Chapter 2 — Introduction to Audit Services and Financial Statement Audit CHAPTER 2 INTRODUCTION TO AUDIT SERVICES AND FINANCIAL STATEMENT AUDIT eee Chapter Overview and Objectives: ee This chapter discusses the fundamental principles of audit services. At the end of this chapter, readers should be able to discuss 1. The fundamental principles of auditing services 2. The different types of audit a. As to nature of assertions b. As to types of auditors 3. The financial statements audit a. The definition and key concepts b. The objective of FS audit c. The general principles of an FS audit d. The theoretical framework of FS audit e. The elements of FS audit f. The assurance provided by FS audit g. The demand for FS audit h. The value of FS audit EE Relevant references: PSA 120 - Framework of Philippine Standards on Auditing PSA 200 - Overall Objectives of the Independent Auditor and the Conduct of an ‘Audit in accordance with Philippine Standards on Auditing Page 37Chapter 2 — Introduction to Audit Services and Financial Statement Audit INTRODUCTION TO AUDIT SERVICES ; ; in taeant years, audit has maintained as the flagship service Tendereg professional accountants not only in the Philippines but across the Blobe, This Primarily due to public's perception of the auditors responsibilty in ensur market integrity. Credible and reliable reporting together with an effective audit function fortifies confidence in the entire financial system. As mentioned in the previous chapter, in business, reliable information becomes an essential aspect of decision-making. However, in most ‘instances, this information is prepared and provided by other persons Or organizations, whose interests contradict with those of the users of the information. This situation had created the need for an objective evaluation of the information by an independent professional accountant. Such service is widely known as audit, The primary objective of an audit function is to improve the quality of or lend Credibility to the information prepared by a particular entity. This objective is met through expression of an opinion that provides users with reasonable assurance that the subject matter of the audit service is free from material misstatements, Such opinion is then communicated to the users through the audit report, Attachment of the audit report to the subject matter of an audit engagement means that the information can be relied upon by the users. AUDITING Definition As defined by the American Accounting Association, an audit is a systematic Process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between these assertions and established criteria and communicating the results thereof. The following are key concepts obtained from the definition of an audit: a. Asystematic process An audit is composed of logical, ordered and structured series of steps and procedures. In order to meet the objectives of an audit engagement, one must follow a sequence of procedures. b. It involves objectively Obtaining and evaluating evidence about assertions, Audit evidence is the informati the conclusions on which thea Aim... Believe... ClChapter 2 — Introduction to Audit Services and Financial Statement Audit Furthermore, in obtaining and evaluating evidence about assertions, auditors shall observe the principle of objectivity. It imposes an obligation on all CPAs not to compromise their professional or business judgment because of bias, conflict of interest or the undue influence of others. c. It ascertains the degree of correspondence between assertions and established criteria In order to meet the objective of an audit engagement, an auditor must be able to express an opinion. To do that, auditor uses criteria (standard or benchmark) to verify the validity of the assertions prepared and presented by the audit client. d. It includes communication of the results to interested users After obtaining sufficient appropriate evidence, the auditor prepares a report which contains an overall opinion. Such report is then communicated to interested users. This is considered to be the most important characteristics of an audit. Failure to communicate the results will render the audit engagement useless. Types of audit Audit may be classified in number of ways such as legislative controls, objectives, risks involved, subject matter, and affiliation of the auditor performing the engagement with the audit client. However, in compliance with the syllabus in Auditing of the Philippine CPA Licensure Examination, we will be limiting the discussion to types of audit as to (1) nature of assertion or data and (2) types of auditor. 1. Nature of assertion or data a. Financial statement (FS) audit > a type of audit pertaining to the gathering of evidence on the assertions embodied in the financial statements of an entity to determine whether the financial statements are fairly presented in accordance with generally accepted accounting principles or another comprehensive and authoritative financial reporting framework > the results of this type of audit is for the use of external users b. Operational audit > a type of audit involving a systematic review of the organization's activities in relation to specified objectives for the purpose of assessing the performance, identifying opportunities for improvement, and developing recommendations for improvement or further action > also known as management audit or performance audit Aim... Believe... Clait Page 39Chapter 2 — Introduction to Audit Services and Financial Statement Audit Compliance audit c. > type of audit involving the review of organizations procedures to determine whether the organization has adhered to specific procedures and rules set down by some higher authority 2. Types of auditor External audit Al b. > > > a type of audit engagement performed by independent or external CPAs on a contractual basis (rendered by CPAs engaged in public practice) it emphasizes that the auditor must not be a member of the entity being audited 3 can provide financial statements, operational and compliance audits to private entities Internal audit > > > an independent appraisal function established with an organization to examine and evaluate its activities as a service to organizations its primary objective is to assist all members of the organization in the effective discharge of their responsibilities can perform operational and compliance audits (for internal use) but not financial statements audit because of independence requirements To establish the independence of internal auditors, they are required to be independent of the different operating units to be audited. In addition, to emphasize their independence, they shall report to the audit committee, any equivalent supervisory board, or board of directors, Below is a sample organizational chart considered as one of the best Practices adopted by different entities to emphasize the independence of internal auditors. Operating Departments im... Believe... Claim.. Page 40Chapter 2 — Introduction to Audit Services and Financial Statement Audit ©. Government audit > the primary objective of this type of audit is to determine whether government funds are being handled properly and in compliance with existing laws and whether programs are being conducted efficiently and effectively > can provide financial statements, operational and compliance audits to public entities including government owned and controlled corporations (GOCCs) Comparison of the different types of audit ia aici Bi it. | OPerational Audit | Compliance Audit Assertions | Financial Operations are | Activities complied statements are conducted with applicable fairly presented | efficiently and _| laws, rules, effectively regulations, contracts or management policy Suitable | GAAP or any other | Objective set by | Applicable Criteria —_| identified financial | the management _| contracts, rules, reporting regulations, laws framework or management policy Report ‘An opinion whether | Report on Degree of the financial efficiency and compliance with statements are effectiveness, applicable laws, fairly presented in | This will also rules, regulations, conformity with an | include or management identified financial_| recommendations | policy. reporting to improve framework operations. Generally | External auditors | Internal auditors | Government performed auditors by IMPORTANT NOTES: 1. Both financial statements and compliance audits use established criteria, whereas, internal audit uses specifically developed criteria. 2. Both financial statements and compliance audits generally cater external users, whereas, internal audit assists the members of the organization in the effective discharge of their responsibilities. Aim... Believe... . Claim. Page 41i id Financial Statement Audit ction to Audit Services an‘ Introductic generally part of the organization, thus, creatip : they do rictirendep financiy Chapter 2- 3. Internal auditors are u employer-employee relationship. With this, statements audit. FINANCIAL STATEMENTS AUDIT Financial statements audit remains to be the most common type of aul, rendered by CPAs. It involves the examination of the financial statements of particular entity to determine whether or not they are presented in Accordance with a specified criterion. Financial statements are ordinarily prepared and presented annually ang ate directed toward the common information needs of a wide range ot users. Ma of those users rely on the financial statements as their major source of information because they do not have the power to obtain additional information to meet their specific information needs. Thus, financial statements need to be prepared in accordance with one, or a combination of: a. Accounting standards generally accepted in the Philippines (Philipping Financial Reporting Standards — PFRSs); b. Internationally accepted accounting standards (International Financial Reporting Standards — IFRSs); and ¢. Another authoritative and comprehensive financial reporting framework which has been designed for use in financial reporting and is identified in the financial statements. Objective of financial statement audit PSA 120 dictates that the objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with generally accepted ‘accounting principles or other identified financial reporting framework. PSA 200 (Revised and Redrafted) further supported the above objective by stating that “in conducting an audit of financial statements, the overall objectives of the auditor are: a. 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; and b. To report on the financial statements, and communicate as required by the PSAs, in accordance with the auditor's findings. Aim... Believe... Claim... Page 2Chapter 2 ~ introduction to Audit Services and Financial Statement Audit From these statements, the following key phrases were emphasized: > Expression of an opinion. The ultimate objective of a financial statements audit is for the auditor to express an opinion regarding the fairness of Preparation and presentation of the financial statements. In forming the audit opinion, the auditor obtains sufficient appropriate audit evidence to be able to draw conclusions on which to base that opinion. > Financial statements are taken as a whole. The opinion expressed by the auditor applies to the complete set of financial statements prepared and presented by the entity. > Reasonable assurance. Though the auditor’s opinion enhances the credibility of the financial statements, user cannot assume that the opinion is a guarantee or an assurance that the presented information is free from any misstatements. > In all material respects. In rendering financial statement audit, auditor is required to adhere to the requirements of Philippine Standards on Auditing. This set of standards applies only to material matters. > Presence of criteria. The financial statements shall be prepared in accordance with an applicable financial reporting framework. > Communication of the results. Again, the ultimate objective of an audit engagement is the communication of the results to various interested users. General Principles of an FS Audit Whenever FS audit are conducted, the following principles must be observed (CPP PJ SAE): 1. The auditor should comply with relevant ethical requirements (Code of Ethics). 2. The auditor should conduct an audit in accordance with Philippine Standards on Auditing. 3. The auditor should plan and perform the audit with an attitude of Professional skepticism. 4. All throughout the audit engagement, the auditor should exercise Professional Judgment. 5, The auditor should obtain Sufficient Appropriate audit Evidence. Page 43, Aim... Believe.i itement it Chapter 2 - Introduction to Audit Services and Financial Sta Audit Theoretical Framework of FS Audit conceptual structure for audit Efforts had been made to formally create a © Id include conditions "= financial statements. The conceptual a ea tavotlie Fedult ONS that should exist whenever FS Audit is conducted to ha . The following are some of the assumptions, postulates or concepts includeg j, this conceptual structure (VIC BPI): 1. All financial data are Verifiable through exi and records i ‘ An audit involves the obtaining and evaluating evidence about assertion, Which should be capable of being verified. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithfy, representation. istence of supporting documents 2. Auditor should always maintain Independence with respect to the financial statements under audit The value and credibility of the auditor’s report lies in the auditors independence. If the auditor is not independent from both of the client and users, the report is of little or no value. 3. No long-term Conflict between the auditor and the client’s management Management may be motivated to present financial information in a manner favorable to them even if it would mean violation of the criterion used, This scenario may create disagreements or conflicts between the auditor and client's management since auditors are expected to attest to data that is fairly presented. Such conflicts may exist temporarily or on a short-term basis but should be resolved prior to the completion of the audit. The auditor shall be satisfied on the resolution of the said conflicts; otherwise, it could lead to the modification of auditor’s report. 4. Audit Benefits the Public Financial statement audit shall have the objective of increasing the quality of the information or lending credibility to the items presented in the financial statements which will assist its different users in making economic decisions. This can be done by providing assurance that the financial statements audited are free from material misstatements, 5. Effective Internal control system reduces the Possibility of errors and fravd Information presented on the financial statements is more reliable when the internal controls designed and implemented by the entity are effective: Aim... Believe... Claim... page= Introduction to Audit Services and Financi: hire tomers of FSaudit incial Statement Audit ‘An audit service is just a composition of a much wider asst elements of the latter, as discussed in Chapter 1, apply tog recall, the following are the elements of an assurance applied in an audit of financial statements. uraNce services. Th . The hat of the former. To Service and how it is IFRS/GAAP/ Sufficient Others a Audit Risk Guitable Appropriate (Cost-Benefit Constraint Criteria) Evidence Professional Skepticism A. Athree-party relationship The table below summarizes the parties, with their respective responsibilities, involved in a financial statement audit. Parties Responsibilities | Auditor (represents the | ~formation and expression of an | practitioner) opinion on the financial statements | ¥ compliance with ethical | requirements (e.g. independence | and competence) | determining the scope of audit in accordance with PSAs and other applicable regulations of professional bodies Management and those | ~ preparation and presentation of the | charged with governance | _ financial statements in accordance | (represents the responsible | with the applicable _ financial Party) reporting framework Y prevention and detection of fraud and error : Yadoption and implementation of adequate accounting and internal control systems i Users of FS (represent the | use the audit report which contsins [intended users) the opinion expressed by the auditor ss