Chapter 2

PHASE I- RISK ASSESSMENT: PRELIMINARY ENGAGEMENT

ACTIVITIES AND PLANNING THE AUDIT

Learning Objectives After studying this chapter, you should be able to:

 Describe the activities involved in client selection and

retention.
 Know how to document the agreed terms of engagement.
 Explain the nature, scope and benefits of audit planning.
 Know the benefits and steps in establishing an audit
strategy.
 Understand the factors to be considered in establishing an
audit strategy.
 Explain the other critical matters in engagement planning.

PRELIMINARY ENGAGEMENT ACTIVITIES

Client Selection and Retention

The firm shall implement policies and procedures for the acceptance and continuance of
client relationships and specific engagements, designed to provide the firm with
reasonable assurance that it will only undertake or continue relationships and
engagements where the firm:

(a) Is competent to perform the engagement and has the capabilities,

including time and resources, to do so;
(b) Can comply with relevant ethical requirements; and
(c) Has considered the integrity of the client, and does not have
information that would lead it to conclude that the client lacks integrity.

The auditor shall be satisfied that appropriate procedures regarding the acceptance and
continuance of client relationships and audit engagements have been followed, and shall
determine that conclusions reached in this regard are appropriate.

If the auditor obtains information that would have caused the firm to decline the audit
engagement had that information been available earlier, the engagement partner shall
communicate that information promptly to the firm, so that the firm and the engagement
partner can take the necessary action.

ACCOUNTING 14 1
 The auditor shall undertake the following activities prior to starting an initial audit:

(a) Performing procedures regarding the acceptance of the client relationships

and the specific audit engagement; and
(b) Communicating with the predecessor auditor, where there has been a change
of auditors, in compliance with relevant ethical requirements.
In order to establish whether the preconditions for an audit are present the auditor shall:

(a) Determine whether the financial reporting framework to be applied in the

preparation of the financial statements is acceptable; and

(b) Obtain the agreement of management that it acknowledges and understands its
responsibility:

(i) For the preparation of the financial statements in accordance with the
practicable financial reporting framework, including where relevant their
fair presentation:
(ii) For such internal controls as management determines in necessary to
enable the preparation of financial statements that are free from material
misstatement, whether due to fraud or error, and

(iii) To provide the auditor with:

 Access to all information of which management is aware that is

relevant to the preparation of the financial statements such as
records, documentation and other matters.
 Additional information that the auditor may request from
management for the purpose of the audit; and
 Unrestricted access to persons within the entity from whom the
auditor determines is necessary to obtain audit evidence.

Figure 2.1 shows a sample questionnaire that could be used in assessing client
acceptance/continuance.

ACCOUNTING 14 2
 Figure 2.1 Illustrative questionnaire That Could Be Used in Assessing Client
Acceptance/Continuance

Client: XYZ Company

YES NO COMMENTS
 Have the audit preconditions been met?
 Have the acceptance/ continuance requirements I the
firm’s quality control manual been followed?
 Any changed in the terms of reference or
requirements for the audit engagement?
 Any independence issues or conflicts of interest?
Consider: family/personal relationships with key
client people, non-audit services such as accounting,
financial interest, and other business relationships.
 Any circumstances that would cast doubt on the
integrity of the client’s owners? consider
convictions, regulatory preceding/sanctions.
suspicion or confirmation of illegal acts or fraud,
police investigators, and any negative publicity.
 Does the firm have the capacity in time,
competencies, and resources to complete the
engagement in accordance with professional and
firm standards?
 Are there any issues identified in previous audits and
other engagements for this entity that need to be
addressed risk?
 Can the client continue to pay our fees?

Conclusion:
Overall assessment of engagement risk (Low, Moderate, or High)
We should this client.

Chris Garcia
Santos & Associates, CPAs
* accept/decline
* continue with/discontinue with

ACCOUNTING 14 3
Agreeing the Terms of Engagement

The agreed terms of the audit engagement shall be recorded in an audit engagement letter or
other suitable form of written agreement and shall include:

(a) The objective and scope of the audit of the financial statements.
(b) The responsibilities of the auditor;
(c) The responsibilities of management
(d) Identification of the applicable financial reporting framework for the preparation of
the financial statements; and
(e) Reference to the expected form and content of any reports to be issued by the auditor
and a statement that there may be circumstances in which a report may differ from
of written and content.

If the terms of the audit engagement are changed, the auditor and management shall agree on and
record the new terms of the engagements in an engagement letter or other suitable form of
written agreement.

If the auditor is unable to agree to a change of the terms of the audit engagement and is not
permitted by management to continue the original audit engagement, the auditor shall:

(a) Withdraw from the audit engagement where withdrawal is possible under applicable
law or regulation; and
(b) Determine whether there is any obligation, either contractual or otherwise, to report
the circumstances to other parties such as those charged with governance owners
or regulators.

Figure 2.2 shows an illustrative of an audit engagement letter.

ACCOUNTING 14 4
Figure 2.2 Illustrative Engagement Letter
Valderama & Co., CPAs
7560 Sen. Gel Puyat Avenue, Makati City

October 15, 2013

Mr. Alberto Santos, Managing Director

ABC, Inc.
165 Tandang Sora, Quezon City

Dear Mr. Santos:

You have requested that we audit the financial statements of ABC, Inc. which comprise the
statement of financial position as at December 31, 2013, and the income statement, statement of
changes in equity and cash-flow statement for the year ended, and a summary of significant
accounting policies and other explanatory information. We are pleased to confirm our acceptance
and our understanding of this audit engagement by means of this letter. Our audit will be
conducted with the objective of our expressing an opinion on the financial statements.

Our Responsibilities

We will conduct our audit in accordance with Philippine Standards on Auditing. Those standards
require that we comply with ethical requirements and plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free from material misstatement.
An audit involves performing procedures to obtain audit evidence about the amounts and
disclosures in the financial statements. The procedures selected depend on the auditor’s judgment,
including the assessment of the risks of material misstatement of the financial statements, whether
due to fraud or error. An audit also includes evaluating the appropriateness of accounting policies
used and the reasonableness of accounting estimates made by management, as well as evaluating
the overall presentation of the financial statements.

Because of the inherent limitations of an audit, together with the inherent limitations of internal
control, there is an unavoidable risk that some material misstatements may not be detected, even
though the audit is properly planned and performed in accordance with PSAs.

In making our risk assessments, we consider internal control relevant to the entity’s preparation of
the financial statements in order to design audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s
internal control. However, we will communicate to you in writing any significant deficiencies in
internal control relevant to the audit of the financial statements that we have identified during the
audit.

Unless unanticipated difficulties are encountered, our report will be substantially in the following
form:

[Form and content of the auditor’s report has not been reproduced.]
ACCOUNTING 14 5
The form and content of our report may need to be amended in the light of our audit findings.

Management’s Responsibility

Our audit will be conducted on the basis that management and those charged with governance
acknowledge and understand that they have responsibility:

a) For the preparation and fair presentation of the financial statements in accordance with
Philippine Financial Reporting Standards;
b) For such internal control as management determines is necessary to enable the preparation
\ of financial statements that are free from material misstatement. whether due to fraud or
error; and
c) To provide us with:

i. Access to all information of which you are aware that is relevant to the
preparation of the financial statements such as records, documentation
and other matters;
ii. Additional information that we may request from you for the purpose of
the audit; and
iii. Unrestricted access to persons within the company from whom we
determine it necessary to obtain evidence.
As part of our audit process, we will request from management and, where appropriate, those
charged with governance written confirmation concerning representations made to us in
connection with the audit.

We look forward to full cooperation from your staff during our audit.

Fees

Our fees which are based on the time required by individuals assigned to the engagement will be
Php100, 000 plus out-of-pocket expenses and will be billed as work progresses. Individual hourly
rates vary according to the degree of responsibility involved and the experience and skill required.

This letter will be effective for future periods unless it is terminated, amended or superseded.

Please sign and return the attached copy of this letter to indicate that it is in accordance with your
understanding of the arrangements for our audit of the financial statements.

Yours truly, acknowledge on behalf of ABC, Inc. by

Alvin Monico Mr. Alberto Santos

Valderama & Co., CPAs Managing Director
(Date)

ACCOUNTING 14 6
PLANNING THE AUDIT

Nature and Scope of Audit Planning

Audit Planninginvolves the establishment of the overall audit strategy for the engagement and
developing an audit plan, in order to reduce audit risk to an acceptably low level. Planning
involves the engagement partner and other key members of the engagement team to benefit from
their experience and insight and to enhance the effectiveness and efficiency of the planning
process.

The nature and extent of planning activities will vary according to the size and complexity of the
entity, the auditor’s previous experience with the entity, and changes in circumstances that occur
during the audit engagement.

Planning is a continuous and iterative process that often begins shortly after or in connection
with the completion of the previous audit and continues until the completion of the current audit
engagement. However, in planning activities an audit, the auditor considers the timing of certain
planning activities and audit procedures that need to be completed prior to the performance of
further audit procedures. For example, the auditor plans the discussion among engagement team
members, the analytical procedures to be applied as risk assessment procedures, the obtaining of
a general understanding of the legal and regulatory framework applicable to the entity and how
the entity is complying with that framework, the determination of materiality, the involvement of
experts and the performance of other risk assessment procedures prior to identifying and
assessing the risks of material misstatement and performing further audit procedures at the
assertion level for classes of transactions, account balances, and disclosures that are responsive
to those risks.

Benefits of Audit Planning

Audit planning generally involves the determination of the expected nature, timing and extent of
the audit. Among the benefits derived from audit planning are the following:

(a) It helps ensure that appropriate attention is devoted to important areas of the audit.
(b) It aids in identifying potential problems and resolving them on a timely basis.
(c) It helps ensure that the audit is properly organized, manage and performed in an effective
and efficient manner.
(d) It assists in the proper assignment and review of the work of the engagement team
members.
(e) It helps coordinate the work to be done by auditors of components and other parties
involved such as experts, specialists. etc.

Overall Audit Strategy

PSA 300 requires that the auditor establish the overall strategy for the audit. This overall audit
strategy sets the scope, timing, and direction of the audit and guides the development of the more

ACCOUNTING 14 7
detailed audit plan. In developing the audit strategy, the auditor considers the results of the
preliminary activities described in the preceding paragraph. The process of establishing the audit
strategy involves

a. Determining the characteristics of the engagement that define its scope. Examples are:

1. The financial reporting framework

2. Industry specific reporting requirements, and
3. The locations of the components of the entity.

b. Ascertaining the reporting objectives of the engagement to plan the timing of the audit
and the nature of the communication required such as

1. Deadlines for interim and final reporting, and

2. Key dates for expected communications with management and those charged with
governance.

c. Considering the important factors that will determine the focus of the engagement teams
efforts, such as

1. Determination of appropriate materiality levels

2. Preliminary identification of areas where there may be higher risks of material
misstatement.
3. Preliminary identification of material components and account balances.
4. Evaluation of whether the auditor may plan to obtain evidence regarding the
effectiveness of internal control, and
5. Identification of recent significant entity-specific, industry, financial reporting or other
relevant developments.

Other Benefits of Developing the Audit Strategy

The process of developing the audit strategy helps the auditor to ascertain the nature, timing and
extent of resources necessary to perform the engagement. The audit strategy sets out clearly, in
response to the matters identified in the above-mentioned process, and subject to the completion
of the auditor’s risk assessment procedures:

(a) The resources to deploy for specific audit areas, such as the use of appropriately
experienced team members for high risk areas or the involvement of experts on
complex matters;
(b) The amount of resources to allocate to specific audit areas; such as

1. The number of team members assigned to observe the inventory count at

material locations.
2. The extent of review of other auditors work in the case of group audits, or

(c) When these resources are deployed, such as whether at an interim audit stage or at

ACCOUNTING 14 8
 key cut-off dates; and
(d) How such resources are managed, directed and supervised, such as when team
briefing and debriefing meetings are expected to be held, how engagement partner
and manager reviews are expected to take place (for example, on-site or off-site),
and whether to complete engagement quality control reviews.

The Appendix of PSA 300 lists examples of matters the auditor may consider in establishing the
overall audit strategy for an engagement. Many of these matters will also influence the auditor’s
detailed audit plan. The examples provided cover a broad range of matters applicable to many
engagements. while some of the matters referred to below may be required to be performed by
other PSAs, not all matters are relevant to every audit engagement and the list is not necessarily
complete. In addition, the auditor may consider these matters in an order different from that
shown below.

Scope of the audit Engagement

The auditor may consider the following matters when establishing the scope of the audit
engagement:

 The financial reporting framework on which the financial information to be audited has
been prepared, including any need for reconciliations to another financial reporting
framework.
 Industry-specific reporting requirements such as reports mandated by industry
regulators.
 The expected audit coverage, including the number and locations of components to be
included.
 The nature of the control relationships between a parent and its components that
determine how the group is to be consolidated.
 The extent to which components are audited by other auditors.
 The nature of the business segments to be audited, including the need for specialized
knowledge.
 The reporting currency to be used, including any need for currency translation for the
financial information audited.
 The need for a statutory audit of stand alone financial statements in addition to an audit
for consolidation purposes.
 The availability of the work of internal auditors and the extent of the auditor’s potential
reliance on suck work.
 The entity’s use of service organizations and how the auditor may obtain evidence
concerning the design or operation of controls performed by them.
 The expected use of audit evidence obtained in prior audits, for example, audit evidence
related to risk assessment procedures and tests of controls.
 The effect of information technology on the audit procedures including the availability
of data and the expected use of computer-assisted audit techniques.

ACCOUNTING 14 9
  The coordination of the expected coverage and timing of the audit work with any
reviews of interim financial information and the effect on the audit of the information
obtained during such reviews.
 The discussion of matters that may affect the audit with firm personnel responsible for
performing other services to the entity.
 The availability of client personnel and data.

Reporting Objectives, Timing of the Audit and Communications Required

The auditor may consider the following matters when ascertaining the reporting objectives of the
engagement, the timing of the audit and the nature of communications required:

 The entity’s timetable for reporting, such as at the interim and final stages.
 The organization of meetings with management and those charged with governance to
discuss the nature, extent and timing of the audit work.
 The discussion with management and those charged with governance regarding the
expected type and timing of reports to be issued and other communications, both written
and oral, including the auditor’s report, management letters and communications to those
charged with governance.
 The discussion with management regarding the expected communications on the status of
audit work throughout the engagement and the expected deliverables resulting from the
audit procedures.
 Communication with auditors of components regarding the expected types and timing of
reports to be issued and other communications in connection with the audit of
components.
 The expected nature and timing of communications among engagement team members,
including the nature and timing of team meetings and timing of the review of work
performed.
 Whether there are any other expected communications with third parties, including any
statutory or contractual reporting responsibilities arising from the audit.

Figure 2.3 presents an illustrative overall strategy memorandum.

ACCOUNTING 14 10
Figure 2.3 Illustrative Overall Strategy Memorandum

Name of Client: XYZ Company

Overall Strategy Memo

Period end December 31, 2014

Scope

The scope of the audit has not changed this period. Audit to comply with PSAs and the PFRS
that affect XYZ Company this year.

Entity Changes

XYZ Company is planning to make sales to other Southeast Asian Countries.

Internet sales are also increasing and XYZ’IT capabilities will be stretched.

XYZ Company is now selling to Momentus Merchandising. This company is renowned for
squeezingprofit margins of suppliers in exchange for giving large orders. It also requires
suppliers to maintain additional inventories of some products for instant delivery as required.

Risk

Our assessment of risk at the financial level is low. Management is not particularly
sophisticated but there is a strong commitment to competence; it has introduced a code of
ethics and, in general, has good attitude toward internal control.

Overall Strategy

1. Materiality for the financial statements as a whole will be increased from P80, 000 to
P100, 000 this period to reflect the growth in sales and profitability during the last
period. Performance materiality (based on our assessment of audit risk) has been set at
P75, 000, except for certain account balances.
2. Use the same senior staff as last period and perform the work at the same time.
3. Perform our risk assessment procedures at the end of August. There are no plans to
change any systems at present.
4. At our team planning meeting to be held on November 15, 2014 we need to:

a) Consider the susceptibility of the financial statements to fraud.

b) Emphasize use of professional skepticism by our staff,
c) Identify fraud scenarios by employees and management; and
d) Focus on identification of related party transactions that have been growing and
expanding our testing.

ACCOUNTING 14 11
 5. Attend the period-end inventory counts. There are still no ongoing inventory control
procedures.
6. Use David (who is knowledgeable about IT systems) to identify the risks of material
misstatement relating to the Internet sales and whether any relevant internal controls
exist to mitigate such risks. He will also assess the general IT controls.

Audit Partner (signed): Maurico Cruz

Date: October 30, 2014

The Audit Plan

Once the audit strategy has been established, the auditor is able to start the development of a
more detailed audit plan to address the various matters identified in the audit plan to address the
various matters identified in the audit strategy, taking into account the need to achieve the audit
objectives through the efficient use of the auditor’s resources. Although the auditor ordinarily
establishes the audit strategy before developing the detailed audit plan, the two planning
activities are not necessarily discrete or sequential changes to the other. The auditor should
develop an audit plan for the audit in order to reduce audit risk to an acceptably low level.

The audit plan is more detailed than the audit strategy and includes the nature, timing and extent
of audit strategy procedures to be performed by engagement team members in order to obtain
sufficient appropriate audit evidence to reduce audit risk to an acceptably low level.
Documentation of the audit plan also serves as a record of the proper planning and performance
of the audit procedures that can be reviewed and approved prior to the performance of further
audit procedures.

The audit plan includes:

 A description of the nature, timing and extent of planned risk assessment procedures
sufficient to assess the risks of material misstatement, as determined under PSA 315.
“Understanding the Entity and its Environment and Assessing the Risks of Material
Misstatement”.
 A description of the nature, timing and extent of planned further audit procedures at the
assertion level for each material class of PSA 330. “The Auditor’s Procedures in
Response to Assessed Risks,” The plan for further audit procedures reflects the auditor’s
decision whether to test the operating effectiveness of controls, and the nature, timing
extent of planned substantive procedures; and
 Such other audit procedures required to be carried out for the engagement in order to
comply with PSAs (for example, seeking direct communication with the entity’s
lawyers).

ACCOUNTING 14 12
Planning for these audit procedures takes place over the course of the audit as the audit plan for
the engagement develops. For example, planning of the auditor’s risk assessment procedures
ordinarily occurs early occurs early in the audit process. However, planning of the nature, timing
and extent of specific further audit procedures depends on the outcome of those risk assessment
procedures. In addition, the auditor my begin the execution of further audit procedures for some
classes of transactions, account balances and disclosures before completing the more detailed
audit plan of all remaining further audit procedures.

Changes to Planning Decisions During the Course of the Audit

The overall audit strategy and the audit plan should be updated and changed as necessary during
the course of the audit.

Planning an audit is a continual and iterative process throughout the audit engagement. As a
result of unexpected events, changes in conditions, or the audit evident obtained from the results
of audit procedures, the auditor may need to modify the overall audit strategy and audit plan, and
thereby the resulting planned nature, timing and extent of further audit procedures. Information
may come to the auditor’s attention and differs significantly from the information available when
the auditor planned the audit procedures. For example, the auditor may obtain audit evidence
through the performance of substantive procedures that contradicts the audit evidence obtained
with respect to the testing of the operating effectiveness of controls. In such circumstances, the
auditor re-evaluates the planned audit procedures, based on the revised consideration of assessed
risks at the assertion level for all or some of the classes of transactions, account balances or
disclosures.

Direction, Supervision and Review

The auditor should plan the nature, timing and extent of direction and supervision of engagement
team members and review of their work.

The nature, timing and extent of the direction and supervision of engagement team members and
review of their work vary depending on many factors, including the size and complexity of the
entity, the area of audit, the risks of material misstatement, and the capabilities and competence
of personnel performing the audit work. PSA 220 contains detailed guidance on the direction,
supervision and review of audit work.

The auditor plans the nature, timing and extent of direction and supervision of engagement team
members based on the assessed risk of material misstatement. As the assessed risk of material
misstatement increases, for the area of audit risk, the auditor ordinarily increases the extent and
timeliness direction and supervision of engagement team members and performs a more detailed
review of their work. Similarly, the auditor plans the nature, timing and extent of review of the
engagement team’s work based on the capabilities and competence of the individual team
members performing the audit work.

ACCOUNTING 14 13
In audits of small entities, an audit may be carried out entirely by the audit engagement partner
(who may be a sole practitioner). In such situations, questions of direction and supervision of
engagement team members and review of their work do not arise as the audit engagement
partner, having personally conducted all aspects of the work, is aware of all material issues. The
audit engagement partner (or sole practitioner) nevertheless needs to be satisfied that the audit
has been conducted in accordance with PSAs. Forming an objective view on the appropriateness
of the judgments made in the course of the audit can present practical problems when the same
individual also performed the entire audit. When particularly complex or unusual issues are
involved, and the audit is performed by a sole practitioner, it may be desirable to plan to consult
with other suitably-experienced auditor’s professional body.

Documentation

The auditor should document the overall audit strategy and the audit plan, including any
significant changes made during the audit engagement.

The auditor’s documentation of the overall audit strategy records the key decision considered
necessary to properly plan the audit and to communicate significant matters to the engagement
team. For example, the auditor may summarize the overall audit strategy in the form of a
memorandum that contains key decisions regarding the overall scope, timing and conduct of the
audit.

The auditor’s documentation of the audit plan is sufficient to demonstrate the planned nature,
timing and extent of risk assessment procedures, and further audit procedures at the assertion
level for each material class of transaction, account balance, and disclosure in response to the
assessed risks. The auditor may use standard audit programs or audit completion checklists.
However, when such standard programs or checklists are used, the auditor appropriately tailors
them to reflect the particular engagement circumstances.

The auditor’s documentation of any significant changes to the originally planned overall audit
strategy and to the detailed audit plan includes the reasons for the significant changes and the
auditor’s response to the events, conditions, or results of audit procedures that resulted in such
changes. For example, the auditor may significantly change the planned overall audit strategy
and the audit plan as a result of material business combination or record or the identification of a
material misstatement of the financial statements. A record of the significant changes to the
overall audit strategy and audit plan, and resulting changes to the planned nature, timing and
extent of audit procedures, explains overall strategy and audit plan finally adopted for the audit
and demonstrates the appropriate response to significant changes occurring during the audit.

The form and extent of documentation depend on such matters as the size and complexity of the
entity, materiality, the extent of other documentation, and the circumstances of the specific audit
engagement.

ACCOUNTING 14 14
Communication With Those Charged With Governance and Management

The auditor may discuss elements of planning with those charged with governance and the
entity’s management. These discussions may be a part of overall communications required to be
made to those charged with governance of the entity or may be made to improve the
effectiveness and efficiency of the audit. Discussions with those charged with governance
ordinarily include the overall audit strategy and timing, of the audit, including any limitations
thereon, or any additional requirements. Discussions with management often occur to facilitate
the conduct and management of the audit engagement (for example, to coordinate some of the
planned audit procedures with the work of the entity’s personnel). Although these discussions
often occur, the overall audit strategy and the audit plan remain the auditor’s responsibility.
When discussions of matters included in the overall audit strategy or audit plan occur, care is
required in order to not compromise the effectiveness of the audit. For example, the auditor
considers whether discussing the nature and timing of detailed audit procedures with
management compromises the effectiveness of the audit making the audit by making the audit
procedures too predictable.

Additional Considerations in Initial Audit Engagements

For initial audits, additional matters the auditor may consider in developing the overall audit
strategy and audit plan include the following:

 Unless prohibited by law or regulation, an arrangement to be made with the previous

auditor, for example, to review the previous auditor’s working papers.
 Any major issues (including the application of accounting principles or of auditing and
reporting standards) discussed with management in connection with the initial selection
as auditors, the communication of these matters to those charged with governance and
how these matters affect the overall audit strategy and audit plan.
 The planned audit procedures to obtain sufficient appropriate audit evidence regarding
opening balances (see PSA 510, “Initial Audit Engagements-Opening Balances”).
 The assignment of firm personnel with appropriate levels of capabilities and competence
to respond to anticipated significant risks.
 Other procedures required by the firm’s system of quality control for initial audit
engagements (for example, the firm’s system of quality control may require the
involvement of another partner or senior individual to review the overall audit strategy
prior to commencing significant audit procedures to review reports prior to their
issuance).

Other Critical Matters in Engagement Planning

1. Application of Analytical Procedures in Planning the Audit

The purpose of applying analytical procedures in planning the audit is to assist in

understanding the business and in identifying areas of potential risk. It will therefore
assist the auditor in planning the nature, time and extent of auditing procedures that will

ACCOUNTING 14 15
 be used to obtain evidential matter for specific account balances or classes of
transactions. By identifying such things is the existence of unusual transactions and
events, and planning ramifications might be brought to light. Likewise, relevant non-
financial information such as number of employees, area of selling space, volume of
goods produced may also contribute to the accomplishment of the purposed of the
analytical procedures.

When use for planning purposes, analytical procedures assists the auditor in planning the
nature, timing and extent of the audit procedures that will be used for the specific
accounts. The approach used in one of obtaining an understanding of the clients business
and transactions identifying areas that may represent higher risks. The auditors will then
plan a more thorough investigation of these potential problem areas and perform a more
effective audit. PSA 520 requires the auditor to perform analytical procedures as a part
of the planning process for every audit.

2. Establishment of an Engagement or Audit Team

An audit team consists of people with different levels of expertise and experience. The
team usually is composed of an engagement partner, a manager at least one senior, and
one or more staff auditors. In determining the number of people who will be assigned to
an engagement, an auditor normally considers the audit’s size and complexity, the
availability and experience of personnel, the necessity for special expertise the
opportunity to train personnel, and the continuity and rotation of personnel.The audit
team assembled for a larger engagement typically is larger than that needed for a smaller
engagement. An engagement involving an entity in a regulated industry, such as
banking, also requires that the major members of the audit team have necessary
knowledge and experience in that industry.

3. Consideration of Work Performed by Other Auditor’s/Parties

The following should be considered:

 The involvement of the auditors in the audit of components, for example,

subsidiaries, branches and divisions.
 The involvement of experts.
 The number of locations.

a. Predecessor Auditor

The successor auditor’s examination may be greatly facilitated by consulting with the
predecessor auditors and reviewing the predecessor’s working papers. Communication
with predecessor auditors can be provide the successor CPA with background
information about the client, details about the client’s system of internal control, and
evidence as to the account balances at the beginning of the year under audited.

ACCOUNTING 14 16
 Auditors are ethically prohibited from disclosing confidential information obtained in the
course of an audit without the consent of the client. The successor auditor should
therefore obtain the client’s consent before making inquiries from the predecessor
auditors.

If the auditor is unable to obtain cooperation from the preceding auditors, or if he feels
that the work done by the proceeding auditors does not meet the requirements of PSAs,
he may have to treat the audit of the new client, previously audited by the other
accountants, just as he would the first audit of a client who has never been audited before.

b. Other CPAs

When a portion of the client (e.g., subsidiary in a distant city) is audited by another CPA
firm, efforts may be coordinated. For example, if the accounts of the subsidiary are to be
consolidated with the overall enterprise, and if that subsidiary is audited by another CPA
firm, the auditors must coordinate timing of necessary reports and procedures to be
performed.

c. Specialists

CPAs may lack the qualification necessary to perform certain technical tasks relating to
the audit. A specialist brings unique knowledge and judgment in a field other than
accounting and auditing. An auditor might decide to have an art appraiser places values
on works of art, a mineralogist determine the physical characteristics of mineral reserves,
or an actuary provide data related to a group’s life expectancy. Effective planning
involves arranging for the appropriate use of specialists both inside and outside of the
client organization.

d. Use of Client’s Staff

The auditors should obtain an understanding with the clients as to the extent to which the
client’s staff, including the internal auditors, can help prepare for the audit. The client’s
staff should have the accounting records up-to-date when the auditors arrive. In addition
many audit working papers can be prepared for the auditors by the client’s staff, thus
reducing the cost of the audit and freeing the auditors from routine work. The auditors
may set up the columnar headings for such working papers and give instructions to the
client’s staff as to the information to be gathered. These working papers should bear the
label Prepared by Client, or PBC; and also the initials of the auditor who verifies the
worked performed by the client’s staff. Working papers prepared by the client should
never be accepted at face values; such papers must be reviewed and tested by the
auditors.

Among the tasks that may be assigned to the client’s employees are the preparations of a
trial balance of the general ledger, preparation of an aged trial balance of accounts
receivable, analyses of accounts receivable, analysis of accounts receivable written off,
lists of property additions and retirements during the year, and analyses of various

ACCOUNTING 14 17
 revenue and expense accounts. Many of these “working papers” may be in the form of
computer spreadsheets and other computerized data files.

e. Internal Auditors

Internal auditors can affect the audit in two ways. First, they can enhance internal control.
For example, if internal auditors determined the bank reconciliations were properly
prepared and all cash receipts were deposited, the entity’s controls would enhance the
reliability of the accounting records. In such cases, independent auditors would be able to
reduce the extent of substantive testing. In deciding whether to reduce the amount of
testing for specific assertions because of work performed by internal auditors, the
independent auditor should consider (1) the materiality of the amount, (2) the risk of
misstatement, and (3) the degree of subjectivity involved in evaluating the accumulated
audit evidence. As these factors increase, the auditor is less likely to rely on the internal
auditor’s work.

The second way internal auditors affect an audit is by assisting independent auditors in
performing specific audit procedures. For example, an internal auditor may observe client
personnel taking the inventory.

4. Assessment of Going Concern Assumption

When planning and performing audit and in evaluating the results thereof, the auditor
should consider the appropriateness of management’s use of the going concern
assumption in the preparation of the financial statements.

PSA 570 requires to evaluate whether substantial doubt exists about an entity’s ability to
continue as a going concern, based on procedures planned and performed to obtain
evidence about the management assertions embodied in the financial statements. That is,
an auditor is not required to design specific procedures to evaluate whether an entity is a
going concern. But when information obtained during the audit raises substantial doubt
about the entity’s ability to continue in operation for a year following the date of the
financial statements being audited, the auditor should add a paragraph calling attention
to the fact that the statements have been prepared assuming that the entity will continue
as a going concern.

Examples, of events or conditions, which individually or collectively, may cast

significant doubt about the going concern assumption, are set out below. The listing is
not all-inclusive nor does the existence of one or more of the items always signify that a
material uncertainly exists.

ACCOUNTING 14 18
 Financial

 Net liability or net current liability position.

 Fixed-term borrowings approaching maturity without realistic prospects of
renewal or repayment: or excessive reliance on short-term borrowings to finance
long-term assets.
 Indications of withdrawal of financial support by debtors and other creditors.
 Negative operating cash flows indicated by historical or prospective financial
statements.
 Adverse key financial ratios.
 Substantial operating losses or significant deterioration in the value of assets used
to generate cash flows.
 Arrears or discontinuance of dividends.
 Inability to comply with the terms of loan agreements.
 Change from credit to cash-on delivery transactions with suppliers.
 Inability to obtain financing for essential new product development or other
essential investments.

Operating

 Loss of key management without replacement.

 Loss of a major market, franchise, license, or principal supplier.
 Labor difficulties or shortages of important supplies.

Other

 Non-compliance with capital or other statutory requirements.

 Pending legal or regulatory proceedings against the entity that may, if successful,
result in claims that are unlikely to be satisfied.
 Changes in legislation or government policy expected to adversely affect the
entity.

The significance of such events or conditions often can be mitigated by other factors. For
example, the effect of an entity being unable to make its normal debt repayments may be
counter-balanced by management’s plans to maintain adequate cash flows alternatives means,
such as by disposal of assets, rescheduling of loan repayments, or obtaining additional capital.
Similarly, the loss of a principal supplier may be mitigated by the availability of a suitable
alternative source of supply.

5. Identification of Related Parties

Transactions with related parties are important to auditors because they will be disclosed
in the financial statements if they are material. Financial reporting standards require

ACCOUNTING 14 19
 disclosure of the nature of the related party relationship; a description of transactions,
including peso amounts; and amounts due from and to related parties. Most auditors
assess inherent risk as high for related parties and related party transactions, both
because of the accounting disclosure requirements and the lack of independence between
the parties involved in the transactions.

A related party is defined as an affiliated company, a principal owner of the client

company, or any other party with which the client deals where one of the parties can
influence the management or operating policies of the other. A related party transaction
is any transaction is any transaction between the client and a related party. Common
examples include sales or purchase transactions between a parent company and its
subsidiary, exchanges of equipment between two companies owned by the same person,
and loans to officers. A less common example is the exercise of significant management
influence on an audit client by its most important costumer.

Because material related party transactions must be disclosed, it is important that all
related parties be identified and included in the permanent files early in the engagement.
Finding undisclosed related party transactions is thereby enhanced. Common ways of
identifying related parties include inquiry of management, review of SEC filings, and
examination of stockholders’ listing to identify principal stockholders.

6. Client’s Legal Obligations

Pertinent current-year information that auditors should review includes (1) minutes of
director’s and stockholder’s meetings. (2) changes to articles of incorporation or by-
laws, and (3) any significant contracts executed during the year. By reading the minutes,
an auditor will obtain information about significant events that have an impact on the
client. For example, an auditor should be alert to the following:

 Major contracts or agreements, including merger and acquisition agreements,

debt agreements, compensation agreements, and asset purchase agreements
 Information about current situations and future business plans
 Authorized of dividends.

For new clients for which historical information relating to these matters in unavailable, the
auditor should review information relating to prior years. For example, instead of reading only
the changes to the articles of incorporation and by-laws, the auditor should read the articles of
incorporation and by-laws since the inception of the entity, making appropriate summaries for
the permanent file. The auditor should also read all contracts having an impact on the current
year.

ACCOUNTING 14 20
 7. Completion of the Initial Audit Program

An audit program is a set of audit procedures specifically designed for each audit. The
program which includes both substantive tests and tests of controls will enable the
auditor to express an opinion on the financial statements taken as a whole.

The auditor should develop and document an audit program setting out the nature, timing
and extent of planned audit procedures required to implement the overall audit plan. The
audit program serves as a set of instructions to assistants involved in the audit and as
means to control and record the proper execution of the work. The audit program may
also contain the audit objectives for each area and a time budget in which hours are
budgeted for the various audit areas of procedures.

Considering materiality, risk of misstatement, and the relative cost of performing audit
procedures, auditors determine the procedures to test the assertions embodied in the
financial statements. The audit program is a list of audit procedures to be performed so
that the auditor will have evidence as a basis for expressing an opinion of the financial
statements. For example, an auditor might include the following two steps in the initial
audit program to test the existence of sales:

1. For example of entries in the sales journal, compare data in the sales journal to
the approved customer order, the sales order, the shipping document, and the
sales invoice.
2. Confirm a sample of accounts receivable at year-end.

Auditing standards require that a written audit program be prepared as a part of each
engagement.

In preparing the audit program, the auditor would consider the specific assessments of inherent
and control risks and the required level of assurance to be provided by substantive procedures.
The auditor would also consider the timing of tests of controls and substantive procedures, the
coordination of any assistance expected from the entity, the availability of assistants and the
involvement of other auditors or experts. Other matters may also need to be considered in more
detail during the development of the audit program.

(1) the broad phases of the program can be outlined at the time of engagement:
(2) other details of the program can be identified after the review of internal structure
and accounting procedures has begun; and
(3) procedures on specific phases of the audit can be further challenged and revised
as the work progresses.

On recurring engagements, the problem for the preceding audit should be studied before
preparing the program for the current audit. The program for the current audit should reflect
modifications or are required by the experience gained in the business, internal control or
accounting methods of the client.

ACCOUNTING 14 21
In planning his examination, the auditor should consider the nature extent and timing of work to
be performed and should prepare a written audit program (or a set of written audit program). An
audit program aids in instructing assistants in the work to be done. It should set forth to
reasonable detail the audit procedures that the auditor believes are necessary accomplish the
objectives of the examination. The form of the audit and the extent of its detail will vary. In
developing the program the auditor should be guided by the results of the planning
considerations and procedures. As the examination progresses, changed conditions or unexpected
results of audit procedures applied may make it necessary to modify planned audit procedures.

In preparing the audit program, the auditor, having an understanding of the accounting system
and related internal control, may wish to rely on certain controls in determining the nature,
timing and extent of required auditing procedures. The auditor may conclude that relying on
certain internal controls is an effective and efficient way to conduct his audit. However, the
auditor may decide not to rely on internal controls when there are other more efficient ways of
obtaining sufficient appropriate audit evidence. The auditor should also consider the timing of
the procedures, the coordination of any assistance expected from the client, the availability of
assistance, and the involvement of other auditors or experts.

The auditor normally has flexibility in deciding when to perform audit procedures, as very few of
them have to be carried out within specific time limits. For example, procedure carried out on
transactions can be performed at any time after the transactions have been recorded. On the other
hand, the auditor may have no discretion as to timing, for example, when observing the taking of
inventories by client personnel.

8. Preparation of a Time Budget

A time budget is an estimate of the total hours an audit is expected to take. It is based on
the information obtained in the first major step in the audit that is, obtaining an understanding
of the client. It takes into consideration such things as:

a) the client’s size as indicated by its gross assets, sales, number of employees
b) location of client facilities
c) the anticipated accounting and auditing problems
d) the competence and experience of staff available.

The total time must be allocated by the preparation of work schedules indicating who is to do
what and how long it should take. Thus, total hours are budgeted by major categories and may be
scheduled on a weekly basis. Time budget also reserves as the basis for estimating fees. It is also
an important tool to communicate to the audit staff those areas the manager or partner believes
are critical and require more time. Furthermore, a time budget is used to measure the efficiency
of the staff and to determine at each stage of the engagement whether the work is progressing at
a satisfactory rate. An illustration of an Audit Budget and Time Summary is shown in Figure 2.4

For repeat engagement,, the development of time budgets is facilitated by reference to the
preceding year’s detailed time records.

ACCOUNTING 14 22
Managing time is an important consideration because billing is often based on the amount of
time charged to the engagement. Indeed, the most costly element of an engagement is the
auditor’s time. Time budgets can motivate staff to perform efficiently, and one criterion by
which audit personnel are evaluated is their ability to complete assignments within the allotted
time. (However, placing too much emphasis on time management can lower the quality of the
audit.)

A special concern in auditing has been the “underreporting of time,” in which a staff member
reports only a fraction of the actual time spent performing a particular audit procedure. Some
auditors take work home, complete it in the evening, and do not charge that time. Staff members
may feel that they will look bad if they cannot complete a procedure within an allocated time, or
they may want to impress their supervisor by finishing (or appearing to finish) below budgeted
time. However, such practices can create several problems, both for the firm for the following
year’s audit team. If the term bases its charges on staff hours worked, underreporting causes the
firm to lose revenue to which it is entitled. Underreporting also creates an unrealistic basis for
the following years’ time budget. In addition, if completing an assignment requires staff
members to work additional hours for which they are not compensated, they may experience
burnout.

A periodic accounting of time and budget may be prepared as a basis for determining the
cause(s) of the variance between actual and budgeted hours. This is illustrated in Figure 2.5 on
page 55. This report will also serve as a guide in projecting the audit time for the succeeding
audits.

The development of time budgets is facilitated in repeat engagements by reference to the

preceding years detailed time records. Sometimes time budgets provide quite unattainable
because the client’s records are not satisfactory condition, or because of other special
circumstances that arise. Even when time estimates are exceeded, there can be no comprised with
qualitative standards in the performance of the field work. The CPA firm’s professional
reputation and its legal liability to clients and third parties do not permit any shortcutting or
omission of audit procedures to meet a predetermined time estimate.

Figure 2.4 Portions of an Audit Budget and Time Summary

ACCOUNTING 14 23
9. Assignment of Personnel to the Engagement

Staff must, therefore, be assigned with that standard in mind. On larger engagements,
there are likely to be one or more partners and staff at several experience levels doing the audit.
Specialists in such technical areas as statistical sampling and computer auditing may also be
assigned. On smaller audits there may be only one or two staff members.

A major consideration affecting staffing is the need for continuity from year to year. An
inexperienced staff assistant is likely to become the most experienced nonpartner on the
engagement within a few years. Continuity helps the CPA firm maintain familiarity with
technical requirements and closer interpersonal relations with client personnel.

Another consideration is that the persons assigned be familiar with the client’s industry.

In PSA 220, “Quality Control for an Audit Financial Statements,” the auditor, and assistants
with supervisory responsibilities, will consider the professional competence of assistants
performing work delegated to them when deciding the extent of direction, supervision and
review appropriate for each assistant.

Any delegation of work to assistants would be in a manner that provides reasonable assurance
that such work will be performed with due care by persons having the degree of professional
competence required in the circumstance.

ACCOUNTING 14 24
To illustrate the importance of assigning appropriate staff to engagements, consider a computer
manufacturing client with extensive inventory of computers and computer parts. Inherent risk for
inventory has been assessed as high. It is essential for the staff person doing the inventory
portion of the audit to be experienced in auditing inventory. In addition, he or she should have a
good understanding of the computer manufacturing industry.

10. Scheduling of Work

Audit work that can always be performed during the interim period includes the consideration of
internal control, issuance of management letter, and substantive tests of transactions that have
occurred to the interim date.

Interim tests of certain financial statements balances, such as accounts receivable, may also be
performed, but this results in additional risk that must be controlled by the auditors. Significant
errors or irregularities could arise in these accounts during the remaining period between time
that the interim test was performed and the statement of financial position date. Thus, to rely on
the interim test of a significant account balance, the auditors must perform additional tests of the
account during the remaining period.

Performing audit work during the interim period has numerous advantages in addition to
facilitating the timely release of the audited financial statements. The independent auditors may
be able to assess internal control more effectively by observing and testing controls at internal
control more effectively by observing and testing controls at various times throughout the year.
Also, they can give early consideration to accounting problems. Another advantage is that
interim auditing creates a more uniform work load for CPA firms. With a large client, such as
San Miguel Corporation, the auditors may have office space within the client’s buildings and
perform auditing procedures throughout the entire year.

Performance of other substantive tests is scheduled near at, and after year-end. Consideration
should be given to such factors as:

a) Deadline for submitting final audit report and filing of income tax returns
b) Ability of the client’s staff to submit required schedules
c) Other audit clients

Planning a Repeat Engagement

It is far easier to plan for a repeat engagement than planning for a first audit of a new client. The
working papers in the previous year’s audit provide a wealth of information useful in planning
the recurring engagement. Of course, the auditor-in-charge of a repeat engagement would have a
good working knowledge of the client’s business. The auditor however should not merely
duplicate last year’s audit program but should modify his approach to the audit for any changes
in the client’s operations, internal control structure, or business environment.

ACCOUNTING 14 25
Special Consideration in the Audit of Small Entities (PAPS 1005)

The Philippine Standards on Auditing (PSAs) contain basic principles and essential procedures
together with related guidance that apply to the audit of the financial statements of any entity,
irrespective of its size, its legal form, ownership or management structure, or the nature of its
activities. The AASC recognizes that small entities give rise to a number of special audit
considerations.

The Philippine Auditing Practice Statement 11005. “The Special Consideration in the Audit of
Small Entities,” which was made effective for audits of financial statements for periods
beginning on or after December 15, 2004 describes the characteristics commonly found in small
entities and indicates how they may affect the application of PSAs. Reference may therefore be
made by the auditor to PAPS 1005 when handling audit of small entities.

Consideration of Environmental Matters in the Audit of Financial Statements (PAPS 1010)

Environmental matters are becoming significant to an increasing number of entities and may, in
certain circumstances, have a material impact on their financial statements. These issues are of
growing interest to the users of financial statements. The recognition, measurement, and
disclosure of these matters is the responsibility of management.

For some entities, environmental matters are not significant. However, when environmental
matters are significant to an entity, there may be a risk of material misstatement (including
inadequate disclosure) in the financial statements arising from such matters: in these
circumstances, the auditor needs to give consideration to environmental matters in the audit of
the financial statements.

PAPS 1010, “The Consideration of Environmental Matters in the Audit of Financial

Statements,” provide practical assistance to auditors by describing:

a) The auditor’s main considerations in an audit of financial statements with respect to

environmental matters;
b) Examples of possible impacts of environmental matters on financial statements; and
c) Guidance that the auditor may consider when exercising professional judgment in this
context to determine the nature, timing and extent of audit procedures with respect to:

 Understanding the entity and its environment and assessing the risks of
material misstatement (PSA 315);
 Consideration of laws and regulations (PSA 250); and
 Other substantive procedures (PSA 620 and some others).

The guidance under (c) reflects the typical sequence of the audit process. Having acquired a
sufficient knowledge of the business the auditor assesses the risk of a material misstatement in
the financial statements. The assessment includes consideration of environmental laws and
regulations that may pertain to the entity, and provides a basis for the auditor to decide whether

ACCOUNTING 14 26
there is a need to pay attention to environmental matters in the course of the audit of financial
statements.

Reference should be made by the auditor in addressing environmental matters that are significant
to the financial statement of the entity. The extent to which any of the audit procedure described
in PAPS 1010 may be appropriate in a particular case requires the exercise of the auditor’s
judgment in the light of the requirements of the PSAs and the circumstances of the entity.

ACCOUNTING 14 27