2020 - 2021 Edition Principles of AUDITING AND ASSURANCE _ Sewdces y. Based on ISAs, PSAs, Framework, PSQC, PAPSs, PSREs, PSAEs, PSRSs, Revised Code of Ethics (2018)it Preface UNITI Chapter UNIT II Chapter UNIT II Chapter sO naw - 10 12 Contents in Brief INTRODUCTION TO ASSURANCE AND AUDITING. ‘SERVICES THE DEMAND FOR AUDITING AND ASSURANCE § PROFESSIONAL PRACTICE OF ACCOUNTANCY: AN OVERVIEW ‘THE PUBLIC ACCOUNTING PROFESSION ENVIRONMENT MANAGEMENT OF A PUBLIC ACCOUNTING PRACTICE PROFESSIONAL ETHICS FUNDAMENTALS OF ASSURANCE AND FINANCIAL, ‘STATEMENT AUDIT FUNDAMENTALS OF ASSURANCE SERVICES INTRODUCTION TO FINANCIAL STATEMENT AUDIT RISK-BASED AUbIT OF FINANCIAL STATEMENTS OVERVIEW OF RISK-BASED AUDIT RISK ASSESSMENT — PARTI PHASE I-A. PERFORMANCE OF PRELIMINARY ENGAGEMENT ACTIVITIES PHASE I-B. PI_ANNING THE AUDIT TO DEVELOP AN OVERALL AUDIT STRATEGY AND AUDIT PLAN RISK ASSESSMENT — PART I! PHASE I-C. 1, PERFORMANCE OF RISK ASSESSMENT PROCEDURES 0 IDENTIFY / ASSESSED RISKS OF MATERIAL MISSTATEMENT THROUGH UNDERSTANDING THE ENTITY RISK ASSESSMENT — PART III PUIASE I-C.2, CONSIDERATION OF INTERNAL CONTROL IN APINANCIAL STATEMENT AUDIT FRAUD AND ERROR i 33 65 14 152 174 199 216 224 255 279 151 198UNIT IV Chapter 13 14 15 16 17 18 UNITY Chapter 19 20 21 22 UNIT VI Chapter 23 24 UNIT VIL Chapter 25 26 Risk RESPONSE RISK RESPONSE — PART I DESIGNING AND EFFECTIVE RESPONSE TO ASSESSED RISK Risk RESPONSE — PART IT IMPLEMENTING THE DESIGNED RISK RESPONSE AND OBTAINING AUDIT EVIDENCE BASIC AUDIT SAMPLING CONCEPTS AUDIT SAMPLING FOR TEST OF CONTROLS AUDIT SAMPLING FOR SUBSTANTIVE TESTS AUDIT DOCUMENTATION REPORTING © AUDIT EVIDENCE EVALUATION COMPLETING THE AUDIT AND POST-AUDIT RESPONSIBILITIES FORMING AN OPINION AND REPORTING ON FINANCIAL ‘STATEMENTS MODIFICATIONS TO THE INDEPENDENT AUDITOR'S * REPORT (AUDITING IN AN INFORMATION TECHNOLOGY (IT) ‘SYSTEM ENVIRONMENT AUDITING IN AN INFORMATION TECHNOLOGY (IT) ‘SYSTEM ENVIRONMENT ~ PARTI AUDITING IN AN INFORMATION TECHNOLOGY (IT) ‘SYSTEM ENVIRONMENT — PART II OTHER SERVICES AND REPORTS PROCEDURES AND REPORTS ON SPECIAL PURPOSE AUDIT ENGAGEMENTS NON-AUDIT ENGAGEMENTS: PROCEDURES AND REPORTS, List of References 334 348 378 413 435 415 516 571 598 636 668 694 Tl iii 333 505 635, 693 782Preface UNITI Chapter Chapter Contents INTRODUCTION TO ASSURANCE AND AUDITING.SERVICES 1 THE DEMAND FOR ASSURANCE AND AUDITING SERVICES Expected Learning Outcomes Economic Demand for Auditing What are Assurance Services? Philosophy of an Audit Importance of Audited Financial Statements Users of Audited Financial Statements The Assurance Analogy and the Philippine Standards on Auditing (PSAs) Review Questions INTRODUCTION TO PROFESSIONAL PRACTICE OF ACCOUNTANCY n Expected Learning Outcomes Accountancy as a Profession Who is a Professional Accountant? Scope of Practice Assurance, Attest, and Auditing Services Defined Assurance Services Attest Services Audit Services Relationship Among Assurance, Attest, and Auditing Services Types of Auditors External Auditors Internal Auditors Government Auditors Forensic Auditors Types of Other Audit Services Internal Audit Compliance Audit Operational Audit OAR 8] 12 13 14 15 15 16 16 17 18 18 19 19 20 21 21 22 22Forensic Audit Types of Other Attest Services Other Non-Assurance Services Agreed-Upon Procedures Tax Preparation and Planning Services Management Advisory Services Compilation, Accounting and Data Processing System Services Review Questions 3 THE PUBLIC ACCOUNTING PROFESSION ENVIRONMENT .- Expected Learning Outcomes Practice of Public Accountancy Defined Certified Public Accountant Requirements to Enter the Accountancy Profession ‘A. Pre-Qualification Education Requirements B. CPA Licensure Examination C. Other Legal Regulatory Requirements Developing Capabilities and Competence after Admission to the Profession Core Values and Competency Requirements for CPAs in Public Practice Regulatory and Professional Organizations that Influence the Profession A. Regulatory Government Agencies B. Professional Organizations C. Standard-Setting Bodies CPA's Legal Liability Legal Concepts Related to Auditor's Liability Legal Liability of the Independent Auditor Limitation on Auditor's Respons Auditor's Defenses Against Client Suits _ Auditor's Defenses Against Third-Party Lawsuits Minimizing Exposure to Legal Liability Society's Expectations and Auditor's Responsibilities Challenges Faced by the Public Accounting Profession The Accounting Profession’s Credibility Crisis Review Questions ~ 23 23 23 24 24 25 53 53 34 56 33Chapter Chapter 4 MANAGEMENT OF A PUBLIC 5 ACCOUNTING PRACTICE Expected Learning Outcomes Establishment and Organization of Public Accountancy Practice Marketing Professional Services Sources of Clients Professional Fees Methods of Billing Clients Auditing in a Globalized Environment Regulation within the Firm System of Quality Control Elements of a System of Quality Control A. Leadership Responsibilities of Quality Within the Firm Ethical Requirements Acceptance and Continuance of Client Relationships and Specific Engagements Human Resources Engagement Performance Monitoring =PS Ab Review Questions PROFESSIONAL ETHICS Expected Learning Outcomes Introduction Why do People Act Unethically The Need for Professional Ethics Characteristics and Values Associated with Ethical Behavior The Code of Ethics for Professional Accountants in the Philippines Threats to Compliance with Rules ‘Safeguards to Mitigate or Eliminate Threats Code of Ethics, Applicability 10 CPAs in Public Practice Resolving Ethical Conflict Review Questions 4 75 16 80 83 85 93 104 14 1S 116 18 119 121 123 125 127 139 140 65 114UNIT II FUNDAMENTALS OF ASSURANCE SERVICES AND FINANCIAL STATEMENT AUDIT Chapter 6 FUNDAMENTALS OF ASSURANCE SERVICES Expected Learning Outcomes 152 Assurance Engagements 153 Nature of Assurance Engagements 153 Objective of An Assurance Engagement 154 Types of Assirance Engagements 154 Reasonable Assurance Engagement 154 Limited Assurance Engagement * 154 7 Other Assurance Services 155, Assertion-Based Engagements vs. Direct Reporting Engagements 155 Elements of An Assurance Engagement 155 Brief Description of Assurance Services 164 Independent Financial Statements Audit 164 Review of Financial Statements 165 Other Review Engagements 165 Other Assurance Services 166 “Assurance Services and Information Technology 166 CPA Web Trust Service 166 Information System Reliability Service 166 “Assurance Services on Other Types of Information 167 Business Performance Measurement 167 Health Care Performance Measurement 167 Risk Assessment 167 Eldercare Plus 167 Brief Description of Non-Assurance Services 168 ‘Agreed-Upon Procedure Services 168 Compilation of Financial and Other Information 168 Tax Services 169 Management Consulting / Advisory Services 169 ‘Accounting and Data Processing or Information Technology System Services 169 Review Questionswill Chapter 7 INTRODUCTION TO FINANCIAL STATEMENT AUDIT Expected Learning Outcomes 174 Independent Auditing Defined 175 Objectives of Auditing 177 Scope of Independent Audit 178 Why Independent Auditing Is Necessary 178 How Information Risk may be Reduced 180 Advantages and Practical Benefits of An Independent Audit 181 Overview of the Audit Opinion Formulation Process 182 Activities of each Phase of the Audit Opinion Formulation Process 184 Management Assertions and Financial Statements 185 Core Concepts of Financial Statement Audit 187 Materiality’ 188 Audit Risk 188 Audit Evidence Regarding Management , Assertions 189 General Principles of an Audit 190 Compliance of Ethical Requirements 190 Reasonable Assurance 190 Responsibility for the Financial Statements 191 ‘Skills and Knowledge Needed in Financial Statement Audit 191 Parties Involved in Preparing and Auditing Financial Statements 192 The Context of Financial Statement Auditing 192 The Business Entity as the Primary Context of Auditing 193 Relating the Audit Process Components to the Business Model 193 Review Questions 104UNIT It Chapter Chapter RISK-BASED AUDIT OF FINANCIAL STATEMENTS 8 OVERVIEW OF RISK-BASED AUDIT PROCESS Expected Learning Outcomes Introduction Risk-Based Audit Process Defined Factors to Consider in Implementing the Audit Risk Modet Limitation of the Audit Risk Modet Risk-Based Audit vs. Account-Based Audit The Risk-Based Audit Process Phase I. Risk Assessment Phase Il. Risk Response Phase Ill. Reporting Relevant Philippine Standards on Auditing (PSAs) to be used in the Risk-Based Audit Process Understanding the Audit Risk Model Review Questions 9 RISK ASSESSMENT - PART I + Expected Learning Outcomes PHASE I-A. PERFORMANCE OF PRELIMINARY ENGAGEMENT ACTIVITIES Introduction Client Selection and Retention Client Acceptance / Retention Decisions Audit Firm Limitations Engagement Letters * Recurring Audits 216 217 217 218 219 220 221 PHASE I-B. PLANNING THE AUDIT TO DEVELOP AN OVERALL AUDIT STRATEGY AND AUDIT PLAN Nature and Scope of Audit Planning Benefits of Audit Planning The Overall Audit Strategy Benefits of Developing the Audit Strategy A. Materiality B. Audit Plan Review Questions and Exercises ik 198 199 216e1 RISK ASSESSMENT - PART I ae " PHASE I-C.1 PERFORMANCE OF RISK ASSESSMENT PROCEDURES TO IDENTIFY / ASSESS RISK OF MATERIAL MISSTATEMENT THROUGH UNDERSTANDING THE ENTITY Expected Learning Outcomes 255 Introduction 256 L. Risk Assessment Procedures and Sources of Information About the Entity and Its Environment, Including lis Internal Control 257 Risk Assessment Procedures 257 I. Understanding the Entity and Its Environment Including Its Internal Control 259 Il. Identifying and Assessing the Risk of Material Misstatement 260 IV. Material Weakness an Internal Control 260 261 V. Documentation Assessing Inherent Risk and Control Risk at the . Assertion Level 261 Using the Audit Risk Model to Determine the Nature, Timing, and Extent of Audit Procedures 267 Audit Risk in the Small Business 272 Review Questions and Exercises 273 Chapter 11 RISK ASSESSMENT - PART IIL PHASE I-C.2, CONSIDERATION OF INTERNAL CONTROL IN A FINANCIAL STATEMENT AUDIT Expected Learning Outcomes 279 Nature and Purpose of Internal Control 280 Internal control System Defined 281 Components and Principles of Internal Control 28 A, Control Environment 284 B. Entity's Risk Assessment Process 285 C. Information System, including the Business Processes, Relevant to Financial Reporting and Communication 286 D. Control Activities 286 E. Monitoring of Controls 287 255 279Objectives of the Study of internal Control 287 Documentation of Understanding 289 How adequacy of Inadequacy of Internal Control Affects Audit Procedures Communication of Performance, Improvements and Observations in Internal Control to Management 301 Reportable Conditions 302 Reporting — Form and Content 303 Review Questions and Exercises 305 Chapter 12 FRAUD AND ERROR Expected Learning Outcomes 315 Introduction 316 Characteristics of Fraud 316 Fraudulent Financial Reporting 316 Misappropriation of Assets 317 Responsibility for the Prevention and Detection of Fraud 318 Responsibilities of the Auditor 318 Risk Assessment 318 Detection 319 Inherent Limitations of an Audit 319 Examples of Fraud Risk Factors 320 Procedures when Errors or Irregularities are Suspected 324 Reporting of Fraud and Error 324 Documentation 325 Withdrawal from the Engagement 325 Review Questions 326 UNITIV RISK RESPONSE” Chapter. 13 RISK RESPONSE - PART I DESIGNING AN EFFECTIVE RESPONSE TO ASSESSED RISK Expected Learning Outcomes 334 Introduction 335 Types of Response 336 Nature of Audit Procedures 337 Tests of Controls or Compliance Tests 337 Types of Compliance Tests 337 Substantive Procedures 338 315xil Chapter 14 ypes of Substantive Tests The Relationship of Audit Techniques, Procedures and Assertions : Deciding the Number of Items to Audit Timing of Testing Timing of Tests of ‘Controls Timing of Substantive Procedures Audit Selecting the Audit Proce Review Questions RISK RESPONSE - PART II IMPLEMENTING THE DESIGNED RISK RESPONSE AND OBTAINING AUDIT EVIDENCE Expected Learning Outcomes Introduction Nature and Significance of Audit Evidence What Constitutes Audit Evidence Sufficient Appropriate Audit Evidence Interrelationship Between Risk, Appropriateness and Sufficiency of Audit Evidence Competence or Appropriateness of Evidence Sufficiency of Evidence Procedures for Obtaining Audit Evidence Inspection of Records or Documents Inspection of Tangible Assets Confirmation Inquiry Written Representation Observation Recalculation Reperformance Analytical Procedures Relationship of Types of Evidence to Audit Objectives Evidence About Accounting Estimates Nature of Accounting Estimates Audit Procedures Reviewing and Testing the Process Used by Management Evaluation of Results of Audit Procedures Evidence for Related Party Transactions Review Questions and Exercises 338 340 341 341 342 343 dures that will be Applied 344 345 348 349 349 350 351 351 353 355 355 355 356 356 357 358 359 359 359 359 360 369 369 370 370 371 371 372 348Chapter Chapter 15 BASIC AUDIT SAMPLING CONCEPTS Expected Learning Outcomes Introduction Nature and Purpose of Audit Sampling Why Auditors Sample Testing Procedures which do not Involve Sampling Sampling vs. Non-Sampling Risk Sampling Risk Non-Sampling Risk Nonstatistical and Statistical Sampling Nonstatistical Sampling Statistical Sampling Attribute and Variables Sampling Techniques Attribute Sampling Technique Design of the Sample Audit Objectives Population Risk and Assurance Tolerable Error Expected Error in the Population Stratification Performing the Audit Procedure Evaluation of Sample Results Analysis of Errors in the Sample Projection of Errors Assessing Sampling Risk Conclusion Detailed Audit Sampling Plan Definition / Description of Audit Sampling Plans Review Questions 16 AUDIT SAMPLING FOR TEST OF CONTROLS Expected Learning Outcomes Test of Controls Steps in the Application of Sampling in Test of Controls Mlustration of Attributes Sampling Nonstatistical Attributes Sampling Review Questions 378 379 379 379 380 381 381 381 382 382 383 387 387 . 388 389 389 390 392 392 393 400 400 402 403 404 405 405 408 413 414 44 415 427 428 xii 378 413xiv Chapter Chapter 17 AUDIT SAMPLING FOR SUBSTANTIVE TESTS Expected Learning Outcomes 5 Substantive Procedures ae Risks in Substantive Tests Probabllty-Proportional-To-Size Sampling (PPS) 437 Advantages and Disadvantages of PPS Sampling 2 : Classical Variables Sampling : Variations of Classical Variables Sampling 439 ‘Steps in Variables Sampling. for Substantive Tests 441 441 “Application of the Steps in Variables Sampling Plan Using PPS Technique for Substantive Tests Reaching a Conclusion in PPS Sampling 454 Application of Classical Variables Sampling Plan Using Classical Techniques 455 Review Questions 428 18 AUDIT DOCUMENTATION Expected Learning Outcomes 475 Introduction 475 Nature of Audit Documentation 475 Objectives of Audit Documentation 477 Form, Content and Extent of Audit Documentation 477 Characteristics of Quality Audit Documentation 479 Documenting Planning and Risk Assessment Procedures 479 Documenting Audit Work Performed 480 Documenting Significant Issues and Their Resolution 480 Copies of Documentation 481 Types of Working Papers 481 Relationship of Working Papers to Financial Statements 484 Content of a Year-End Audit File Index 488 Mechanics of Working Paper Preparation 491 Computer-Generated Working Papers 491 Ownership and Custody of Working Paper 492 Confidentiality of Working Papers 492 Review Questions 48 435 475UNIT V REPORTING Chapter 19 AUDIT EVIDENCE EVALUATION Expected Learning Outcomes Introduction Evaluating the Sufficiency and Appropriateness of Audit Evidence Factors to Consider Final Analytical Procedures Documentation Review Questions Chapter 20 COMPLETING THE AUDIT AND POST — AUDIT RESPONSIBILITIES Expected Learning Outcomes Introduction Completing the Audit Related arty Transactions Subsequent Events Review Letters of Inquiry / Review for Contingent Liabilities Evaluation of Going Concern Assumption Management Representation Analytical Procedures Evaluating Findings, Formulating an Opinion and Drafting the Audit Report Post-Audit Responsibilities Review Questions and Exercises Chapter 21 FORMING AN OPINION AND REPORTING ON FINANCIAL STATEMENTS Expected Learning Outcomes Introduction Forming an Opinion on the Financial Statements Forms of Opinion Preparation of the Auditor's Report for Audits Conducted in accordance with International Standards on Auditing 506 507 508 510 su S12 51S 516 516 S17 523 528 $33 S41 S47 550 553 556 571 572 573 574 583 505 506 516 571xvl Responsibilities for the Financial Statement Auditor's Responsibilities for the Audit of the Financial Statements Other Reporting Responsibilities Name of the Engagement Partner Signature of the Auditor ° Auditor's Address Date of the Auditor's Report ‘Supplementary Information Presented with Financial Statements Review Questions and Exercises 22 MODIFICATIONS TO THE INDEPENDENT AUDITOR’S REPORT Expected Learning Outcomes Introduction Types of Modified Opinions Objective Determining the Type of Modification to the Auditor's Opinion Form and Content of the Auditor's Report when the Opinion is Modified Description of Auditor's Responsibility When the Auditor Expresses a Qualified or Adverse Opinion Description of Auditor's Responsibility When the Auditor Disclaims an Opinion Communication with Those Charged with Governance Mlustrative Audit Reports with Modified Opinion Review Questions and Exercises 586 587 590 591 591 591 592 592 593 598 599 599 600 603 604 605 605 605 619 598xvii UNIT VI AUDITING IN AN INFORMATION TECHNOLOGY (IT) SYSTEM ENVIRONMENT 635 Chapter 23 AUDITING IN AN INFORMATION TECHNOLOGY (IT) SYSTEM ENVIRONMENT - PART I 636 Expected Learning Outcomes 636 Introduction 637 Nature of IT and Its Capabilities 637 Major Components of an Information System 638 Functions of an Information System 639 Characteristics of Various Types of IT-Based Systems 640 Auditor's Responsibilities 642 Internal Control in an IT Environment 642 General Controls _ . 642 Application Controls 650 Review Questions 654 Chapter 24 AUDITING IN AN INFORMATION TECHNOLOGY (IT) SYSTEM ENVIRONMENT - PART II 668 Expected Learning Outcomes 668 Introduction 669 Impact of Computers on Accounting System 669 Major Types of Computer Fraud 671 ‘Effects of Computers on the Audit Process 672 Auditing Clients Using Information technology (IT). Systems 676 Audit Techniques Using Computers 678 Specialized Audit Programs and Additional. «Techniques 682 Internal Contrel Considerations 682 The Effect of Electronic Records on Audit Evidence 685 Review Questions and Exercises 686avi UNIT VII OTHER SERVICES AND REPORTS Chapter 25 PROCEDURES AND REPORTS ON SPECIAL PURPOSE AUDIT ENGAGEMENTS Expected Learning Outcomes 694 Introduction 695 A. Audits of Financial Statements Prepared in Accordance with Special Purpose Frameworks 697 B. Audits of Single Financial Statements and Specific Elements, Accounts or Items of a Financial Statements 704 C. Summarized Financial Statements 113 Review Questions and Exercises 72 Chapter 26 NON-AUDIT ENGAGEMENTS; PROCEDURES AND REPORTS Expected Learning Outcomes 731 Examination of Prospective Financial Information 732 Engagements to Review Financial Statements 741 Engagements to Perform Agreed - Upon Procedures Financial Information 752 Review Questions and Exercises 773 List of References 693 694 731 782UNIT I INTRODUCTION TO ASSURANCE AND AUDITING SERVICES Chapter 1 The Demand for Auditing and Assurance Services 2 _ Professional Practice of Accountancy: An Overview 3 The Public Accounting Prefession Environment 4 Management of a Public Accounting Practice 5 Professional EthicsChapter THE DEMAND FOR AUDITING AND ASSURANCE SERVICES Expected Learning Outcomes After studying this chapter, you should be able to: A. Describe the role of auditing in meeting society's demands for reliable financial information Understand why individual external auditors are expected to ” make professional and ethical judgments about the information provided by business organizations. . Explain the nature of assurance services. . Explain the importance of audited financial statements. Enumerate the various parties who are interested in audited financial statements. Understand the need for increased globalization of accounting and auditing standards. LLBSCHAPTER 1 THE DEMAND FOR AUDITING AND | ASSURANCE SERVICES ECONOMIC DEMAND FOR AUDITING Why do many of the largest companies spend millions of pesos each year for their annual audit? Is it worth asking why an entity would decide to spend so much money on an audit? Is it because these audits are required by law? While true in certain circumstances, this answer is far too simplistic. Although audits are often utilized in situation where they are not required by law, audits were in demand long before Securities Laws and the Bureau of Internal Revenue required them. ¥ a . The demand for auditing can be understood as the need for‘accountability when business owners hire others to manage their businesses, as is typical in modern corporations. Until the late 18" and early 19" centuries, most organizations were relatively small and were owned and operated as sole proprietorships or partnerships. Because businesses were generally run by theif’ owners and borrowing was limited, accountability to outside parties often was minimal. The birth of modern accounting and auditing occurred during the industrial revolution, when companies became larger and needed to raise capital to finance expansion. Over time, capital markets developed, enabling companies to raise the investment capital necessary to expand new markets, finance expensive research and development, and fund the buildings, technology, and equipment needed to deliver products to market. - A capital market allows a public company to sell small pieces of ownership (i.e., stocks) or to borrow money in the form of thousands of small Joans (i.e., bonds) so that vast amounts of capital can be raised from a wide variety of investors and creditors, A public company is a company that sells its stocks or bonds to the public, giving the public a valid interest in the proper use of the company’s resources. Thus, the growth of the modern corporation led to diverse groups of owners who are not directly involved in running the business (shareholders) and the use of professional managers hired by the owners to run the corporation on a day-to-day4 Chapter 1 basis. In this setting, the managers serve as agents for the owners (who ae sometimes referred to as principals) and fulfill a stewardship function by managing the corporation’s assets. It is important to understand that the relationship between an owner and manage, often results in information asymmetry between tha two parties. Information asymmetry means that the manager generally has more information about the “true” financial position and results of operations of the entity than does the absentee owner. What are Assurance Services? The name assurance servicesvis used to describe the broad range of information enhancement services performed by a certified public accountant (CPA) that are designed to enhance the degree of confidence in the information. In general, assurance services consists of two (2):types: @ those that increase the reliability of information and (6) those that involve putting information in a form or context that facilitates decision making. A significant portion of the assurance services provided by CPAs is referred to as attestation services. To attest to information means to provide assurance as to its reliability. In an attestation engagement, CPAs provide a report on subject matter or an assertion about that subject matter. One of the most sought-after attestation services is the examination or audit of historical financial statements. In this book, we will focus on the Audit and Assurance Services that involve reliability enhancement. Philosophy of an Audit As the amount of capital involved and the number of potential owners increase, the potential impact of accountability also increases. The auditor's role is to ine whether the reports prepared by the manager conform to the contract’s ns. Thus, the auditor's verification of the financial information adds credibility to the report and reduces information-risk, or the risk that inform circulated by a company’s management will be false misleading. Reducing information risk potentially benefits both the owner and the manager. Economic decisions are made under conditions of uncertainty; there is always * risk that the decision maker will select the w . i a =: m4 rong alternative and incur significant loss. The credibility added to the information by auditors acti” SADemand for Auditing and Assurance Services § reduces the decision maker's risk. information rsh, which i the i K To be more precise, the auditors reduce at the financial information used to make a Businesses, instituti indivi Feelin ad probes and individuals must maintain records of their financial buuinieas spetationer| - These records are necessary to evaluate and guide eid Rees letermine financial status, to meet legal requirements and riay swich to ty ene Creditors and investors, present and prospective, exiciaion andi tive financial statements of many enterprises for credit Resennttaice nt purposes. Government agencies will need financial eae cy: the cutis imposed upon them by law internal Wisiness onetarions: reports for planning, directing and controlling These parties therefore, need reliable and credible financial information. The process employed to establish the reliability or unreliability of the financial statements and supporting records is referred to as an audit examination. Auditing of financial records has become an important factor in the dissemination of financial information and the services of the independent certified public accountant are considered indispensable. Increasingly, his written report is required to add credibility to the financial statements. A free-market economy can exist only if there is sharing of reliable information among parties that have an interest in the financial performance of an organization. The market is further strengthened if the information is transparent and unbiased — that is, the data is not presented in such a way that it favors one party over another. An organization’s reported information must reflect the economics of, its transactions and the current economic condition of both its assets and any obligations owed. uditors undertake to gather evidence to obtain ncial. statements are. free of - material nd that they are presented in accordance k. The external audit is intended to Ina financial statement audit, the ai high level of assurance that finan misstatements due to fraud or errors al with appropriate. accounting framewor! 1 enhance the confidence that users can place on management-prepared financial statements. When the auditor has no reservations about management's financial statements or internal controls, the report is referred to as an unqualified audit report. ee6 Chapter rties, but the most important is the Public, as represented by investors, lenders, workers, and others who make decisions based on financial information about an organization, Auditing requires the highest level of technical competence, freedom from bias, and concern for integrity of the financial reporting process. In essence, auditors should view themselves as guardians of the capital markets. ‘The.public-expects auditors to (@) find fraud, (b) require accounting principles the st portray the spirit of the concepts adopted by accounting standard setters, and be independent of management. When it comes to being independent, auditors must not only be independent in fact, but they must act in a manner that ensures that they are independent in appearance. Auditors serve a number of pai An independent auditor's opinion contained in the audit report provides both internal and external users with input to making logical and informed d ns about financial position, managerial performance and economic vulnerability. Without auditors, decisions such as these are more likely to be made from biased financial information resulting from a business entity’s undisclosed errors, irregularities or illegal acts. IMPORTANCE OF AUDITED FINANCIAL STATEMENTS Audited financial statements are the accepted means by which business corporations report their operating results and financial position. The word audited, when applied to financial statements, means that the balance sheet and the statements of income, retained earnings, and cash flows are accompanied by an_audit report prepared. by independent public. accountants, expressing their professional opinion as to the faimess of the company’s financial statements. Of course, reporting in accordance with an agreed-upon set of accounting principles does not solve the problem by itself. Because the manager is responsible for reporting on the results of his or her own actions, which the absentee owner cannot directly observe, the manager is in a position to manipulate the reports. Again, the owner adjusts for this possibility by assuming that the manager will manipulate the reports to his or her benefit and by reducing the manager’s compensation accordingly. It is at this point that the demand for auditing arises. If the manager is honest, it may very well be in the manager's self-interest to hire an auditor to monitor and independently report to the owner on his or her activities. The owner likely will be willing to invest more in the business and to pay the manager more if the manager can be held accountable for how he or she uses the owner's invested resources.— Demand for Auditing and Assurance Services 7 Financial statements prepared by management and transmitted to outsiders without first being audited by independent accountants leave a credibility gap. In reporting on its own administration of the business, management can hardly be expected to be entirely impartial and unbiased. Independent auditors have no material personal or financial interest in the business; their reports can be expected to be impartial and free from bias. Unaudited financial statements may have been honestly, but carelessly, prepared. Liabilities may have been overlooked and omitted from the balance sheet. Assets may have been overstated as a result of arithmetical errors or due to a lack of knowledge of financial accounting and reporting standards. Net income may have been exaggerated because expenses were capitalized or because sales transactions were recorded in advance of delivery dates. Finally, there is the possibility that unaudited financial ‘statements have been deliberately falsified in order to conceal theft and fraud or as a means of inducing the reader to invest in the business or to extend credit. Although deliberate falsification of financial statements is not common, it does occur and can cause devastating losses to persons who make decisions based upon such misleading statements. For all these reasons (accidental errors, lack of knowledge of accounting principles, unintentional bias, and deliberate falsification), financial statements may depart from financial accounting and reporting standards principles. Audits provide users with assurance that the financial statements are presented in accordance with the financial accounting principles and reporting standards. Figure 1-1 presents an overview of the potential financial statement users and the decisions they make based on the financial reports.8 Chapter 1 re 1-1: Users of Audited Financial Statements Figu User Types of Decisions | Management Review performance, make operational decisions. Report results | to capital markets Stockholders __| Buy or sell stock Bondholders Buy or sell bonds Financial Institutions | Evaluate loan decisions, considering interest rates, terms, and isk Taxing Authorities Determine taxable income and tax due Regulatory Agencies | Develop regulations and monitor compliance Make collective bargaining decisions | Labor Unions Court System Assess the financial position of a company in litigation Vendors Assess credit risk Protect employees from surprises concerning pensions and other Retired Employees post-retirement benefits THE ASSURANCE ANALOGY AND THE PHILIPPINE STANDARDS ON AUDITING (PSAs) ‘An audit provides reasonable assurance of detecting material misstatements of the financial statements (both errors and fraud) and noncompliance with laws that have a direct and material effect on the determination of financial statement amounts. Although an audit does not obtain reasonable assurance of detecting noncompliance with laws that have only an indirect effect on the financial statements, the auditors remain alert for such situations. If instances of noncompliance are discovered, regardless of type, the auditors should ‘caréfully evaluate their effects on the financial statements. Currently, the International Auditing and Assurance Standards Board (AASB) issues pronouncements designed to foster the development of consistent worldwide auditing standards while the Auditing and Standards Practice Council of the Philippines (AASC) reviews and recommends for approval to the PRC- BOA their adoption as the Philippine Standards on Auditing (PSAs). In the Philippines, the law that regulates the Practice of Accountancy (RA 9298) provides that the Professional Regulatory Board of Accountancy shall monitor the conditions affecting the practice of accountancy and adopt such measures to enhance and maintain the high professional, ethical and auditing standards including promulgation of accounting and auditing standards, domestic and