BME 21

1ST SEMESTER

GOVERNANCE,
BUSINESS ETHICS,
RISK
MANAGEMENT,
AND INTERNAL
CONTROL
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BME 21 Prelims
 Focus of governance is short- and long-term profit to investors
 Operational risk of Enron increases because of complexity
 Internal control cannot control all the risks and events of a company
 All businesses must choose their risk appetite (level of risk a company is willing to
adapt), risk appetite will be the basis of the decisions of a company/management
 Enron wanted to keep their stock prices high
 Audit Committee – oversee financial processes, made of independent/outside
directors
 The scandals of 1990’s and 2000’s highlighted the need for good corporate
governance
 Governance, ethics, risk management, internal control (GERI)
 The business model of Enron is a hard asset
 The SPE’s of Enron are separate entities, the assets will be diverted to the company in
exchange for a non-cash asset
 Scandals are result of no consideration of risk appetite of the company, lack of good
governance, unethical directors
 Management runs the company, management and governance is different in different
companies
 Management (agents), shareholders (principal)
 If the strategy on the short-term is to decrease expenses, the sales will become okay,
but it cannot be called sustainable in the long-run
The 2000s did not sit well in the business and financial community. This turbulent decade will
forever be remembered in the vortex of history of modern business as a time of accounting
shenanigans and corporate failures. Corporate giants such as Enron, WorldCom, and Tyco
(governance problems) among others collapsed and eventually filed for bankruptcy. When the
dust has cleared, many employees lost their jobs and billion dollars of investments evaporated
in thin air. These financial scandals sent shock waves across global stock markets affecting the
investing community.
When financial scandals of these magnitude happen, investors often ask the question, U But to
others, the question should have been, "Where was the corporate governance?"
In 2001, Enron Corporation was a colossal energy company, with an annual revenue of more
than 100 million. At that time, it ranked 7th in terms of revenue. Enron was formed in 1985
through the merger of Houston Natural Gas and InterNorth of Nebraska. During its early years,
Enron had a simple business model, operating as a natural gas pipeline company centered on the
delivery of specific amounts of natural gas to utilities and other customers. However, after the
deregulation of the electricity market in the early 1990s, Enron's business evolved from hard
assets to more complex and speculative energy derivatives. It also began to trade natural gas
commodities. These, among others, increased the risk in Enron's operations.
Meanwhile, to finance projects and its ambitious aggressive business strategies, Enron's debts
and its debt ratio increased. These movements in Enron's financial leverage could affect the
company's stock price and, consequently, the stock options of corporate executives. Because of
these, corporate executives began to window dress Enron's accounting records to make it appear
that the company's financial condition is sound. Enron officials at that time were Chief
Executive Officer (CEO) Jeffrey Skilling, Chief Financial Officer (CFO) Andrew Fastow, and
Board Chair Kenneth Lay.
One of the questionable accounting practices applied to Enron's corporate financials was
perpetrated through the use of improper transactions involving "special purpose entities"
(SPES). SPES are legal entities set up to accomplish specific and very narrow corporate
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objectives. However, in the case of Enron, many special purpose entities (SPES) were simply
created to conduct improper off-balance sheet accounting intended to hide massive losses and
debts from the eyes of the investing public.
The audit committee members who were supposed to ensure proper accounting treatment
merely performed a cursory review of these SPE transactions. It was found out later that those
members of the audit committee such as John Mendelsohn and John Wakeham (Enron's
independent directors) were receiving sizable "perks" from Enron. Mendelsohn, for instance,
was the president of MD Andersen Cancer Center which receives cash donations from Enron.
On the accounting side, these SPE transactions involved Enron receiving borrowed funds that
were made to look like revenues, without recording the liabilities on the company's statement of
financial position. This effectively resulted to high revenues which bolstered the company's
profit ratio while, at the same time, showed a manageable leverage or debt level. As such,
investors and stock analysts were made to believe that Enron was doing well, at least
financially.
The SPE loans were guaranteed with Enron stock which, at that time, was trading at over $100
per share in the New York Stock Exchange (NYSE). The start of the collapse was when Enron's
stock price declined. Creditors of Enron started to recall the loans due to the decline in the
company's valuation. The company found it too difficult to maintain its financial position,
O in August 2001, Jeffrey Skilling resigned as CEO. This created a firestorm of controversies
over the ability of the company to continue business operations and led to loss of Enron's
reputation. The day after Skilling resigned, Enron's Vice President for Corporate Development,
Sherron Watkins, sent an anonymous letter to Kenneth Lay. In her letter, Watkins expressed her
fears that Enron "might implode in a wave of accounting scandals.
Enron eventually reported a third quarter 2001 loss of $618 million and a one-time adjustment
decreasing shareholders' equity by a staggering $1.2 billion. The adjustment was related to
transactions with partnerships run by CFO Fastow. Fastow had created those off-balance sheet
partnerships for Enron and for himself. He personally earned $30 million dollars in management
fees from deals with those partnerships, Fastow's conflict of interest was allowed because
Enron's Code of Ethics was not strictly implemented
Hopes of financial rescue from corporate "white knights," Dynergy and ChevronTexaco Corp,
almost bailed out Enron from bankruptcy when they announced a tentative agreement to buy the
company for $8 billion. However, Enron's credit rating was downgraded to "junk" status in
November. Eventually, Dynergy and ChevronTexacoCorp. withdrew their purchase agreement.
After the purchase withdrawal, any hope of financially resuscitating of Enron collapsed. Enron's
stock price plummet to only $0.40 per share and the company for bankruptcy.
After the Enron bankruptcy, the Sarbanes-Oxley Act was passed with the objective of protecting
corporate investors through strengthening of corporate governance, strict regulation of the audit
profession and internal controls over financial reporting
Definition of Terms
 Accounting shenanigans - accounting schemes that distort amounts and disclosures in
the financial statements in order to hide financial problems and/or to paint a brighter
picture of economic performance. It is synonymous with the term "window dressing."
 Agency problem - a situation that exists when the "agents" of the corporation use their
authority for their own benefit and not for the benefit of the "principal" or owners.
The term "agents" pertains to corporate managers while principal pertains to the
shareholders of the company.
 Audit committee-committee composed of directors tasked to perform oversight of the
financial reporting process, selection of the external auditor, and receipt of audit
findings from both internal and external auditors.
 Board of directors - the governing body elected by the stockholders that exercises the
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corporate powers of a corporation, conducts all its business and controls its properties
 Corporate governance - system of stewardship and control to guide organizations in
fulfilling their long-term economic, moral, legal, and social obligations toward their
stakeholders.
 Corporate issuer - a corporation that issues securities such as stocks and bonds to the
public.
 Debt ratio - a measure of financial soundness computed as total liabilities divided by
total assets.
 Energy derivatives - are complex financial instruments whose underlying asset is
based on energy products such as oil, natural gas, or electricity, Energy derivatives are
traded on a formal exchange such as the Chicago Mercantile Exchange
 Enterprise risk management - a process, effected by an entity's board of directors,
management, and other personnel, applied in strategy setting and across the enterprise
that is designed to identify potential events that may affect the entity, to manage risks
to be within its risk appetite, and to provide reasonable assurance regarding the
achievement of entity objectives.
 Executive director - a director who has executive responsibility of day-to-day
operations of a part or the whole of the organization.
 External auditor-independent accounting firm that renders a report or opinion on the
financial statements of client companies.
 Independent director - a person who is independent of management and the
controlling shareholder, and is free from any business or other relationship which
could reasonably be perceived to materially interfere with his/her exercise of
independent judgment in carrying out his/her responsibilities as a director.
 Internal control - a process effected by an entity's board of directors, management, and
other personnel, designed to provide reasonable assurance regarding the achievement
of objectives relating to operations, reporting, and compliance.
 Management - a group of officers given authority by the board of directors to
implement the policies it has laid down in the conduct of the business of the
corporation
 Nonexecutive director - a director who does not perform any work related to the
operations of the corporation.
 Off-balance sheet accounting - the practice of not reflecting an asset and/or a liability
on the financial statements.
 Organization for Economic Co-operation and Development (OECD) - inter
governmental entity founded in 1961 intended to stimulate economic growth through
the formulation of policies for better lives."
 Publicly listed company - a company whose shares of stock are traded in the stock
market such as the Philippine Stock Exchange
 Sarbanes-Oxley Act - a corporate governance regulation passed in the United States
requiring the strengthening of corporate governance structures among corporate
issuers, stricter regulation of the auditing profession, and assessment of internal
controls over financial reporting among others.
 Special purpose entity - an entity created for a narrow and specific business objective;
for instance, an SPE is created simply for the purpose of obtaining finance.
 Stakeholders-any individual organization, or society at large who can either affect
and/or be affected by the company's strategies, policies, business decisions, and
operations in general. This includes, among others, customers, creditors, employees,
suppliers, investors, as well as the government and community in which it operates.
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 Stakeholder theory-states that the corporation exists not only for the benefit of the
stockholders but also for the benefit and protection of the other stakeholders such as
employees, creditors, suppliers, government, and the society in general.
 Stockholder theory - theory stating that the corporation exists for the benefit of the
shareholders or stockholders
 Short-termism - a term that connotes actions of corporate managers intended to
increase short-term profits only
 White knight -a "friendly investor that purchases a target company at a fair price and
with the support of existing management and directors.

Chapter 1
Definition of Corporate Governance
The opening vignette highlights the need for corporate governance. It is a must. Corporate
governance, in a nutshell, is the effective way of "directing and controlling companies. The way
in which companies are directed and controlled is of interest to investors, directors, managers,
regulators, auditors, and practically, to everyone. In line with the above statement, corporate
officers such as CEOs, CFOs, directors, and others, must act for the long-term best interests of
shareholders and other stakeholders. Without corporate governance, as shown in the Enron
scandal, it will be game over.
The term "corporate governance" became a household name ever since the Enron and World
Com fiascos struck the business world. As presented in the opening vignette, the Sarbanes-
Oxley Act (SOX Act) was passed in the United States right after those financial scandals. The
SOX Act is primarily a corporate governance regulation.
SoX seeks to strengthen the functioning of the board of directors in the oversight of managerial
performance as well as enhancing board independence. Enhancing board independence
essentially requires the appointment of more independent directors on corporate boards. These
independent directors, aside from being detached from operational duties, must not have any
business dealings with the company which could affect the exercise of objective and
independent judgment.
SoX regulations also require evaluation of internal controls to ensure reliable and transparent
financial reporting to investors. Investors need financial Information to aid in their investment
decisions. Sox also instituted improvements in the oversight of the conduct of audits of
corporate financial statements, whistle-blower policies, and transparent disclosures of financial
and nonfinancial information among others.
The new definition of corporate governance can be found in the Principles of Corporate
Governance crafted by the Organization for Economic Co-operation and Development (OECD).
The OECD is an inter-governmental entity founded in 1961 intended to stimulate economic
growth through the formulation of policies for "better lives." It defined corporate governance as:
Corporate governance is the system of stewardship and control to guide organizations in
fulfilling their long-term economic, moral, legal, and social obligations toward their
stakeholders.
The definition of corporate governance can be broken into three parts:
1. It is a system of stewardship and control of corporate entities;
2. It is intended to fulfill long-term obligations (economic, moral, legal, social) of the company,
and
3. It benefits the stakeholders.
Concept of stewardship and control
Corporate governance is distinct from operating and managing the business Management runs
the business and is involved in the day-to-day operations of the company. However, the idea of
doing business is not simply to operate a business. There must be an oversight or monitoring of
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corporate performance and operating results. This is the essence of stewardship and control.
This role is being performed by the board of directors. Simply stated, management deals with
"running the business" whereas corporate governance deals with "making sure that the business
is being run properly."
During pandemic times or during periods of economic difficulty, corporate governance plays a
critical role. During the 1997 Asian financial crisis, companies that implemented effective
governance survived. These companies had functioning corporate boards which were able to
monitor liquidity, implement business continuity plans, and advice management on action plans
to be undertaken. This is also a sign of a well-governed company. Figuratively, corporate
governance works like a captain of the ship who must navigate the ship to safer waters in the
midst of a bad weather."
Fulfillment of Long-Term Obligations
Corporate governance is not simply a deterrence to fraud nor an end in itself. Corporate
governance is the process through which the company can fulfill its long-term economic, moral,
legal, and social obligations to stakeholders. In this sense, stakeholders include not only the
investors but also creditors, suppliers, employees, government regulators, and even the society
as a whole.
Fulfillment of economic obligations would include providing sufficient returns to shareholders
such as dividends. However, dividends can only be declared legally if and when there are
sufficient earnings. To ensure the sufficiency of revenues, profit, and dividends, the board of
directors must periodically conduct an oversight of the financial performance of the company, If
the company is performing adversely, the board of directors can question the management team
for its unsatisfactory performance. It may also give advice to management on how to improve
its operating results.
Payment of appropriate compensation to employees is one of the moral obligations of the
company to its employees. Legal obligations would include being able to comply with legal
requirements and contractual obligations. Fulfillment of corporate social responsibility is also
within the objectives of corporate governance.
Stockholder theory and stakeholder theory
Stockholder theory suggests that the corporation exists for the benefit of the shareholders or
stockholders. Therefore, corporate managers (e.g., CEO, CFO) have a duty to maximize returns
to the benefit of stockholders. (Stockholders are the one that invested the risk capital, thus the
basis of stockholder theory)
On the other hand, stakeholder theory states that the corporation exists not only for the benefit
of the stockholders. It also exists for the benefit of the other stakeholders. The other
stakeholders include employees, creditors,
suppliers, government, and the society in
general. While corporate managers have a
duty to maximize shareholders' returns,
they also have a duty to the society as a
whole. This would include paying taxes to
the government, repayment of debts to
creditors, and protecting the environment
among others.
It is noteworthy to mention that the OECD
definition emphasizes the stakeholder
theory

Long-term sustainability goal of governance

According to the OECD, "Corporate governance is a system of direction, feedback, and control
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using regulations, performance standards, and ethical guidelines to hold the board and senior
management accountable for ensuring ethical behavior-reconciling long. term customer
satisfaction with shareholder value-to the benefit of all stakeholders and society.
The OECD further states that the purpose of corporate governance is to maximize the
organization's long-term success, creating sustainable value for its shareholders and
stakeholders.
Corporate governance must not only ensure that short-term profit goals are achieved. Its goal is
to ensure achievement of long-term profitability and cash flows. This is to prevent the so-called
"short-termism."
"Short-termism" is a term that connotes actions of corporate managers intended to increase
short-term profits only. It is relatively easy to increase the profit for next year in order to meet
profit targets. Managers, for instance, could reduce the company's advertising expenses as well
as its research and development (Rand D) costs for next year. At the same level of revenue, and
all other things held constant, profit for next year will certainly increase Managers will then be
rewarded in terms of performance bonuses for achieving a certain profit target.
However, due to the reduced budget for advertising and Rand D, there will be limited product
exposure to customers and lack of product improvements. Because of these, revenue will
decrease for the long-term period following next year. Thus, such a financial strategy is not
sustainable over the long-term although it enables managers to achieve the profit target in the
short-term
The Agency Problem
The agency problem" is a situation that exists when the agents of the corporation use their
authority for their own benefit and not for the benefit of the "principal or owners. The term
"agents" pertains to corporate managers while principal pertains to the shareholders of the
company.
A company owned by a thousand or more shareholders will not be run by the owners
themselves for that would result to disorder and chaos. Besides, not all shareholders possess
managerial ability to manage their own businesses. In this case, the owners will hire managers.
As hired individuals, these managers (the agents) must act for the best interests of the owners
(the principal). However, this does not always hold true in real life such as in the case of Enron.
As mentioned previously, managers tend to focus on just short-term profit in order to achieve
the profit target and thereby obtain bonuses to the detriment of the owners. It is also possible on
the part of managers to engage in self-dealing transactions that will not benefit the owners of the
company. Take the case of a purchase manager in an ABC Company who sets up his own
trading business. ABC Company, through the purchase manager, buys materials from the
trading business at excessive prices. This transaction benefits the personal business of the
purchase manager but it is disadvantageous on the part of ABC Company
To ensure that corporate managers act in the best interests of the owners, the following are being
implemented:
1. External and internal audits;
2. Oversight of managerial performance by the board of directors;
3. Management compensation is linked to corporate performance and/or stock price:
4. Code of ethical conduct;
5. Internal controls, and Government regulation (e.6., Sarbanes-Oxley, SEC regulations),
Difference between governance and management
Governance and management are two distinct functions Management takes charge of the day-
to-day operations of the business. Simply stated, management deals with running the business."
Governance, on the other hand, is ensuring that the business is being run properly. Furthermore,
this oversight and governance role is being performed by the board of directors together with
various board committees such as the audit committee and risk oversight committee.
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When it comes to setting the future direction of the company, the board of directors approves
the company's strategic plans and long-term capital investment proposals. is the management
who will implement these plans. Managers will carry out projects intended to provide the
company with steady revenue and cash flow streams. The board of directors, though detached
from operating these projects, must conduct an oversight of actual performance
Board Independence
For an appropriate oversight and assessment of managerial performance, the board of directors
must be both objective and competent. Otherwise, the result of any performance assessment will
not be truthful and will not meet its intended objectives.
In the case of small and family-owned businesses, the managers are also the members of the
board. This is acceptable since the business has no public accountability due to its size and
nature. In case of poor managerial performance or fraudulent activities, only the family
members suffer the consequences. However, it will be a different case when it comes to a bank
or a publicly listed company.
When a bank is ordered "close by the Bangko Sentral ng Pilipinas (BSP) or goes bankrupt,
many depositors are affected. When a listed company closes, the shares of many investors
evaporate into nothing. That is why there is strict regulation regarding the composition of the
board of directors of a bank and a publicly listed company, Government regulators require a
minimum number of independent directors in the corporate boards of these entities
An independent director (must be a NED, detached from operations) is a person who is
independent of management and the controlling shareholder, and is free from any business or
other relationship which could reasonably be perceived to materially interfere with his/her
exercise of independent judgment in carrying out his/her responsibilities as a director. An
independent director is generally expected to perform an honest assessment of managerial
performance that a director who is part of management.
On the other hand, nonexecutive directors (NEDs) are those who are not involved in operations
and are not corporate officers. Independent directors are automatically NEDS but not all NEDs
are independent directors. However, NED’s can possess large shares of the company but still be
detached from operations.
Board Setups
There are two types of corporate board setups, namely:
1 all-executive board, and
2. board with nonexecutive directors.
An all-executive setup is a board comprised solely of executive or corporate managers. As
discussed previously, this is often the case for small or family-owned corporations. The second
type is often the case for publicly-listed companies and other regulated entities such as banks
and insurance companies.
Accounting Impact of WorldCom
The perpetrators improperly recognized as assets WorldCom’s telecommunication line expenses
to assets. The amount of the improper capital amounted to 53.3 billion, discovered by World
Con's internal audit and Cynthia Cooper Eventually was found out by forensic accountants that
the total amount of the fraud was $11 billion
Account Effect on the Accounts Effect to Investors
Total Assets over Increase
Total Line Expenses Under
Net Income over Increase
Net cashflow over

Day 2

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 Corporate governance – mere compliance with SEC codes
 Stockholder – the one who invested the risk capital, when a company collapse, they
are the one that suffers
 TCWG (those charged with governance) – tasked to do corporate governance
* Millions charity - companies contribute to charities
* Reforestation projects - costs and expenses * environmental projects/programs
* banks = how to incorporate environmental programs to their loan granting process * minimize
loans to be given to companies that pollute the environment reduce interest rate on borrowings
on companies who are protecting the environment
Increase in costs - decrease in profit
PSA 250
 Non-compliance – acts of the company that are contrary to laws and regulations
 Whether the act was intentional or unintentional, it is still punishable
o Acts of commission
o Acts of omission
 Causes of material misstatement
o Fraud
o Error
o Katangahan
o Non-compliance

BME 21 Midterms
General steps in F/S audit
1. Understand the client and its environment, procedures (TOC &/or ST).
including internal control. 4. Wrap-up the audit.
2. Assess the risks of material misstatements. 5. Issue the audit opinion.
3. Design and perform "further" audit
Duty Potential Likelihood Impact Significan Risk Response
Risks Misstatements t
Risks
Sales are Fictitious 4 5 Yes Increase unpredictability
unattainab Sales Nature of the timing and
le extent of substantive
procedures
 If auditors do not assess their clients' risks, they will have no basis for designing audit
programs that respond to those risks.
 Regardless of the amount and type of substantive testing they perform, the auditors
will have no way of knowing whether their audit procedures have reduced audit risk
to an acceptably low level.
Risk assessment procedures
The objective of the risk assessment phase of the audit is to identify sources of risk, and then to
assess whether they could possibly result in a material misstatement in the financial statements.
This provides the auditor with the information needed to direct audit effort to areas where the
risk of material misstatement is the highest, and away from less risky areas.
Risk assessment has two distinct parts:
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 Risk identification (asking "what can go wrong"); and.
 Risk assessment (determining the significance of each risk).
Analytical Procedures, defined
Analytical procedures - evaluation of financial information through analysis of plausible
relationships among both financial and non-financial data.
Analytical procedures also encompass such investigation as is necessary of identified
fluctuations or relationships that are inconsistent with other relevant information or that differ
from expected values by a significant amount.
Audit planning stage - To identify risks of material misstatements (e.g., unusual fluctuations in
certain accounts, unreasonable relationships between accounts)
• Audit wrap-up stage -
 Determine whether unanswered questions still exist.
 The auditor wants to know if the questions raised in the beginning are now answered.
Low detection risk – year end
High detection risk – interim
Risk Management

 Objective setting  Assess
 Identify Risks  Respond
Internal Control Components (PSA 315) financial reporting, and communication;
(a) The control environment; (d) Control activities;
(b) The entity's risk assessment process; (e) Monitoring of control
(c) The information system, including the
related business processes, relevant to
Control environment includes the attitudes, awareness, and actions of management and those
charged with governance concerning the entity's internal control and its importance in the entity.
The control environment also includes the governance and management functions and sets the
tone of an organization, influencing the control consciousness of its people.
It is the foundation for effective internal control, providing discipline and structure.
The control environment encompasses the following elements:
 Communication and enforcement of style.
integrity and ethical values.  Organizational structure.
 Commitment to competence.  Assignment of authority and
 Participation by those charged with responsibility.
governance.  Human resource policies and practices.
 Management's philosophy and operating
Entity's risk assessment process - process is its process for identifying and responding to
business risks and the results thereof.

For financial reporting purposes, the entity's risk assessment process includes how management
identifies risks relevant to the preparation of financial statements that are presented fairly, in all
material respects in accordance with the entity's applicable financial reporting framework,
estimates their significance, assesses the likelihood of their occurrence, and decides upon
actions to manage them.

Risks can arise or change due to circumstances such as the following:

• Changes in operating environment. Changes in the regulatory or operating environment can
result in changes in competitive pressures and significantly different risks.
• New personnel. New personnel may have a different focus on or understanding of internal

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control.
• New or revamped information systems. Significant and rapid changes in information systems
can change the risk relating to internal control.
• Rapid growth. Significant and rapid expansion of operations can strain controls and increase
the risk of a breakdown in controls.
• New technology. Incorporating new technologies into production processes or information
systems may change the risk associated with internal control.
• New business models, products, or activities. Entering into business areas or transactions with
which an entity has little experience may introduce new risks associated with internal control.
• Corporate restructurings. Restructurings may be accompanied by staff reductions and changes
in supervision and segregation of duties that may change the risk associated with internal
control. • Expanded foreign operations. The expansion or acquisition of foreign operations
carries new and often unique risks that may affect internal control, for example, additional or
changed risks from foreign currency transactions.
• New accounting pronouncements. Adoption of new accounting principles or changing
accounting principles may affect risks in preparing financial statements.

Information system, including the related business processes, relevant to financial reporting, and
communication - An information system consists of infrastructure (physical and hardware
components), software, people, procedures, and data. Infrastructure and software will be absent,
or have less significance, in systems that are exclusively or primarily manual.
The information system relevant to financial reporting objectives, which includes the financial
reporting system, consists of the procedures and records established to initiate, record, process,
and report entity transactions as well as events and conditions) and to maintain accountability
for the related assets, liabilities, and equity.

Accordingly, an information system encompasses methods and records that:

• Identify and record all valid transactions. - no omissions of valid transactions
• Describe on a timely basis the transactions in sufficient detail to permit proper classification of
transactions for financial reporting.
• Measure the value of transactions in a manner that permits recording their proper monetary
value in the financial statements.
• Determine the time period in which transactions occurred to permit recording of transactions
in the proper accounting period.
•Present properly the transactions and related disclosures in the financial statements.

Communication involves providing an understanding of individual roles and responsibilities

pertaining to internal control over financial reporting. It includes the extent to which personnel
understand how their activities in the financial reporting information system relate to the work
of others and the means of reporting exceptions to an appropriate higher level within the entity.
Open communication channels help ensure that exceptions are reported and acted on.

Control activities - are the policies and procedures that help ensure that management directives
are carried out, for example, that necessary actions are taken to address risks that threaten the
achievement of the entity's objectives.

Generally, control activities that may be relevant to an audit may be categorized as policies and
procedures that pertain to the following:
• Performance reviews. • Physical controls.
• Information processing • Segregation of duties.
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Monitoring of controls - Management's monitoring of controls includes considering whether
they are operating as intended and that they are modified as appropriate for changes in
conditions. Monitoring of controls may include activities such as management's review of
whether bank reconciliations are being prepared on a timely basis, internal auditors' evaluation
of sales personnel's compliance with the entity's policies on terms of sales contracts, and a legal
department's oversight of compliance with the entity's ethical or business practice policies.

Procedures in Obtaining Understanding of Internal Control

1. Make inquiries of appropriate company personnel
2. Inspect documents and records - internal control manual of procedures
3. Observe the company's activities and operations
4. Walk-through

* PSA 315 requires the auditor to obtain an understanding of the entity and its environment,
including its internal control for the purpose of identifying and assessing the risks of material
misstatement at the (a) FS level and (b) assertion level for material account balances,
transactions and disclosures.
• Knowledge about the INOMIc of the entity includes identifying business risks, fraud risks and
other significant risks that may materially affect the financial statements.
Components of audit risk
1. Inherent risk - susceptibility of an account
balance or class of transactions to material
misstatement assuming the absence of internal
controls.
2. Control risk - risk that a material misstatement
that could occur will not be prevented or
detected on a timely basis by internal controls.
3. Detection risk - risk that the auditor’s
substantive procedures will not detect a material
misstatement or omission.

PSA 330 - Responding to the Assessed Risks

• As the acceptable level of detection risk
decreases = design and perform…
NATURE- more effective substantive tests
Example: ocular visits to verify existence
of customers rather than just confirmation
more detailed tests-not analytical
procedures
Example: perform substantive TESTS
OF DETAILS rather than analytical
procedures
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TIMING -should be year-end, not interim
EXTENT -larger sample sizes
more extensive (e.g., more number of branches audited, more warehouses visited

PSA 520, Analytical Procedures

Analytical procedures - analysis of financial
ratios and trends, and investigation of unusual
fluctuations and
relationships that are inconsistent with expected
amounts.
Basic premise: There is a plausible relationship
among financial data that are expected to continue in the absence of known conditions to the
contrary.
• Mandatory to be performed during (1) audit planning and (2) completing the audit stages
In developing expectations, the auditor may use:
* Prior year’s F/S * Industry averages
* Budgets * Non-financial data
Identify unusual fluctuations (e.g., abnormal • They are potential material misstatements
increases, decrease in amounts/ unexpected • To be examined in a more deeper manner
changes) during substantive test stage.

PSA 320, Materiality

* Financial information is material if its omission or misstatement could influence the economic
decisions of F/S users.
* There are no perfect F/S. You can’t prepare F/S that are totally free from smallest
inaccuracies.. but at how much can we tolerate such error at a level that FS users’ decisions
won’t be affected.
* Lower materiality = greater amount of audit evidence needed (because the auditor intends to
locate smaller errors)… Materiality P 1 HAS inverse relation to audit evidence
RMM increase = increase in audit procedures
* It is the smallest aggregate of misstatements that could misstate any one of the F/S
- If misstatements aggregating P 100,000 would be material to the income statement but
misstatements would have to aggregate P 150,000 to materially affect the balance sheet, the
auditor will use the smaller amount (P100,000).
* To be determined during audit planning
* 2 levels:
• 1. Overall materiality
• 2. Tolerable error
1. Calculate the overall materiality = % x
Benchmark
Benchmarks:
- Revenue
- Profit

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- Total assets
2. Allocate the overall materiality to account balances (to allow the auditor determine the audit
procedures that will be applied to specific accounts). This is called tolerable misstatement -
amount of error that the auditor can tolerate
No exact rules how to compute or how to allocate. Judgment plays a critical role. But there is
AASC Bulletin.
3. At the end of the audit, compare the aggregate “uncorrected” misstatements with the overall
materiality.
• Performance materiality
PSA 450: Evaluation of Misstatements Identified during the Audit:

PSA 550, Related Parties

* Related party - refers to persons or
entities that may have dealings with one
another in which one party has the
ability to exercise significant influence or
control over the other party in making
financial and operating decisions.
* Transacting with related parties are not
prohibited acts, generally speaking, and are
considered ordinary features
of business. However, the auditor should
understand and detect them because a
related party transaction may be motivated
by other than ordinary business
considerations or even fraud.

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* Many related party transactions are in the normal course of business. In such circumstances,
they may carry no higher risk of material misstatement of the financial statements than similar
transactions with unrelated parties.
However, the nature of related party relationships and transactions may, in some circumstances,
give rise to higher risks of material misstatement of the financial statements than transactions
with unrelated parties. For example:
- Related parties may operate through an extensive and complex range of relationships and
structures, with a corresponding increase in the complexity of related party transactions.
- Related party transactions may not be conducted under normal market terms and conditions;
for
example, some related party transactions may be conducted with no exchange of consideration.
* Because related parties are not independent of each other, many financial reporting
frameworks establish specific accounting and disclosure requirements for related party
relationships, transactions and balances to enable users of the financial statements to understand
their nature and actual or potential effects on the financial statements.
* Where the applicable financial reporting framework establishes such requirements, the auditor
has a responsibility to perform audit procedures to identify, assess and respond to the risks of
material misstatement arising from the entity’s failure to appropriately account for or disclose
related party relationships, transactions or balances on the auditor’s ability to detect material
misstatements are greater for such reasons as the following:
- Management may be unaware of the existence of all related party relationships and
transactions,
particularly if the applicable financial reporting framework does not establish related party
requirements.
- Related party relationships may present a greater opportunity for collusion, concealment or
manipulation by management. During the audit, the auditor may inspect records or documents
that may provide information about related party relationships and transactions, such as:
• Review of prior year’s working papers for names and identities of related parties.
• Review SEC, BIR filings made with government agencies such as income tax returns, annual
reports and other SEC reports
• Review minutes of meetings of shareholders and the board of directors.>>> BOARD RESO 5-
2022: that ABC Co. Guarantee the loan of XYZ co.
• Shareholder registers to identify the entity’s principal shareholders.
* Review accounting records for large or unusual transaction or balances, especially those made
at the end of the year.
* Review confirmations of loans receivable and payable, and confirmations from banks to
identify the existence of guarantees.
* Review investment transactions (e.g., associates, subsidiaries, interest in joint venture)
 An audit cannot be expected to provide assurance that all related party transactions will be
identified. However, the auditor should be alert of related parties and transactions between
them. Indications of potential related party relationships:
 Transactions with abnormal terms of trade (e.g., too low interest rate, unusual price-too high,
too low, repayment terms-no due date)
 Transactions that lack an apparent logical business purpose
 Unrecorded transactions such as receipt or provision of management services at no charge
 High volume or significant transactions with certain customers or suppliers as compared with
others
 Transactions in which substance differs over form.
13* If the auditor identifies RPT, the auditor should determine that such are disclosed in the
notes. Failure of the client to do so may remain to qualified or adverse opinion.
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* Obtain written representation from management concerning the completeness of information
provided regarding the identification of related parties and the adequacy of related party
disclosures.

PSA 540, Auditing accounting estimates, fair value and related disclosures
Accounting estimate - an approximation of the amounts of an item in the absence of precise
means of
measurement; often made in conditions of uncertainty regarding the outcome of events that
have occurred or are
likely to occur and involve the use of judgment.
Accounts involving estimates >>> credit loss, fair value (e.g. unquoted shares), restructuring
provisions,
decommissioning liability, depreciation, depletion
* The auditor should obtain sufficient appropriate evidence that the (a) accounting estimate is
properly disclosed
in the notes and (b) accounting estimate is reasonable
Audit procedures:
* Test the process used by management to develop the estimate
* Make an independent estimate and compare with client’s estimate
* Review subsequent events which confirm the estimate made

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