BASIC CONCEPTS OF

FINANCIAL STATEMENT AUDIT

chapter 1
(Psalm 118:8 )
[It is] better to trust in the LORD
than to put confidence in man.
 Expected Learning Outcomes
After reading this chapter, you should be able to
a. Recall the purpose of a FS audit
b. Identify the managements assertions when presenting the FS
c. Describe each major phase in FS audit
d. Identify the most common procedures applied to FS audit
e. Understand the purpose of audit documentation
f. Identify the different types of audit reports and state the type appropriate for each
conclusion drawn based on assessment of audit documentation
g. Formulate appropriate audit adjusting entries
h. Complete a working trial balance
Introduction to Audit - Overview
Definition & objective
An audit is an official examination of the accounts
(or accounting systems) of an entity (by an auditor).
The main objective of an audit is to enable an
auditor to convey an opinion as to whether or not the
financial statements of an entity are prepared
according to an applicable financial framework
 Quick Check
A Financial Statement audit aims to
a. present financial information about an entity for use by external users
b. determine whether FS presented by management are prepared in
accordance with an applicable financial reporting framework
c. determine whether the entity appropriately pays its income tax due
d. determine whether the entity is able to pay its maturing obligations
 Quick Check
A Financial Statement audit aims to
a. present financial information about an entity for use by external users
b. determine whether FS presented by management are prepared
in accordance with an applicable financial reporting framework
c. determine whether the entity appropriately pays its income tax due
d. determine whether the entity is able to pay its maturing obligations
Concepts of accountability, stewardship and agency

The shareholders own the company.

The company is managed and controlled
by its directors.
The directors have a stewardship role.
The relationship between the shareholders
of a company and the board of directors is
also an application of the general legal
principle of agency.
 Concepts of accountability, stewardship and agency

As agents for the shareholders, the board of

directors should be accountable to the
shareholders.
In order for the directors to show their
accountability to the shareholders, it is a general
principle of company law that the directors are
required to prepare annual financial statements,
which are presented to the shareholders for their
approval.
 The audit report: Independence, materiality and true and fair

Over time, the annual audit was developed as a way of adding

credibility to the financial statements produced by management.
The statutory audit is now a key feature of company law throughout
the world.
An auditor reports to the shareholders on the financial statements
produced by a companys management.
The audit report: Independence, materiality and true and fair

Directors Financial Statements Shareholders

Adds credibility

Audit report
on financial statements
 Auditing Defined
By the American Accounting Association:

An audit is a systematic process of objectively obtaining and evaluating

evidence regarding assertions about economic actions and events to ascertain
the degree of correspondence between these assertions and established criteria
and communicating the results to interested users.
 Types of Audits

Financial statement audit

Compliance Audit

Operational Audit
 The independent Financial Statement Audit

Responsibility for the financial statements Management

Assurance provided by the auditor
Reasonable assurance (not absolute) that the financial statements taken as a whole are
free from material misstatements.
Inherent limitations
 The independent Financial Statement Audit

The use of testing/sampling risk

Error in application of judgment
Reliance on management representation
Inherent limitations of the clients accounting and internal control system
Nature of evidence
Audit evidence is generally persuasive rather than conclusive in nature
 Level of assurance
The degree of assurance that can be provided about the reliability of the
financial statements of a company will depend on:
the amount of work performed in carrying out the assurance process, and
the results of that work.
 Level of assurance
An audit provides a high, but not absolute, level of assurance that the
audited information is free from any material misstatement. This is often
referred to as reasonable assurance.
 General principles governing the audit of financial
statements
1. The auditor should comply with the Code of Professional Ethics for
CPAs promulgated by BOA.
2. The auditor should conduct an audit in accordance with PAS.
3. The auditor should plan and perform the audit with an attitude of
professional skepticism.
 Theoretical framework of Auditing

1. Audit function operates on the assumption that all financial data are
verifiable.
2. The auditor should always maintain independence with respect to the
financial statements under audit.
3. There should be no long-term conflict between the auditor and the client
management.
 Theoretical framework of Auditing

4. Effective internal control system reduces the possibility of errors

and fraud affecting the financial statements.
5. Consistent application of GAAP or PFRS results in fair
presentation.
6. What was held true in the past will continue to hold true in the
future in the absence of known conditions to the contrary.
7. The audit benefits the public.
 Financial statement assertions

Existence or occurrence
Completeness
Rights & Obligations
Measurement & Allocation
Presentation & Disclosure
 Existence or occurrence

Management asserts that all assets, liabilities

and equity reported in the FS actually existed at
the reporting date and that reported income is
earned and reported expenses are incurred
during the reporting period.
 Completeness

Management asserts that all transactions and

accounts that should be presented in the FS are
the results of the transactions and other events
that actually occurred during the reporting
period.
 Rights & Obligations

Management asserts that the entity has

property rights to or control over all recorded
assets, and that all liabilities represent
obligations at the reporting date.
 Measurement & Allocation

Management asserts that the measurement bases of all

assets, liabilities, equities, income and expenses are
appropriate in accordance with the reporting standards
and that revenues, cost and expenses are recognized
during the proper reporting period based on the
appropriate revenue and expense recognition principles
 Presentation & Disclosure

Management asserts that all FS components are

presented, classified and described properly and all
relevant and required disclosures are included and
that the FS elements presented and the related notes
represent the substance and not merely the legal
form of the recorded transactions.
 Quick Check
What managements assertion does the auditor address when he/she
obtains evidential matter on the appropriate balance of Trade and Other
payables that will be shown in the statement of financial position?
a. Existence or occurrence
b. Completeness
c. Rights and Obligations
d. Measurement and allocation
 Quick Check
What managements assertion does the auditor address when he/she
obtains evidential matter on the appropriate balance of Trade and Other
payables that will be shown in the statement of financial position?
a. Existence or occurrence
b. Completeness
c. Rights and Obligations
d. Measurement and allocation
 Quick Check
What managements assertion does the auditor address when he/she
reviews the classification of a tract of land acquired exclusively for capital
appreciation?
a. Existence or occurrence
b. Presentation and disclosure
c. Rights and Obligations
d. Measurement and allocation
 Quick Check
What managements assertion does the auditor address when he/she
reviews the classification of a tract of land acquired exclusively for capital
appreciation?
a. Existence or occurrence
b. Presentation and disclosure
c. Rights and Obligations
d. Measurement and allocation
 Quick Check
What managements assertion does the auditor address when he/she
obtains evidence on the shipping terms of inventories in transit shipped
by a vendor?
a. Existence or occurrence
b. Completeness
c. Rights and Obligations
d. Measurement and allocation
 Quick Check
What managements assertion does the auditor address when he/she
obtains evidence on the shipping terms of inventories in transit shipped
by a vendor?
a. Existence or occurrence
b. Completeness
c. Rights and Obligations
d. Measurement and allocation
 THE AUDIT PROCESS
Includes both investigation and a report
This process starts when the reporting entity engages the services of an
independent auditor and ends when the auditor issues an audit report.
The auditor evaluates the internal control procedures of the client to
determine the extent and types of audit procedures necessary to gather
evidence as basis for the audit opinion.
 Major phases in FS Audit
a. pre-engagement activities
b. Audit planning and evaluation of internal
control
c. Evidence gathering
d. Reporting
 Pre-engagement activities
Includes procedures conducted to determine whether or not to accept a new
engagement or retain existing client.
Designed to manage conflicts and threats to the auditor
If the engagement is accepted or retained, the terms shall be documented in
an engagement letter
 Quick Check
Which of the following is the main objective of the conduct of pre-
engagement activities?
a. To determine whether or not accept a new client or retain an existing
client
b. To set the amount of the audit fee to be charged to the client
c. To be familiar with the working staff of the audit client
d. To assess the likelihood of issuing an unqualified opinion
 Quick Check
Which of the following is the main objective of the conduct of pre-
engagement activities?
a. To determine whether or not accept a new client or retain an existing
client
b. To set the amount of the audit fee to be charged to the client
c. To be familiar with the working staff of the audit client
d. To assess the likelihood of issuing an unqualified opinion
Audit planning and evaluation of internal control

Involves evaluation of internal control to determine the extent of audit

procedures necessary to be performed
Requires active involvement of the whole audit team, from the partner in
charge down to the audit staff.
Audit planning includes the following tasks:
1. obtaining an understanding of the client, its business, industry and accounting
policies;
2. Obtaining an understanding of the clients internal control system;
3. Assessing materiality and audit risk;
4. Identify audit objectives;
5. Determining whether reliance can be placed on certain controls in the system;
6. Determining the nature, extent and timing of substantive tests to be performed
7. Designing and finalizing the audit program.
 Quick Check
What is the main purpose of an auditor in his/her evaluation of the clients
internal control system?
a. To properly distribute the different tasks to the members of the audit team
b. To make a decision whether or not to accept a new engagement or retain an
existing client
c. To determine the extent of audit procedures necessary to be performed
d. To gather sufficient evidential matter as basis for audit opinion
 Quick Check
What is the main purpose of an auditor in his/her evaluation of the clients
internal control system?
a. To properly distribute the different tasks to the members of the audit team
b. To make a decision whether or not to accept a new engagement or retain an
existing client
c. To determine the extent of audit procedures necessary to be performed
d. To gather sufficient evidential matter as basis for audit opinion
 Evidence gathering or Audit Documentation

Must accomplish the objective of documenting the fact that the audit was
adequately planned and sufficient, competent evidential matter is obtained
that serves as basis for the audit opinion reached (ISA 230 par. 5)
 Quick Check
An auditor gathers audit documentation mainly to
a. Detect fraud and misstatements
b. Evaluate management effectiveness
c. Evaluate internal control
d. Form an opinion on the fairness of the FS
 Quick Check
An auditor gathers audit documentation mainly to
a. Detect fraud and misstatements
b. Evaluate management effectiveness
c. Evaluate internal control
d. Form an opinion on the fairness of the FS
 Audit procedures
Confirmation obtaining written statements from a third party;
Physical count and observation
Inquiry obtaining written and oral information from management, employees and others
Documentation obtaining internal evidence and external evidence
(for example: contracts, minutes of meeting, vouchers, bank statements etc)
Comparisons establishing trends and valid relationships of information
Recalculations establishing correctness of account balances
Mechanical tests of data verifying mathematical accuracy of accounting data
(tracings, footings and cross-footings)
 Typical examples of audit documentation
a. Information that enables the auditor to accept or reject an entity as a client
a. (information relating to the prospective clients industry, members of the board of directors, products manufactured, etc)
b. Information that enables the auditor to determine the audit approach
a. (information relating to the effectiveness of internal control procedures and whether or not such procedures are being
complied with)
c. Information as to whether a particular FS account balance is complete, valid and accurate
d. Information relating to the completeness, validity, and accuracy of the FS taken as a whole
including information relating to the consistency of the FS with the auditors knowledge
of the business
 The form, content, and extent of audit documentation
depend on factors, such as (ISA 230 A2)
The size and complexity of the entity
The nature of the audit procedures to be performed
The identified risks of material misstatements
The significance of the audit evidence obtained
The nature and extent of exceptions identified
The need to document a conclusion or the basis for a conclusion not readily
determinable from the documentation of the work performed or evidence obtained
The audit methodology and tools used.
 Audit file documentation serves
a. Organize and coordinate all phases of the audit engagement
b. Provide evidence to demonstrate that the planned audit procedures were in fact performed;
c. Aid partners in reviewing the work performed by audit staff members
d. Provide evidence that the auditors complied with the auditing standards;
e. Record the judgments involved in forming the audit opinion
f. Aid in planning and conducting future audits of the client
g. Provide information in rendering additional services to the audit client
a. E.g. preparing income tax returns, and in making recommendations for improvement of the clients internal control procedures
 Audit documentation (or audit working papers) must be organized in a
logical manner using an indexing system so that the working papers and
other documents can be easily located and shared among audit team
members.
The working papers and other documents should be organized in a manner
that facilitates file review and quality control monitoring by the manager,
engagement partner, quality control reviewer / monitor.
 Audit documents are the property of the audit firm.
Working papers are confidential, and generally must not be made available to
outsiders without consent of the client.
Under no circumstances should working papers be destroyed after they have
been subpoenaed or after an announcement has been made for litigation
involving an engagement.
If the auditors are charged with negligence, their audit working papers serve
as a major basis to refute or substantiate such a charge.
 Quick Check
An audit documentation should
a. not contain comments concerning management
b. Show that accounting records agree or reconcile with the
management
c. be destroyed after an announcement has been made for litigation
involving an audit engagement
d. be made available to others even without the consent of the audit
client
 Quick Check
An audit documentation should
a. not contain comments concerning management
b. Show that accounting records agree or reconcile with the
management
c. be destroyed after an announcement has been made for litigation
involving an audit engagement
d. be made available to others even without the consent of the audit
client
 Types of audit working papers
1. Audit administrative working papers
2. Working trial balance and lead schedules
3. Adjusting journal entries and reclassification entries
4. Supporting schedules, analyses, reconciliations and computational working
papers
5. Corroborating documents
 Audit administrative working papers
Aid the auditors in the planning and administration of engagements and
include the audit plans and audit programs, time budgets, internal control
questionnaires and flowcharts and engagement letter.
Administrative working papers may take the form of narrative
documentation used to summarized the phases of audit work performed on
the engagement
 Quick Check
A working paper that gives the components of a line item to be presented
on the face of the FS is called
a. Working trial balance
b. Supporting schedule
c. Lead schedule
d. Draft of financial statements
 Quick Check
A working paper that gives the components of a line item to be presented
on the face of the FS is called
a. Working trial balance
b. Supporting schedule
c. Lead schedule
d. Draft of financial statements
 Quick Check
Which of the following pair of accounts would an auditor most likely
analyze on the same working paper?
a. Notes receivable and accounts payable
b. Notes receivable and interest payable
c. Notes receivable and interest income
d. Interest income and interest expense
 Quick Check
Which of the following pair of accounts would an auditor most likely
analyze on the same working paper?
a. Notes receivable and accounts payable
b. Notes receivable and interest payable
c. Notes receivable and interest income
d. Interest income and interest expense
 In risk response phase the audit documentation
includes the following:
Audit plan that address
All material FS areas
The assessed risk of material misstatement at the FS and assertion levels
The nature, timing, and extent of the further audit procedures performed that respond to the assessed
risks
Significant risks identified
Nature and extent of consultation with others
Significance and nature of the evidence obtained at the assertion being tested
A clear explanation of the results obtained from the test and how any exceptions were
followed up
In risk response phase the audit documentation
includes the following:
Actions taken as a result of audit procedures
Changes if any required to the overall audit strategy
Use of significant judgments applied on significant matters in performing work and
evaluating results
Discussions with management on significant matters
Memoranda, analysis details assumptions used and how the validity of the
underlying assumption used was established
Cross references to supporting documentation and evidence that the FS agree or
reconcile with the underlying accounting records
 In reporting phase the audit documentation
includes the following:
Completed audit program
Evidence of file reviews
Information that is inconsistent with or contradicts the final conclusions
Summary of financial effect of unadjusted errors identified, and
managements response
Actions taken to address significant matters and the basis for the conclusions
reached
 Quick Check
Which of the following is a list of activities to be undertaken by the
auditor to gather audit evidence?
a. Audit documentation
b. Audit plan
c. Audit program
d. Audit strategy
 Quick Check
Which of the following is a list of activities to be undertaken by the
auditor to gather audit evidence?
a. Audit documentation
b. Audit plan
c. Audit program
d. Audit strategy
 Files of audit documentation

For each years engagement and

Current files pertain to documentation relating
to that years examination

Permanent Relatively unchanging data

files
 The following are examples of current files in
the audit documentation
Working trial balance
Summary of audit adjusting and classifying entries
Lead schedule
Bank reconciliation
Aged accounts receivables
Minutes of meetings during the reporting period
Narrative documentation summarizing bases for resolutions involving uncertainties
 Examples of permanent file in audit
documentation are as follows:
Articles of incorporation
Corporate by laws
Copy of pension contract with funding agency
Copy of trust indentures for long-term debt
Copy of the effective collective bargaining agreement
 Quick Check
All of the following are normally included in the auditors current file of
audit documentation except
a. Copy of prior years FS
b. Minutes of the meetings of the board of directors during the
reporting period
c. Working trial balance
d. A copy of the entitys organizational chart
 Quick Check
All of the following are normally included in the auditors current file of
audit documentation except
a. Copy of prior years FS
b. Minutes of the meetings of the board of directors during the
reporting period
c. Working trial balance
d. A copy of the entitys organizational chart
 Quick Check
The current file of an audit documentation most likely would include
a. Bond indenture of 20 year bonds payable
b. Articles of incorporation
c. Pension plan contract
d. Analysis of accounts receivable
 Quick Check
The current file of an audit documentation most likely would include
a. Bond indenture of 20 year bonds payable
b. Articles of incorporation
c. Pension plan contract
d. Analysis of accounts receivable
In the risk assessment phase documentation would include
description of or copy of communication relating to
(Guide to using ISAs in the Audit of SMEs)

1. pre-engagement procedures
2. Independence and ethics assessments
3. Terms of engagement
4. Materiality consideration
5. Overall audit strategy
6. Audit team discussions, including possible causes of material misstatements due to
fraud
7. Risk assessment procedures performed and the results
8. Assessed risk of material misstatements identified based on the understanding of
the entity and related internal control
 Reporting
The auditor should review and assess the conclusions drawn from the audit
evidence obtained as basis for the expression of an opinion on the FS.
The auditors report should contain a clear written expression of an opinion
on the FS taken as a whole
 Types of opinion
Unmodified
Modified
 Modified Opinion
Qualified Opinion
Misstatements exist, individually or in aggregate, material but not pervasive to the FS
Auditor is unable to obtain sufficient appropriate audit evidence

Adverse Opinion
Misstatements are both material and pervasive
Auditor is able to obtain sufficient appropriate audit evidence

Disclaimer Opinion
No opinion
Possible effects of undetected misstatements (if any, could be both material & pervasive)
Auditor is unable to obtain sufficient appropriate audit evidence
 Quick Check
In which of the following circumstances would an auditor choose between
issuing a qualified opinion and issuing a disclaimer of opinion on a clients
financial statements?
a. Departure from reporting framework
b. Inadequate disclosure of accounting policies
c. Inability to obtain sufficient appropriate evidence
d. Unreasonable justification for a change in accounting policy
 Quick Check
In which of the following circumstances would an auditor choose between
issuing a qualified opinion and issuing a disclaimer of opinion on a clients
financial statements?
a. Departure from reporting framework
b. Inadequate disclosure of accounting policies
c. Inability to obtain sufficient appropriate evidence
d. Unreasonable justification for a change in accounting policy
 Working trial balance
Is a schedule listing the balances of accounts in the general ledger for the
current and previous year, with columns for adjusting entries, reclassification
entries and the financial statements amounts
 Two Types of Working trial balance

One-section Looks like an ordinary worksheet

and list all ledger accounts
trial balance
Two-section Divided into two components
The working comprehensive income
trial balance and the working financial position
 One-section trial balance
Trial Balance Adjustments & Adjusted profit or loss Adjusted financial
Reclassifications position
Debit Credit Debit Credit Debit Credit Debit Credit
 Two-section trial balance
Working Comprehensive Income Working Financial Position
Unadjusted Adjustments & Adjusted Unadjusted Adjustments & Adjusted
Balance Reclassifications balances Balance Reclassifications balances
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Refer to Illustrative problem
 Quick Check
Which of the following factors are considered in the selection of audit procedures
to be performed in an engagement?

I composition of audit team III level of audit risk

II audit objectives IV type of audit evidence available

a. II, III, IV
b. I, II, IV
c. I, II, III
d. III, IV
 Quick Check
Which of the following factors are considered in the selection of audit procedures
to be performed in an engagement?

I composition of audit team III level of audit risk

II audit objectives IV type of audit evidence available

a. II, III, IV
b. I, II, IV
c. I, II, III
d. III, IV
 Quick Check
Which of the following is classified as a substantive test?
a. Review of payroll checks
b. Reconcile disbursements per books with checks appearing in the bank
statement
c. Scanning of employment contracts
d. Accounting for a sequence is issued credit memoranda
 Quick Check
Which of the following is classified as a substantive test?
a. Review of payroll checks
b. Reconcile disbursements per books with checks appearing in the bank
statement
c. Scanning of employment contracts
d. Accounting for a sequence is issued credit memoranda