how well management’s assertions match the established criteria. The auditor’s task is to assess whether there is reasonable alignment (reasonable assurance) between: 1. What management says (assertions), and 2. What the criteria require.

Criteria

• are the standards or rules against which assertions are evaluated.

• Example

  • Financial Reporting Standards (IFRS, PFRS).

  • Regulatory requirements (SEC, BIR in the Philippines).

  • Contracts or laws (for compliance audits).

Express an independent opinion

The ultimate goal of auditing is to _______________ on whether the financial statements presents fairly, in all material respects, the financial performance and position of the entity and are prepared in accordance with applicable financial reporting frameworks.

Opinions

• Unmodified (clean opinion)

• Qualified Opinion (modified opinion)

• Adverse Opinion

• Disclaimer of Opinion

Unmodified (clean opinion)

FS are free from material misstatement.

Qualified Opinion (modified opinion)

FS are fairly presented, except for certain issues.

Adverse Opinion

FS do not present a true and fair view.

Disclaimer of Opinion

auditor cannot form an opinion due to insufficient evidence.

Auditor’s Report

The report must be:

• Clear and understandable to intended users.

• Transparent in highlighting any significant findings.

• Compliant with standards (ISA 700, 705, 706).

Communication of audit

results to management and interested third parties completes the audit process.

Communication of audit

generally follows a prescribed format by clearly outlining the nature of the work performed and the conclusions reached.

The audit adds value if the auditor

• Has expertise in both obtaining and evaluating evidence regarding the financial statements and the economic assertions embodied in the financial statements.

• Is independent of management and the third-parties, and can thus provide an objective opinion on the fairness of financial statements.

Financial Statement Audit, Compliance Audit, Operational/Performance Audit, Forensic Audit

Types of Auditing Based on Nature of Work

Financial Statement Audit

focuses on expressing an opinion on the fairness of financial statements.

Financial Statement Audit

An independent examination of an entity’s financial statements with the objective of expressing an opinion on whether they are prepared, in all material respects, in accordance with an applicable financial reporting framework (e.g., IFRS, PFRS).

Financial Statement Audit

• Purpose: To provide reasonable assurance that the financial statements are free from material misstatement due to fraud or error.

• Key Features:

  • Most common and widely required audit.

  • Covers income statement, financial position, cash flows, and disclosures.

  • Required by law for corporations, banks, and government-owned entities.

Financial Statement Audit

Example: An external auditor examines a listed company’s 2024 financial statements to ensure compliance with PFRS before submission to the SEC.

Compliance Audit

ensures that the entity adheres to laws, rules, and contractual obligations. Examination to determine whether an entity is adhering to laws, regulations, policies, contracts, or agreements.

Compliance Audit

• Purpose: To provide assurance that the organization has complied with specific rules and obligations.

• Key Features:

  • Focuses on compliance, not necessarily financial reporting.

  • Often performed in regulated industries or by government agencies.

  • May be combined with financial audits.

Compliance Audit

Example: A BIR tax audit in the Philippines to check if a company correctly complied with tax laws; or an audit of a university to verify compliance with scholarship grant conditions.

Operational/Performance Audit

evaluates efficiency, effectiveness, and economy of operations.

Operational/Performance Audit

A review of any part of an organization’s operating procedures and methods to evaluate efficiency, effectiveness, and economy of resource utilization.

Operational/Performance Audit

• Purpose: To assess whether operations are carried out in line with organizational objectives and whether resources are being used optimally.

• Key Features:

  • Broader in scope than financial audits.

  • Examines not only compliance but also performance and management practices.

  • Often performed by internal auditors.

Operational/Performance Audit

Example: A government agency audit of a road construction project to determine if funds were used economically and whether the project met quality standards.

Forensic Audit

investigates fraud and financial irregularities.

Forensic Audit

A specialized audit focused on detecting, investigating, and documenting fraud, financial crimes, or irregularities for use in legal proceedings.

Forensic Audit

• Purpose: To uncover evidence of fraud or misappropriation and support litigation or prosecution.

• Key Features:

  1. Involves deep investigation and analysis of unusual patterns.

  2. Requires expertise in law, investigation, and accounting.

  3. May include tracing money laundering, embezzlement, or corruption.

Forensic Audit

Example: Investigation of a company’s suspicious cash withdrawals and shell transactions used to siphon funds.

External Audit, Internal Audit, Government Audit, Specialized/Other Audits (by Third-Party Professionals)

Types of Auditing Based on Auditor

External Audit

conducted by independent auditors outside the organization.

External Audit

An independent examination of an entity’s financial statements by auditors who are not employees of the entity but are appointed by shareholders, regulators, or stakeholders.

External Audit

• Objective: To provide an independent audit opinion on whether the financial statements present a true and fair view in accordance with applicable financial reporting standards (e.g., IFRS, PFRS).

• Key Features:

  • Conducted by Certified Public Accountants (CPAs) in public practice.

  • Ensures objectivity and independence from management.

  • Legally required for corporations, public entities, and certain industries.

External Audit

Example: A listed company in the Philippines hires an external auditor to review its 2024 annual financial statements before submission to the SEC and PSE.

Internal Audit

performed by internal auditors as part of management’s control framework.

Internal Audit

An independent and objective assurance and consulting activity performed by an organization’s own employees (internal auditors) to improve the effectiveness of governance, risk management, and internal control processes.

Internal Audit

• Objective: To help management achieve organizational goals by identifying weaknesses, inefficiencies, and risks.

• Key Features:

  • Focuses on efficiency, compliance, and risk management, not just financial accuracy.

  • Reports to the Audit Committee or Board of Directors, not to management alone.

  • Broader in scope (includes operational, compliance, IT, and performance audits).

Internal Audit

Example: The internal audit department of a bank evaluates whether loan approvals comply with credit risk policies and regulatory guidelines.

Government Audit

carried out by state auditing bodies (e.g., Commission on Audit in the Philippines).

Government Audit

An audit performed by government auditors to ensure that public funds are properly collected, managed, and spent in accordance with laws and regulations.

Government Audit

• Objective: To promote accountability, transparency, and proper use of taxpayers’ money.

• Key Features:

  • In the Philippines, performed by the Commission on Audit (COA), an independent constitutional body.

  • Focuses on financial, compliance, and performance audits of government agencies, LGUs, and government-owned or controlled corporations (GOCCs).

Government Audit

Example: COA auditing the Department of Public Works and Highways budget utilization for flood control projects to ensure that funds were used lawfully and efficiently.

Scope of Government Audit

1. Financial and compliance audit

2. Economy and efficiency audit

3. Programs results

Financial and compliance audit

determines whether financial operations are properly conducted, the financial reports of an audited entity are presented fairly, and the entity has complied with applicable laws and regulations.

Economy and efficiency audit

determines whether the entity is managing and utilizing its resources economically and efficiently, the causes of inefficiencies or uneconomical practices and whether the entity has complied with laws and regulations concerning matters of economy and efficiency.

Programs results

determines if the desired results and benefits are being achieved, if the objectives established by the legislative or other authorizing body are being met and if the agency has considered alternatives which might yield results at a lower cost.

Specialized/Other Audits (by Third-Party Professionals)

Some audits may be conducted by professionals other than CPAs, depending on the scope. These are usually supplemental audits, sometimes requested by regulators, boards, or courts.

Environmental Audit

Performed by environmental specialists to assess compliance with environmental laws.

IT/Systems Audit

Conducted by IT auditors to evaluate data security and system reliability.

Forensic Audit

Performed by forensic accountants or investigative auditors to uncover fraud.

Primary Objective

To express an independent opinion on whether the financial statements present a true and fair view (presents fairly in all material respect) of an entity’s financial position, performance, and cash flows in accordance with applicable financial reporting standards.

Secondary Objectives

• Detection and prevention of frauds and errors.

• Assurance to stakeholders that management is accountable.

• Promoting good governance and transparency.

• Enhancing the reliability of financial information for decision-making.

PSA 200 Revised and Redrafted, “Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with PSAs”

sets out the overall objective of the independent auditor, and explains the nature and scope of an audit designed to enable the independent auditor to meet those objectives.

Overall Objectives of 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, thereby enabling 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

• To report on the financial statements, and communicate as required by the PSAs, in accordance with the auditor’s findings.

Fair presentation framework

is used to refer to a financial reporting framework that requires compliance with the requirements of the framework

• Acknowledges explicitly or implicitly that, to achieve fair presentation of the financial statements, it may be necessary for management to provide disclosures beyond those specifically required by the framework.

• Acknowledges explicitly that it may be necessary for management to depart from a requirement of the framework to achieve fair presentation of the financial statements. Such departures are expected to be necessary only in extreme rare circumstances.

Code of Professional Ethics for Certified Public Accountants

The auditor should comply with the “_________________________” promulgated by the Board of Accountancy and approved by Professional Regulations Commission.

Professional competence and due care, Integrity, Confidentiality, Professional behavior, Objectivity

Part A of the Code of Professional Ethics for Certified Public Accountants sets out the fundamental ethical principles that all professional accountants are required to observe, including: __________, __________, ____________, __________, __________

Philippine Standards on Auditing

The auditor should conduct an audit in accordance with ____________________

Professional skepticism

The auditor should plan and perform the audit with an attitude of ____________________ recognizing that circumstances may exist which may cause the financial statements to be materially misstated.

Elements of the Theoretical Framework of Auditing (1 to 4)

• The data to be audited can be verified.

• Short-term conflicts may exist between managers who prepare data and auditors who examine the data.

• Auditors must have independence and freedom from managerial constraint.

• Effective internal control system reduces the possibility of errors and fraud affecting the financial statements.

Elements of the Theoretical Framework of Auditing (5 to 7)

• Consistent application of generally accepted accounting principles (GAAP) or financial reporting standards results in fair presentation of financial statements.

• What was held true in the past will continue to hold true in the future in the absence of known conditions to the contrary.

• An audit benefits the public.

Economic Benefits of a Financial Statement Audit

1. Access to Capital Markets

2. Lower Cost of Capital

3. Deterrent to Inefficiency and Fraud

4. Control and Operational Improvements

Overview of the Audit Process & Auditor’s Responsibilities

• Audit Planning & Engagement Acceptance

• Internal Control Evaluation & Risk Assessment

• Substantive Testing (Audit Evidence Gathering)

• Audit Completion & Forming an Opinion

• Reporting

Audit Planning & Engagement Acceptance

• Objective: Establish the foundation for an effective and efficient audit.

• Key Activities:

  • Engagement acceptance

  • Engagement letter

  • Understanding the entity

  • Risk assessment

  • Developing audit strategy and plan:

Audit Planning & Engagement Acceptance

Auditor’s Responsibilities:

• Ensure independence and compliance with the Code of Ethics.

• Understand client’s business and environment.

• Assess audit risks and materiality.

• Design an overall audit plan and detailed audit program.