Chapter 4:

Audit process Preliminary engagement activities

Financial statement audit generally begins with the financial
statements of the client entity.
because there would be no audit to perform without
these said financial statements
General approach to financial statement audit:
requires consideration of the (1) financial statement
assertions, (2) audit evidence, and (3) audit procedures


(1) Financial statement assertions
Management:
responsible for the fair presentation of the financial
statements that reflect the nature and operations of the
client entity
implicitly or explicitly makes assertions regarding the
recognition, measurement, presentation and disclosure
of the various elements of the financial statements and
related disclosures

Financial statement assertions are categorized as follows:
1. assertions about classes of transactions and events for the
period under audit - COCAC
1. Completeness
all transactions and events that should have
been recorded are recorded
2. Occurrence
the transactions and events that have been
recorded have occurred and pertained to the
entity
3. Classification
transactions and events have been recorded
in the proper accounts
4. Accuracy
amounts and other data relating to recorded
transactions and events have been recorded
appropriately
5. Cut-off
Transactions and events have been recorded
in the correct accounting period

2. assertions about account balances at the period end under
audit: - ERoVaC
1. Existence
assets, liabilities, and equity interests exist
2. Rights and obligations
entity holds or controls the rights to assets
and liabilities are obligations of the entity
3. Valuation and allocation
assets, liabilities, and equity interests are
included in the financial statements at the
appropriate amounts and any resulting valuation
or allocation adjustments are properly and
appropriately recorded
4. Completeness
all assets, liabilities, and equity interests
that should have been recorded have been
recorded

3. assertions about presentation and disclosure - COCA
1. Completeness
all disclosures that should have been included in
the financial statements have been included
2. Occurrence and rights and obligations
disclosed events, transactions, and other
matters have occurred and pertained to the
entity
3. Classification and understandability
financial information has been appropriately
presented and described and disclosures are
clearly expressed
4. Accuracy and valuation
financial and other information are disclosed
fairly and at appropriate amounts



(2) Audit evidence
Audit evidence:
refers to the information obtained by the auditor in
arriving at the conclusions on which the audit opinion is
actually based
will either prove or disprove the validity of the client
managements assertions
at the conclusion of the audit:
auditor should carefully evaluate the audit
evidence gathered in order to come up with
an appropriate audit opinion
audit evidence comprises:
1. source documents and accounting records
underlying the financial statements
2. corroborating information
from other relevant sources


(3) Audit procedures
Auditor uses the financial statement assertions tin assessing the
risks by considering the different types of potential misstatements
that may occur:
thereby designing the audit procedures that are
responsive to the assessed risks

Audit procedures selected should enable the auditor to gather
sufficient appropriate audit evidence about some particular
assertion:
regardless of the audit procedures selected

Commonly-used audit procedures include: - COICAI
1. Confirmation:
consists of response to an inquiry to confirm or
corroborate information contained in the
accounting records
2. Observation
consists of looking at the process or procedure
being performed by others
3. Inspection
involves examining the records, documents, or
tangible assets of the entity being audited
4. Calculation or computation
consists of checking the arithmetical accuracy
of source documents and accounting records or
performing independent calculations
5. Analytical procedures
consists of the analysis of significant ratios and
trends including the resulting investigation of
fluctuations and some relationships that are
inconsistent with other relevant information or
deviate from predicted amounts
6. Inquiry
consists of the seeking of information from
knowledgeable persons inside or outside the
entity being audited


Audit process
Audit process:
sequence of different audit activities

Emphasis and order of certain activities may vary depending
upon a particular audit, but basically this process should
include the following audit activities: - PACPCI
1. Preliminary engagement activities
2. Audit planning
3. Considering the internal control system
4. Performing substantive tests
5. Completing the audit
6. Issuing the audit report







1. Preliminary engagement activities
refer to PSA 300
undertaken to determine whether or not to accept the
audit engagement!

Preliminary engagement activities:
performed (1) to know if the auditor is qualified to
handle the engagement and (2) to evaluate whether the
financial statements are auditable or not
in making this assessment, the auditor should
consider the following:
1. his competence
2. his independence
3. his ability to serve the client
4. integrity of the prospective clients
management
I. Auditors competence
Code of Ethics mandates that the auditors should not portray
themselves as having expertise which they do not possess.
auditor should obtain a preliminary knowledge of the clients
business and industry to know if (1) he has the
necessary skills and the competence to handle the
engagement or (2) whether such competence can be
obtained before the completion of the audit
competence can be acquired through a
combination of education, training, and expertise

II. Auditors independence
Code of Ethics states that essential to the credibility of the
auditors report is the concept of independence
auditor should consider if there are any threats to the
audit teams independence and objectivity, and if so,
whether adequate safeguards can be established

III. Auditors ability to serve the client properly (PSA 220)
engagement should not be accepted if there are not
enough qualified personnel to perform the audit
audit work should be assigned to personnel who have
the appropriate capabilities, competence, and time to
perform the audit engagement in accordance with the
professional standards
there should be sufficient direction, supervision, and
review of work at all levels to provide reasonable
assurance that the firms standard of quality is maintained
in the performance of the engagement

IV. Integrity of the prospective clients management (PSA 220)
auditors should conduct a background investigation of
the prospective client in order to minimize the likelihood
of association with clients whose management lacks
integrity
This task would involve:
(1) Inquiring appropriate parties in the business community
inquiring the prospective clients banker, legal counsel,
or underwriter to obtain information about the reputation
of the prospective client

(2) Communicating with the predecessor auditor
Communication with the predecessor auditor is not only a matter
of courtesy to the predecessor auditor:
it also allows the incoming auditor to obtain info.
about the prospective client to determine whether to
accept or reject the engagement
But before the incoming auditor can contact the predecessor
auditor of the prospective client:
incoming auditor should obtain prospective clients
permission to communicate with the predecessor auditor
because the Code of Ethics prevents an auditor from
disclosing any information obtained about the client
without the clients explicit permission

Refusal of the prospective clients management to permit this:
will raise serious questions as to whether or not the
engagement will be accepted!







Once permission of the client is obtained, the incoming auditor
should inquire into matters that may affect the decision to
accept the engagement, which includes:
1. predecessor auditors understanding as to the reasons
for the change of auditors
2. any disagreement between the predecessor auditor
and the client
3. facts that might have bearing on the integrity of the
prospective clients management like fraud or non-
compliance with laws and regulations
Code of Ethics requires the predecessor auditor to respond fully
to the incoming auditors inquiry and advise the incoming auditor
if there are any professional reasons why the engagement should
not be accepted.

Retention of existing clients:
Clients should be evaluated (1) at least once a year or (2) upon
occurrence of major events such as changes in management,
directors, ownership, nature of clients business, or other
changes that may affect the scope of the examination.
In general:
conditions which would have caused an accounting firm
to reject a prospective client may also result or lead to
a decision of terminating an audit engagement

Before performing any significant audit activities, PSA 300
requires the auditor to undertake the following preliminary
engagement activities: - PEE
1. Performing procedures regarding the continuance of the
client relationship and the specific audit engagement
2. Evaluating compliance with ethical requirements, including
independence
3. Establishing an understanding of the terms of the
engagement

Performing the preliminary engagement activities at the beginning
of the current audit engagement assists the auditor in: - PI
Planning the audit, and
Identifying areas that may affect the auditors ability to
perform the audit engagement adversely

Engagement letter:
Engagement letter:
written contract between the auditor and the client
Engagement letter should be prepared:
after accepting the audit engagement
Engagement letter sets forth: - OMS-FFR
1. objective of the audit of financial statements
which is to express an opinion on them
2. managements responsibility for the fair presentation
of the financial statements
3. scope of the audit
4. forms or any reports or other communication that the
auditor expects to issue
5. fact that there is an unavoidable risk that material
misstatements may remain undiscovered
because of the limitations of the audit
6. responsibility of the client to allow the auditor to have
unrestricted access to whatever records, information,
or documentation requested in connection with the
audit
Engagement letter may also include: - BEAR
1. billing arrangements
2. expectations of receiving management letter
3. arrangements concerning the involvement of others
(experts, other auditors, internal auditors)
4. request for the client to confirm the terms of the
engagement

Importance of the engagement letter:
to avoid misunderstanding with respect to the audit
engagement, and
to document and confirm the auditors acceptance of
the appointment






Recurring audits:
auditor does not normally send new audit engagement
letter every year
The following factors may cause the auditor to send a new
engagement letter: - LIARS
1. legal requirements and other government agencies
pronouncements
2. indication that the client misunderstands the objective
and scope of the audit
3. any revised or special terms of the engagement
4. recent change of senior management, BODs, or of
ownership
5. significant change in the nature or size of the clients
business
If the auditor decides not to send a new engagement letter:
it may be appropriate for the auditor to remind the
client of the original arrangements

Audit of components:
If the auditor of a parent entity is also the auditor of its
subsidiary, branch, or division (component):
auditor should consider the following factors in making
a decision of whether to send a separate letter to the
component:
1. who appoints the auditor of the component
2. whether a separate audit report is to be
issued on the component
3. legal requirements
4. extent of work performed by other auditor
5. degree of ownership by parent
6. degree of independence of the components
management

2. Audit planning
In audit planning, auditor obtains sufficient understanding of the
entity and its environment:
to understand the transactions and events affecting
the financial statements, and
to identify potential problems

A preliminary assessment of risk and materiality is made:
to develop an overall audit strategy, and
to develop a detailed approach for the expected conduct
and scope of the examination


3. Considering the internal control system
involves obtaining an understanding of the entitys
control systems and assessing the level of control risk
Control risk:
risk that the clients internal control may not prevent
or detect material misstatements in the financial
statements

Auditor considers the entitys internal control system because
the condition of the entitys internal control directly affects
the reliability of the financial statements
i.e. the stronger the internal control system, the more
assurance it provides about the reliability of the entitys
financial statements

If auditor wants to assess control risk at less than high level:
sufficient appropriate audit evidence must be obtained
to prove that the internal control is functioning as intended
(i.e. effectively) and that it can be relied upon
sufficient appropriate audit evidence can be
obtained by performing tests of controls














4. Performing substantive tests
involves examining the documents and the evidence
supporting the amounts and disclosures in the financial
statements

Using the information obtained in the audit planning and in the
consideration of internal control system:
auditor performs substantive tests to determine if the
entitys financial statements are presented fairly and
in accordance with the financial reporting standards

Extent of substantive tests is highly dependent on the results of
the auditors consideration of the internal control system.
if the entitys internal control system is functioning as
intended, the scope of the auditors substantive tests
can be reduced
if the entitys internal control system cannot be relied
upon, the scope of the auditors substantive tests will
be expanded and will be more extensive


5. Completing the audit
involves performing additional audit procedures to
complete the audit and to become satisfied that the
evidence gathered is consistent with the auditors
report, after the auditor has completed testing the
account balances in the financial statements
Completing the audit procedures include: - RAPO
1. Review of subsequent events and contingencies
2. Assessing the going concern assumption
3. Performing overall analytical procedures
4. Obtaining written representations from management

Auditor must have sufficient appropriate audit evidence in order
to reach a conclusion about the fairness of the entitys financial
statements.


6. Issuing a report
On the basis of audit evidence gathered and evaluated:
auditor forms a conclusion about the given financial
statements
this conclusion is communicated to various
interested users through an audit report





































Sample of an engagement letter:
To the Board of Directors of UP-CM company:

You have requested that we audit the balance sheet of
UP-CM Company as of December 31, 2013 and the related
statements of income and cash flows for the year then
ended. We are pleased to confirm our acceptance and our
understanding of this engagement by means of this
letter. Our audit will be made with the objective of our
expressing an opinion on the financial statements.

We will conduct our audit in accordance with the
Philippine Standards on Auditing. Those standards
require that we plan and perform the audit to obtain
reasonable assurance about whether the financial
statements are free of material misstatements. An audit
includes examining, on a test basis, evidence supporting
the amount and disclosures in the financial statements.
An audit also includes assessing the accounting principles
used and significant estimates made by management, as
well as evaluating the overall financial statement
presentation.

Because of the test nature and other inherent limitations
of an audit together with the inherent limitations of any
accounting and internal control system, there is an
unavoidable risk that even some material misstatements
may remain undiscovered.

In addition to our report on the financial statements, we
expect to provide you with a separate letter concerning
any material weaknesses in accounting and internal
control systems which come to our notice.

We remind you that the responsibility for the
preparation of the financial statements including
adequate disclosure is that of the management of the
company. This includes the maintenance of adequate
accounting records and internal controls, the selection
and application of accounting policies, and the
safeguarding of the assets of the company. As part of
our audit process, we will request from the management
written confirmation concerning representation made to
us in connection with the audit.

We look forward to full cooperation with your staff and
we trust that they will make available to us whatever
records, documentation, and other information that are
requested in connection with our audit. Our fees, which
will be billed as work progresses, are based on the time
required by the individuals assigned to the engagement
plus out-of-pocket expenses. Individual hourly rates vary
according to the degree of responsibility involved and the
experience and skill required.

This letter will be effective for future years 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 arrangement for our audit of the financial
statements.

Herrera, Santos, Manolong & Company

Acknowledged on behalf of UP-CM company by
(signed)

_______________________
Name and Title
Date