Chapter 3 2.

2 Misappropriation of assets- theft of an

entity's assets committed by the entity's
Auditor’s Responsibility
employees
Misstatements may emanate from:
Aka: "employee fraud " because it is often
1. ERROR- unintentional misstatements in the perpetrated by employees in relatively small and
financial statements, including the omission of an immaterial amounts.
amount or a disclosure, such as:
Often accompanied by false or misleading records
 Mathematical or clerical mistakes in the or documents in order to conceal the fact that the
underlying records and accounting data; assets are missing.
 Incorrect accounting estimates arising This may include:
from oversight or misinterpretation of
facts; or  Embezzling receipts;
 Mistakes in the application of accounting  Stealing entity's assets such as cash,
policies. marketable securities, and inventory; or
 Lapping of accounts receivable
2. FRAUD- intentional act by one or more
individuals among management, those charged Fraud involves:
with governance, employees, or third parties,
1. motivation to commit the act
involving the use of deception to obtain an unjust
2. perceived opportunity to do so
or illegal advantage.
NOTE: Auditor's responsibility for the
 auditor is primarily concerned with
detection of fraud and error is essentially the
fraudulent acts that cause material
same.
misstatements in the financial
statements. Responsibility of Management and Those
Charged with Governance
Types of Fraud
PSA 240 requires:
2.1 Fraudulent financial reporting- intentional
misstatements or omissions of amounts or Management to establish a control environment
disclosures in the financial statements to deceive and to. implement internal control policies and
financial statement users. procedures designed to ensure, among others, the
detection and prevention of fraud and error.
Aka: management fraud because it usually
involves members of management or those Individuals charged with governance of an
charged with governance. entity to ensure the integrity of an entity's
accounting and financial reporting systems and
Involves:
that appropriate controls are in place.
 Manipulation, falsification or alteration of
Auditor's Responsibility- the auditor is not and
records or documents;
cannot be held responsible for the prevention of
 Misrepresentation in or intentional
fraud and error.
omission of the effects of transactions
from records or documents; Planning Phase
 Recording of transactions without
substance; or 1. When planning an audit, the auditor should
make inquiries of management about the
 Intentional misapplication of accounting
possibility of misstatements due to fraud and
policies
error.
Such inquiries may include: consider whether such a misstatement resulted
from a fraud or an error:
 Management's assessment of risks due to
fraud; Errors will only result to an adjustment of
 Controls established to address the risks; financial statements
or
Fraud may have other implications on an audit. If
 Any material error or fraud that has
not material, the auditor:
affected the entity or suspected fraud that
the entity is investigating.  Report the matter to the appropriate
level of management at least one level
Auditor should also inquire of those individuals
above those involved; and
in charge of governance to seek their views on
 Be satisfied that the fraud has no other
the adequacy of accounting and internal control
implications for other aspects of the audit
systems in place, the risk of fraud and error, and
or that those implications have been
the integrity of management.
adequately considered.
2. The auditor should assess the risk at both
Material-fraud:
financial statements level and assertions that
fraud or error may cause the financial statements  Consider implication for other aspects
to contain material misstatements. of the audit (reliability of
representations)
Fraud risk factors- events or conditions that
 Discuss the matter and the approach to
provide an opportunity, a motive or a means to
further investigation with an appropriate
commit fraud, or indicate that fraud may already
level
have occurred.
 Attempt to obtain evidence to
Auditor's response and professional judgments determine whether a material fraud in
about the increased risk of material fact exists and, if so, their effect
misstatements:  Suggest that the client consult with legal
counsel about questions of law.
 heightened level of professional
skepticism; Completion Phase
 knowledge, skill, and ability of
5. The auditor should obtain a written
personnel assigned significant
representation from the client's management that:
responsibilities are commensurate with
the auditor's assessment of risk;  management acknowledges its
 design more effective audit procedures responsibility for the implementation
or may increase the extent of the and operations of accounting and
procedures to be performed. internal control systems that are
designed to prevent and detect fraud and
Testing Phase
error
3. During the course of the audit, the auditor may  believes the effects of those uncorrected
encounter circumstances that may indicate the financial statement misstatements
possibility of fraud or error. In these aggregated by the auditor during the
circumstances; the auditor should perform audit are immaterial, both individually
procedures necessary to determine whether and in the aggregate
material misstatements exist.  has disclosed to the auditor all
significant facts relating to any frauds
4. When material misstatement in the financial
or suspected frauds
statements are identified, the auditor should
  has disclosed to the auditor the results of  Inquire management for policies and
its assessment of the risk that the procedures
financial statements may be materially  Inquire management for laws and
misstated as a result of fraud regulations that may have effect in the
operations of the entity
Reporting Phase
 Discuss with management the policies
6. Material error or fraud exists; the auditor and procedures adopted for litigation
should request the management to revise the claims and assessments
financial statements. Otherwise, the auditor will  Discus legal and regulatory framework
express a qualified or adverse opinion. with auditors of subsidiaries in other
countries
7. If the auditor is unable to evaluate the effect of
fraud on the financial statements because of a 2. Auditor should design procedures to help
limitation on the scope of the auditor's identify instances of noncompliance with laws
examination, the auditor should either qualify or and regulations
disclaim opinion on the financial statements. 3. Auditor should also design audit procedures to
obtain sufficient appropriate audit evidence
3. NONCOMPLIANCE WITH LAWS AND about compliance with those laws and regulations
REGULATIONS- acts of omission or commission
by the entity being audited, either intentional or  Reading minutes of meetings
unintentional, which are contrary to the  Inquire management if entity is in
prevailing laws or regulations. compliance
Common examples include:  Inspecting correspondence with the
relevant licensing or regulatory
 Tax evasion; authorities
 Violation of environmental protection
laws; and Testing Phase
 Inside trading of securities. 4. When the auditor becomes aware of possible
instance of noncompliance, the auditor should
Responsibility of Management: oversight of
obtain an understanding of the nature of the
those charged with governance, to ensure that the
act and the circumstances in which it has
entity's operations are conducted in accordance
occurred, and sufficient other information to
with laws and regulations; responsible for the
evaluate the possible effect on the financial
prevention and detection of noncompliance
statements.
Auditor's Responsibility: recognize that
noncompliance by the entity with laws and  Discontinuation of operations and
regulations may materially affect the financial litigation
statements.  Require disclose
 So serious as to call into question the fair
Planning Phase presentation of the FS
1. Auditor should obtain a general 5. When the auditor believes there may be
understanding of the legal and regulatory noncompliance, the auditor should document the
framework applicable to the entity and the findings, discuss them with management, and
industry and how the entity is complying with that consider the implication on other aspects of the
framework. audit.

 Existing knowledge
Completion Phase Chapter 4

6. The auditor should obtain written THE AUDIT PROCESS- Accepting an

representations that management has disclosed Engagement
to the auditor all known actual or possible
General Approach to Auditing Financial
noncompliance with laws and regulations that
Statements
could materially affect the financial statements.

Reporting Phase

7. When the auditor believes that there is

noncompliance with laws and regulations that
materially affects the financial statements, the
auditor should request the management to
revise the financial statements. Otherwise, the
auditor will have to express either qualified or
adverse opinion.

8. If a scope limitation has precluded the auditor

from obtaining sufficient appropriate evidence to
evaluate the effect of noncompliance with laws
and regulations, the auditor should express a
qualified opinion or a disclaimer of opinion

Fraud risk factors that relate to misstatements

resulting from fraudulent financial reporting: Financial statement assertions can be
classified into:
1. Management's Characteristics and
Influence over the Control 1. Rights and obligation
Environment. That the entity has rights over the reported
2. Industry Conditions. assets and that it has valid obligation to settle
3. Operating Characteristics and the reported liabilities.
Financial Stability
2. Valuation and allocation
Fraud risk factors that relate to misstatements
resulting from misappropriation of assets: That assets and liabilities are properly valued
and that revenues and expenses are properly
1. Susceptibility of Assets to measured. A typical audit procedure to. test this
Misappropriation assertion includes recalculation of financial
2. Controls statement values such as depreciation, accrued
interest and amortized costs of financial assets
and liabilities.

3. Presentation and disclosure

That assets and liabilities are properly

classified and that disclosures in the notes to
the financial statements are adequate. In
addition, the auditor may review major contracts
such as loan agreements to identify important
information that needs to be disclosed in the notes
to the financial statements.
Testing: application of the relevant accounting
standards.

4. Existence or occurrence

That assets and liabilities exist as of the financial

statement date and that revenues and expenses
occurred during the reporting period.

concerned with the potential overstatement of

accounts

Testing: physical examination or ocular

PSA 500: Assertions about classes of
inspection of the asset or external confirmation
transactions and events for the period under
5. Completeness audit:

That all items that should be reported in the 1. Occurrence - transactions and events
financial statements are so included. that have been recorded have occurred
and pertain to the entity.
Testing: source documents such as sales invoice 2. Completeness- all transactions and
and determine if it is recorded in the sales journal. events that should have been recorded
concerned with the potential understatement of have been recorded.
accounts 3. Accuracy- amounts and other data
relating to recorded transactions and
When the auditor traces items from the source events have been recorded appropriately.
documents to the accounting records, the auditor 4. Cutoff- transactions and events have been
is obtaining evidence that all transactions (as recorded in the correct accounting period.
represented by the source documents) have been 5. Classification- transactions and events
completely recorded. On the other hand, when have been recorded in the proper
the auditor works from the accounting records accounts.
back to the supporting documents, the auditor is
obtaining evidence that the recorded items exist Assertions about account balances at the period
and are supported by documents. end:

Tracing forward: from the source documents to 1. Existence- assets, liabilities, and equity
the accounting records is performed primarily to interests exist.
test for understatement. This procedure will 2. Rights and obligations- the entity holds
satisfy the completeness assertion. or controls the rights to assets, and
liabilities are the obligations of the entity.
Tracing backwards or vouching: performed 3. Completeness- all assets, liabilities, and
primarily in order to satisfy the equity interests that should have been
existence/occurrence assertion. It is performed recorded are in fact recorded.
to test for possible overstatement of an account. 4. Valuation and allocation- assets,
liabilities, and equity interests are
included in the financial statements.at
appropriate amounts and any resulting
valuation or allocation adjustments are
appropriately recorded.
Assertions about presentation and disclosure: 5. Computation-consists of checking the
arithmetical accuracy of source
1. Occurrence and rights & obligations-
documents and accounting records or
disclosed events, transactions, and other
performing independent calculations.
matters have occurred and pertain to the
6. Analytical Procedures-consist of the
entity.
analysis of significant ratios ad trend
2. Completeness- all disclosures that
including the resulting investigation of
should have been included in the financial
fluctuations and relationships that are
statements are in fact included.
inconsistent with other relevant
3. Classification and understandability -
information or deviate from predicted
financial information is appropriately
amounts.
presented and described, and disclosures
are clearly expressed. Audit Evidence
4. Accuracy and valuation - financial and
Audit procedures are the means used by the
other information are disclosed fairly and
auditor to obtain sufficient appropriate evidence
at appropriate amounts.
Audit evidence refers to the information obtained
Audit procedures
by the auditor in arriving at the conclusions on
The objective of the audit is to determine the which the audit opinion is based; comprise source
validity of the financial statement assertions. documents and accounting records; prove or
disprove the validity of the assertions
Auditors normally develop specific audit
objectives for each of the relevant assertions. Audit Opinion
These audit objectives serve as a guide to
The results of the procedures performed and the
auditors in assessing the risks of material
audit evidence obtained are carefully evaluated to
misstatement and in designing the appropriate
arrive at the appropriate opinion about the fair
audit procedures to be performed.
presentation of the financial statements.
One basic criterion: procedures selected should
THE AUDIT PROCESS
enable the auditor to gather sufficient
appropriate evidence about the validity of an The audit process is the sequence of different
assertion. activities involved in an audit.
Some of the common audit procedures used by
the auditor to gather sufficient appropriate
evidence include:

1. Inspection- involves examining of

records, documents, or tangible assets.
2. Observation- consists of looking at a
process or procedure being performed by
others.
3. Inquiry- consists of seeking information
from knowledgeable persons inside or
outside the entity.
4. Confirmation- consists of the response to
an inquiry to corroborate information 1. Accepting an Engagement
contained in the accounting records.
Make a decision of whether to accept or reject an
audit engagement. This process requires
evaluation of the auditor's qualification as well as
the auditability of the prospective client's financial
4. Performing Substantive Tests
statements. A preliminary understanding of the
client’s business and background stage of the Substantive tests are audit procedures designed
audit. to detect material misstatements in the financial
statements.
PSA 300: "preliminary planning activities" and
would involve: The nature, timing and extent of the substantive
tests are highly dependent on the results of the
a) Performing procedures regarding the
auditor's consideration of internal control.
continuance of the client relationship
and the specific audit engagement; 5. Completing the Audit
b) Evaluating compliance with ethical
requirements, including independence; Some of the common procedures performed at
and this stage of the audit include review of
c) Establishing an understanding of the subsequent events and contingencies, assessing
terms of the engagement. the appropriateness of the use of the going
concern assumption, performing overall analytical
2. Audit Planning review procedures, and obtaining written
representations from the client's management.
Knowledge of the client's business and industry is
important because it helps the auditor in 6. Issuing a Report
understanding the transactions and events
affecting the financial statements. On the basis of audit evidence gathered and
evaluated, the auditor forms a conclusion about
The auditor's understanding of the client, the financial statements. This conclusion (in the
combined with the assessment of risk and form of an opinion) is communicated to various
materiality, should enable the auditor to develop interested users through an audit report.
an overall audit plan and a detailed approach for
the expected conduct and scope of the audit. Accepting an Engagement

3. Considering the Internal Control In making this decision, the firm should consider:
Its competence;
The stronger the internal control is, the more
assurance it provides about the reliability of the  Its independence;
accounting data and the financial statements.  Its ability to serve the client properly;
 The integrity of the prospective client's
Consideration of internal control involves management; and
obtaining understanding of the entity's internal  The adequacy of the accounting records
control systems and assessing the level of
control risk- that is, the risk that the client's Competence
internal control may not prevent or detect
Auditor should obtain a preliminary knowledge of
material misstatements in the financial
the client's business and industry to determine
statements.
whether the auditor has the degree of
Tests of controls- performed when the auditor competence required by the engagement
decides to assess control risk at less than high
Independence
level, sufficient appropriate audit evidence must
be obtained to prove that the internal control is Auditor should consider whether there are any
functioning effectively threats to the audit team's independence and
objectivity and, if so, whether adequate safeguards prospective client's
can be established. management.

Ability to serve the client properly Adequacy of the Accounting Records

An engagement should not be accepted if there are The audit of the financial statements is performed
no enough qualified personnel to perform the on the assumption that the financial statements
audit (PSA 220). In addition, there should be are verifiable. Therefore, the client's accounting
sufficient direction, supervision and review of records and documents supporting the amounts
work at all levels in order to provide' reasonable and disclosures in the financial statements must
assurance that the firm's standard of quality is be adequate enough to permit examination of the
maintained in the performance of the engagement. accounts.

Integrity of management  Retention of Existing Clients

PSA 220: conduct a background investigation of Clients should be evaluated at least once a year
the prospective client in order to minimize the or upon occurrence of major events, such as
likelihood of the association with clients whose changes in management, directors, ownership,
management lacks integrity. nature of client’s business, or other changes that
may affect the scope of the examination.
1. Making inquiries of appropriate
parties in the business community such Engagement letter
as prospective client's banker, legal
counsel or underwriter to obtain PSA 210: serves as the written contract between
information about the reputation of the the auditor and the client.
client.
 The objective of the audit of financial
2. Communicating with the predecessor
statements which is to express an opinion on
auditor. This communication allows the
successor auditor to obtain information the financial statements;
about the client that will be useful in  The management's responsibility for the fair
determining whether the engagement presentation of the financial statement;
will be accepted.  The scope of the audit;
 The forms or any reports or other
Auditor should obtain the client's communication that the auditor expects to
permission to communicate with the issue;
predecessor auditor.  The fact that because of the limitations of the
audit, there is an unavoidable risk that
Refusal of the prospective client's material misstatements may remain
management to permit this will raise undiscovered; and
serious questions as to whether the  The responsibility of the client to allow the
engagement will be accepted. auditor to have unrestricted access to
whatever records, documentation and other
 The predecessor auditor's information requested in connection with the
understanding as to the reasons audit.
for the change of auditors;
In addition, the auditor may also include the
 Any disagreement between the
following items in the engagement letter:
predecessor auditor and the
client; or  Billing arrangements;
 Any facts that might have a  Expectations of receiving management
bearing on the integrity of the representation letter;
  Arrangements concerning the
involvement of others (experts, other
auditors, internal auditors and other
client personnel); and
 Request for the client to confirm the
terms of the engagement.

Importance of the engagement letter

1. Avoid misunderstandings with respect to

the engagement; and
2. Document and confirm the auditor's
acceptance of the appointment.

Recurring audits

Auditor does not normally send new engagement

letter every year, except:

 Any indication that the client

misunderstands the objective and scope
of the audit;
 Any revised or special terms of the
engagement;
 A recent change of senior management,
board of directors or ownership;
 À significant change in the nature or size
of the client's business; or
 Legal requirements and other
government agencies pronouncements.

Audits of Components

When the auditor of a parent entity is also the

auditor of its subsidiary branch or division
(component), the auditor should consider these
whether to send a separate letter for the
component:

 Who appoints the auditor of the

component;
 Whether a separate audit report is to be
issued on the component;
 Legal requirements;
 The extent of any work performed by
other auditor;
 Degree of ownership by parent; or
 Degree of independence of the
component's management