CHAPTER 2

OVERVIEW OF AUDITING

I. Review Questions

1. One definition of auditing is that it is a systematic process by which a

competent, independent person objectively obtains and evaluates evidence
regarding assertions about economic actions and events to ascertain the degree
of correspondence between those assertions and established criteria and
communicating the results to interested users.

The Philippine Standards on Auditing (PSA) 120 “Framework of Philippine

Standards on Auditing” states the objective of an audit as follows:
“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 an identified financial reporting framework.”

2. This apparent paradox arises from the distinction between the function of
auditing and the function of accounting.

The accounting function is the process of recording, classifying and

summarizing economic events to provide relevant information to decision
makers.

The rules of accounting are the criteria used by the auditor for evaluating the
presentation of economic events for financial statements and he or she must
therefore have an understanding of generally accepted accounting principles
(GAAP), as well as generally accepted auditing standards (GAAS).

The accountant need not, and frequently does not, understand what auditors do,
unless he or she is involved in doing audits, or has been trained as an auditor.

3.
Audits of Compliance Operational
Financial Audits Audits
Statements
Purpose To determine To determine To evaluate
whether the whether the whether
financial client is operating
statements are following procedures are
presented in specific efficient and
accordance with procedures set effective.
2-2 Solutions Manual - Principles of Auditing and Other Assurance Services
GAAP. by higher
authority.
Audits of Compliance Operational
Financial Audits Audits
Statements
Users of Different groups Authority Management of
Audit Report for different setting down organization
purposes – procedures,
many outside internal or
entities. external
Nature Highly Not Highly
standardized standardized, nonstandard;
but very specific often very
and usually subjective
objective
Performed
by:
CPAs Almost Occasionally Frequently
universally
COA Occasionally Frequently Frequently
Auditors
BIR Auditors Never Universally Never
Internal Frequently Frequently Frequently
Auditors

4. The major differences in the scope of audit responsibilities are:

1. CPAs perform audits in accordance with Philippine Standards on
Auditing of published financial statements prepared in accordance
with identified and applicable Statements of Financial Accounting
Standards.
2. COA auditors perform compliance or operational audits in order to
assure the Congress of the expenditure of public funds in accordance
with its directives and the law.
3. BIR agents perform compliance audits to enforce the tax laws as
defined by Congress, interpreted by the courts, and regulated by the
BIR law.
4. Internal auditors perform compliance or operational audits in order to
assure management or the board of directors that controls and policies
are properly and consistently developed, applied and evaluated.

5. An independent audit is a means of satisfying the need for reliable information

on the part of decision makers. Factors of a complex society which contribute
to this need are:
1. remoteness of information
a. owners (stockholders) divorced from management
b. directors not involved in day-to-day operations or decisions
 Overview of Auditing 2-3
c. dispersion of the business among numerous geographic locations
and complex corporate structures
2. bias and motives of provider
a. information will be biased in favor of the provider when his goals
are inconsistent with the decision maker.

3. voluminous data
a. possibly millions of transactions processed daily via sophisticated
computerized systems
b. multiple product lines
c. multiple transaction locations
4. complex exchange transactions
a. new and changing business relationships lead to innovative
accounting and reporting problems
b. potential impact of transactions not quantifiable, leading to
increased disclosures

6. The four primary causes of information risk are remoteness of information,

bias in motives of the provider, voluminous data, and existence of complex
exchange transactions.

The three main ways to reduce information risk are:

1. User verifies the information itself.
2. The users share the information risk with management.
3. Have audited financial statements provided.

The advantages and disadvantages of each are as follows:

Advantages Disadvantages
User 1. User obtains 1. High cost of obtaining
verifies information desired. information.
informatio 2. User can be more 2. Inconvenience to the
n confident of the person providing the
qualifications and information because
activities of the person large number of users
getting the information. would be on premises.
Users 1. No audit costs incurred. 1. Users may not be able
share to collect on losses.
informatio
n risk with
managem
ent
Audited 1. Multiple users obtain 1. May not meet needs of
financial the information. certain users.
statement 2. Information risk can 2. Cost may be higher
2-4 Solutions Manual - Principles of Auditing and Other Assurance Services
s are usually be reduced than the benefits in
prepared sufficiently to satisfy some situations, such
users at reasonable as for a small company.
cost.
3. Minimal inconvenience
to management by
having only one
auditor.

7. Information risk is the possibility that information upon which a business

decision is made is inaccurate. Four causes of information risk are:
• remoteness of information,
• biases and motives of the provider,
• voluminous data, and
• complex exchange transactions.

8. Three primary ways users of information can reduce information risk are:
• users can verify the information themselves,
• users can share information risk with management, and
• users can obtain audited financial statements.

9. Four factors that are likely to significantly reduce information risk in the next
five to ten years are:
• technological advances,
• more companies will go on–line, reducing the risk of investors
obtaining outdated information,
• new accounting and auditing standards, and
• auditors will find more efficient and effective audit techniques.

10. Refer to pages 45 and 46 of the textbook.

11. A report by an independent public accountant concerning the fairness of a

company’s financial statements is commonly required in the following
situations:
(1) Application for a bank loan.
(2) Establishing credit for purchase of merchandise, equipment, or other
assets.
(3) Reporting operating results, financial position, and cash flows to
absentee owners (stockholders or partners).
(4) Issuance of securities by a corporation.
(5) Annual financial statements by a corporation with securities listed on
a stock exchange or traded over the counter.
(6) Sale of an ongoing business.
(7) Termination of a partnership.
 Overview of Auditing 2-5
12. To add credibility to financial statements is to increase the likelihood that they
have been prepared following the appropriate criteria, usually the relevant and
applicable SFAS. As such, an increase in credibility results in financial
statements that can be believed and relied upon by third parties.

13. Business risk is the risk that the investment will be impaired because a
company invested in is unable to meet its financial obligations due to
economic conditions or poor management decisions. Information risk is the
risk that the information used to assess business risk is not accurate. Auditors
can directly reduce information risk, but have only limited effect on business
risk.
14. An operational audit attempts to measure the effectiveness and efficiency of a
specific unit of an organization. It involves more subjective judgments than a
compliance audit or an audit of financial statements because the criteria of
effectiveness and efficiency of departmental performance are not as clearly
established as are many laws and regulations or generally accepted accounting
principles.

The report prepared after completion of an operational audit is usually directed

to management of the organization in which the audit work was done.
15. A compliance audit is an audit to determine whether financial reports or other
assertions are in compliance with established criteria. The necessary
ingredients are verifiable data and the existence of standards established by an
authoritative body. An operational audit, on the other hand, is a review of a
department or other unit of a business or governmental organization to
measure the effectiveness and efficiency of operations. Internal auditors often
perform operational audits as do auditors employed by the Commission on
Audit (COA) of the national government and public practitioners as part of
their consultancy services.
16. The first quoted sentence overstates the case. Although annual audits by CPA
firms are universal practice for large corporations, they are not essential to
many small businesses. The financial statements of large corporations go to
many stockholders (often hundreds of thousands) who demand the assurance of
reliability supplied through independent audits by CPA firms. Moreover the
SEC and the stock exchanges require that listed companies have annual audits.

For a small business concern, the primary need for annual financial statements
is to support an application for a bank loan. If a small business does not need
to borrow, or can obtain borrowed funds without providing audited statements,
the cost of an audit may not be justified.

Often a small business can obtain from a CPA firm specialized services other
than an audit, which are more useful and may cost less. Examples are the
review or compilation of financial statements, installation of a computer based
accounting system, or a study of internal control. Thus, the second quoted
2-6 Solutions Manual - Principles of Auditing and Other Assurance Services
sentence, as well as the first, is too sweeping to be correct. A decision not to
have an audit is not always “false economy.”
17. (a) An example of possible bias on the part of the provider of financial
information is the situation in which an individual or business entity
applies for a bank loan. In such circumstances, there is an incentive to
overstate assets, income, and owner’s equity, and to overlook or minimize
liabilities. Distortions of this type give the appearance of greater financial
strength.

(b) A bank loan officer may insist that a prospective borrower provide audited
financial statements. This provides assurance that the data in the financial
statements have been examined by independent competent persons.

II. Multiple Choice Questions

1. d 6. c 11. b 16. d 21. d
2. a 7. b 12. a 17. a
3. a 8. c 13. c 18. a
4. d (PSAs) 9. b 14. c 19. d
5. b 10. d 15. a 20. c

III. Comprehensive Cases

Case 1. a. The major advantages and disadvantages of a career as a BIR agent,

CPA, or an internal auditor are:

Employme Advantages Disadvantages

nt
BIR agent 1. Extensive training in 1. Experience limited
individual, corporate, to taxes.
gift, trust, and other 2. No experience with
taxes is available with operational or
concentration in area financial statement
chosen. auditing.
2. On-hand experience 3. Training is not
with sophisticated extensive with any
selection techniques. business enterprise.
 Overview of Auditing 2-7
CPA 1. Extensive training in 1. Exposure to taxes
audit of financial and to the business
statements, enterprise may not
compliance auditing be as in-depth as
and operational the BIR agent or the
auditing. internal auditor.
2. Opportunity for 2. Likely to be less
experience in auditing, exposed to
tax counseling, and operational auditing
management than is likely for
consulting practices. internal auditors.
3. Experience in a
diversity of enterprises
and industries with the
opportunity to
specialize in a
particular industry.

Employme Advantages Disadvantages

nt
Internal 1. Extensive exposure to 1. Little exposure to
Auditor all segments of the taxation and the
enterprise with which audit thereof.
employed. 2. Experience is
2. Constant exposure to limited to one
one industry enterprise, usually
presenting opportunity within one or a
for expertise in that limited number of
industry. industries.
3. Likely to have
exposure to
compliance, financial
and operational
auditing.

b. Other auditing careers that are available are:

1. COA auditor
2. Auditors within many of the branches of the government
3. Auditors for many local government units

Case 2. The most likely type of auditor and the type of audit for each of the
examples are:
Example Type of Auditor Type of Audit
1. COA Compliance
2. CPA; Internal Auditor Operational
2-8 Solutions Manual - Principles of Auditing and Other Assurance Services
3. Internal auditor; CPA Compliance
4. CPA Financial
statements
5. CPA Tax audit; FS audit
6. COA Financial
statements
7. CPA Financial
statements
8. COA Operational audit
9. CPA; Internal Auditor Financial
statements
10. Internal auditor or Operational audit
CPA
11. CPA or COA Operational audit
12. CPA; BIR Compliance

Case 3. a. The overriding objective of an independent audit is to provide

reasonable assurance that the financial statements fairly reflect the
economic substance of the transactions and events reflected in those
statements. To this end, the auditor tests management’s assertions as
embodied in the financial statements, and renders an opinion concerning
fairness. Testing involves gathering and evaluating evidence relating to
the assertions. The opinion assumes the form of an audit report
formulated and issued at the conclusion of the examination.

b. An independent audit may be beneficial to Lyn Cruz in the following

ways:
1. Correction of identified weaknesses in the accounting system may
improve the quality of financial reporting;
2. The independent auditor may be able to assist Lyn in improving
physical safeguards over assets;
3. An independent audit may facilitate Lyn’s efforts in raising new
capital;
4. The audit may identify a need for improved budgeting and
performance reporting, thus improving control over costs and
revenues;
5. Although not designed for this purpose, the audit may disclose
defalcations by employees;
6. To determine amounts receivable or payable under bonus, profit
sharing, and pension plans; lease agreements; royalty agreements;
and other contracts and agreements;
7. To serve as an error and/or irregularity prevention device by
making employees aware of audit coverage.
 Overview of Auditing 2-9

Case 4. Types of Auditors and Services Performed

Topic Type of Auditor Class of Work
1 CPA Audit of financial
statements
2 CPA Audit of financial
statements
3 Internal auditor; Operational audit
CPA
4 COA Operational audit
5 Bank examiner Compliance audit
6 CPA Management advisory
services
7 CPA Audit of financial
statements
8 Internal auditor; Operational audit
CPA
9 BIR; CPA Compliance audit
10 CPA; COA Compliance audit