FRAMEWORK 0F

FINANCIAL STATEMENT AUDIT

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 Describe the fundamental concepts in a
financial statement audit and the audit
process.
Explain the risk-based audit approach.

LEARNING Identify and describe preliminary

engagement activities.
OBJECTIVES
Describe the nature and scope of audit
planning.
Discuss how the auditor performs risk
assessment procedures.

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FUNDAMENTAL
CONCEPTS IN
CONDUCTING
FINANCIAL
STATEMENT
AUDIT

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OVERALL OBJECTIVES OF INDEPENDENT AUDITOR
(PSA 200)

• To obtain reasonable assurance about whether the financial

statements as a whole are free from material misstatement,
whether due to fraud or error, thereby enabling the auditor to
express an opinion on whether the financial statements are
prepared, in all material respects, in accordance with an
applicable financial reporting framework
• To report on the financial statements, and communicate as
required by the PSAs, in accordance with the auditor’s
findings

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 AUDIT PROCESS
Understand nature of Develop clear
Develop understanding of
engagement and whether understanding of
operating risks that affect
auditor wants to accept purposes of audit and
client.
potential engagement. intended recipients.

Understand and control Develop audit program to

Communicate assurance
risks that auditor may fail gather sufficient evidence
intended regarding
to detect material to reach a conclusion on
fairness of financial
misstatements in financial fairness of entity’s
statement presentation.
statements. financial statements.

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AUDIT APPROACHES
• Audit resources are targeted on testing large volume of transactions and account
Substantive
procedures balances without any particular focus on specific areas of financial statements
approach

• Substantive procedures are focused on balance sheet accounts, with only very limited
Balance sheet procedures being carried out on income statement items
approach

• Requires auditors to assess effectiveness of internal controls of entity and then to direct
substantive procedures primarily to those areas where it is considered that systems
Systems-based
approach objectives will not be met

• Audit resources are directed toward those areas of financial statements that may
Risk-based contain misstatements as consequence of risks faced by business
approach

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RISK AND AUDIT

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RISK-BASED AUDIT
• Focuses on risks to entity’s operations
and ensures controls are in place to
eliminate, mitigate or compensate for
those risks
• Begins with assessment of types and
likelihood of misstatements in account
balances, then adjusts amount and type
of audit work to likelihood of material
misstatements occurring in account
balances
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RISK ELEMENTS AFFECTING AUDIT
Engagement
Risk
Financial
Business
Reporting
Risk
Risk

AUDIT
RISK

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 RISK-BASED APPROACH
• Risk assessment – What can go wrong?
– Perform risk assessment procedures to identify and assess risks of material
misstatement in financial statements
• Risk Response – Did it go wrong?
– Perform further procedures to respond to assessed risks and determine if
material misstatements have occurred
• Reporting – Opinion
– What is appropriate wording of audit opinion based on the work
performed?

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RISK-BASED AUDIT PROCESS

Phase I – Risk Phase II – Risk Phase III -

Assessment Response Reporting
• Preliminary • Designing overall • Evaluating audit
engagement responses and evidence
activities audit procedures • Forming opinion
• Audit planning • Implementing and preparing
• Risk assessment responses to auditor’s report
procedures assessed risks

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PRELIMINARY ENGAGEMENT ACTIVITIES

Relevant
Purpose
PSAs
Quality Control of an Helps auditor in
Audit of Financial
Statements relating to • planning the audit
continuance of client • identifying areas that may
adversely affect auditor’s
relationship, ethical ability to perform audit
requirements (PSA 220) engagement

Agreeing Terms of Audit

Engagements (PSA 210)

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CPA’s assessment
• Own competence and capabilities
• Compliance with relevant ethical requirements
• Consideration of client’s integrity
Establishing preconditions for audit
• Acceptable financial reporting framework
• Management’s acceptance of its responsibility
• Preparation of financial statements
• Internal control
• Free access to information and persons
Agreeing terms of engagement

CLIENT SELECTION/RETENTION
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CLIENT SELECTION GUIDE

Obtain preliminary knowledge of client’s business and industry to determine

whether CPA has degree of competence required by engagement

Consider whether there are threats to audit team’s independence and

objectivity, and if so, whether adequate safeguards can be established

Determine that there are enough qualified personnel to perform audit in

accordance with professional standards

Conduct background investigation of prospective client to minimize likelihood

of association with clients whose management lacks integrity
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 CONSIDERATIONS REGARDING INTEGRITY OF
CLIENTS

Identity and business

reputation of client’s
Nature of client’s Indications of
principal owners, key
operations, including inappropriate limitation
management, related
its business practices in scope of work
parties and those charged
with governance

Indications that client

might be involved in Reasons for proposed
money laundering and appointment of firm
other criminal activities
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COMMUNICATING WITH PREDECESSOR
AUDITOR

Benefit
• Allows incoming auditor to obtain information about the client that will be
useful in determining whether the engagement will be accepted

What to do
• Obtain client’s prior permission to communicate with predecessor auditor
• Inquire into predecessor’s understanding as to reason/s for change of
auditor, any disagreement with client, any facts that may have a bearing
on integrity of prospective client’s management e.g. fraud, noncompliance
with laws and regulations
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ENGAGEMENT LETTER

Importance
• Avoids misunderstandings with respect to details of
engagement
• Documents and confirms auditor’s acceptance of
appointment, objective and scope of scope of
audit, extent of his responsibilities to the client and
the form of any reports
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ENGAGEMENT LETTER

Contents

• Objective and scope of the engagement

• Responsibilities of the auditor
• Management’s responsibility
• Forms or reports/other communication that auditor expects to issue
• Unavoidable risk that even some material misstatement may remain
undiscovered
• Unrestricted access to personnel, records, documentation and other
information
• Fee and billing arrangements
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AUDIT PLANNING

Relevant PSAs
• Planning an Audit of Financial Statements (PSA 300)
• Identifying and Assessing the Risks of Material Misstatements Through Understanding the
Entity and its Environment (PSA 315)
• Materiality in Planning and Performing an Audit (PSA 320)
• The Auditor’s Responses to Assessed Risks (PSA 330)
Nature
• Plan of action to organize, coordinate and schedule activities with respect to audit

Purpose
• to ascertain best combination of work that will enable auditor to arrive at sufficiently low
level of risk at minimum cost
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AUDIT PLANNING
• helps ensure that
➢appropriate attention is devoted to important areas of
audit
Benefits ➢potential problems are identified and resolved promptly
➢audit engagement is properly organized and managed
effectively and efficiently
• assists in proper assignment of work to engagement team
members and review of their work

• developing overall audit strategy and detailed approach for

expected conduct of audit
• involves engagement partner and other key members of
Scope engagement team
• extent of planning will depend on size of entity, complexity
of audit, auditor’s previous experience with entity and
business
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 AUDIT STRATEGY

Sets scope, timing

Allows auditor to
and approach to
determine
audit

Resources to deploy How to manage,

Amount of resources When to deploy
for specific audit direct, supervise
to allocate resources
areas resources

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AUDIT STRATEGY CONSIDERATIONS

Characteristics of engagement
• Financial reporting framework for F/S
• Industry-specific requirements, if any
• Number & locations of premises, branches, etc.
• Nature of client and need for specialized knowledge
• Reporting currency
• Effect of IT on audit procedures, including availability of data

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AUDIT STRATEGY CONSIDERATIONS

• Reporting objectives
• Timetable for interim and final reporting
• Organization of meetings with management
• Expected types and timings of auditor’s reports/communications
• Expected nature and timing of communication amongst team
members
• Expected communications with 3rd parties, if any
• Nature, timing and extent of resources
• Selection of and assignment of work to audit team
• Budgets
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 AUDIT STRATEGY CONSIDERATIONS

• Materiality
Significant • Results of risk assessment
factors and • Results of previous audits
• Evidence of management’s commitment to internal
preliminary controls
engagement • Volume of transactions
activities • Significant business developments /changes; industry
developments; financial reporting changes

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AUDIT PLAN

Specific, detailed plan to address how various matters identified in overall

strategy will be applied

Includes specific descriptions of

• NTE of risk assessment procedures

• NTE of further audit procedures, including
• What audit procedures are to be carried out
• Who should do them
• How much work should be done
• When the work should be done
• Any other procedures necessary to conform to PSAs
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AUDIT PLAN CONTENTS
Description of entity
Audit objectives
Description of nature and extent of other services
Timetable of audit work
Work to be done by entity’s employees
Assignment of audit staff
Target completion dates of major segments of engagement
Preliminary evaluation and judgment re materiality
Any special issues to be resolved during engagement AUDPRIN / 26
AUDIT PLANNING CONSIDERATIONS AND
ACTIVITIES

Understanding of
entity and its Assessment of risk and Application of
environment, including materiality analytical procedures
its internal control

Coordination,
Nature and timing of
direction, supervision
reports, etc.
and review

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UNDERSTANDING OF ENTITY AND ITS
ENVIRONMENT

Consists of an understanding of following aspects:

• Industry, regulatory and other external factors

• Nature of the entity
• Objectives and strategies of the entity and related business
risks that may result in material misstatement of financial
statements
• Measurement and review of entity’s financial performance
• Internal control

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ASSESSMENT OF RISKS AND MATERIALITY

When developing an audit strategy, auditor should consider carefully

appropriate levels of materiality and audit risk.

Audit plan should be made regarding

• How much evidence to accumulate

• How and when this should be done

Best audit strategy

• Approach that results in most efficient audit

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ASSESSMENT OF RISKS AND MATERIALITY

In designing an audit plan, auditor should make preliminary estimate of

materiality to determine amount of evidence to accumulate.

Materiality is a relative concept and a matter of professional judgment.

• Magnitude of an omission or misstatement of accounting information that,

in light of surrounding circumstances, makes it probable that judgment of a
reasonable person relying on information would have been changed or
influenced by omission or misstatement
• Qualitative considerations – irregularities, inadequate or improper
accounting policy, regulatory restrictions, related party transactions or
events requiring disclosure
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MATERIALITY

• Inverse: more evidence will be

Relationship
required for low peso amounts of
with
materiality than for a high peso
evidence
amount

• Audit planning
Application
• Completion phase

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AUDIT RISK

risk that auditor gives an inappropriate audit opinion on the financial

statements, concluding that the statements are fairly stated when in fact
they are not
• A material misstatement in an assertion about the account has occurred
❖Inherent risk – susceptibility of a financial statement assertion to a
material misstatement, assuming there are no related internal controls
❖Control risk –a material misstatement could occur in a financial
statement assertion and not be prevented or detected by the client’s
internal controls
• The auditor does not detect the misstatement (detection risk).
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 AUDIT RISK MODEL (ARM)
Audit Risk = Risk of Risk that Auditor
Material X Fails to Detect
Misstatement Misstatement

Planned
Acceptable Inherent X Control X Detection
Audit Risk = Risk Risk Risk

AAR = IR X CR X PDR

PDR = AAR / (IR x CR) AUDPRIN / 33

 AUDIT RISK COMPONENTS
INHERENT CONTROL DETECTION AUDIT
RISK RISK RISK RISK

Susceptibility not Material

Auditor’s
of assertions internal prevented mis- Unmodified
procedures
to material control or detected statements materially
for
mis- structure by IC remaining misstated
verifying
statements undetected FS
assertions

Mis-
statements Detected by
prevented audit
or detected procedures
by IC
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AUDIT RISK AND EVIDENCE

ARM may be used during planning stage to

• Estimate amount of evidence required
• Plan nature, timing and extent of audit work
Amount of evidence required varies
• inversely with amount considered to be material
• Inversely with detection risk that auditor is prepared to take (the lower
the detection risk, the greater the amount of evidence required)
• Directly with inherent risk and control risk, and inversely with audit risk
that auditor is prepared to take
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 Low Moderate High

AUDIT RISK AND RMM= IR x CR

RMM
25%
RMM
50%
RMM
100%

EVIDENCE Audit risk 5% 5% 5%

PDR 20% 10% 5%
REQUIRED Quality and
amount of
Low Moderate High
evidence to be
collected

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DETECTION RISK AND EVIDENCE

As RMM increases, the auditor will

respond accordingly by
Detection risk directly impacts • Assigning more experienced personnel
quality and amount of evidence • Increasing supervision and review of work
performed by less experienced staff
to be collected. members
• Obtaining high quality evidence
• Increasing quantity of evidence obtained

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 Audit Risk Materiality
AUDIT RISK, (RMM (Planning Planned
MATERIALITY occurring
and not
Materiality or
Tolerable
Audit
Procedures
AND AUDIT determined) Misstatement)
More
PROCEDURES High Low
extensive
Less
Low High
extensive

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RISK AND MATERIALITY

Concepts of materiality and risk are closely related and inseparable.

• Risk is a measure of uncertainty whereas materiality is a measure of size or

magnitude.
• Taken together, risk and materiality measure the uncertainty of amounts of
a given magnitude.
Example - Audit plan: accumulate evidence such that there is 5% risk
(acceptable audit risk) of failing to uncover misstatements exceeding
tolerable misstatements of P500,000 (materiality)

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 APPLICATION OF ANALYTICAL PROCEDURES

Evaluation of financial
information by studying
plausible relationships
among both financial and
non-financial data

Purposes
• To assist auditor in planning the nature, timing and
extent of other auditing procedures
• To obtain evidential matter about particular assertions
related to account balances or classes of transactions
• As an overall review of financial information in final
review stage of the audit AUDPRIN / 40
• An organized approach Estimated
• A standard starting place to start examining account
financial statements balance
• Attention directing
• Identify potential problem areas
• Describe the financial activities
• Identify unusual changes in relationships in the
data
• Ask relevant questions Recorded
• What could be wrong? account
• What legitimate reasons are there for these balance
results?

PRELIMINARY ANALYTICAL
PROCEDURES AUDPRIN / 41
ANALYTICAL PROCEDURES
Stages of Use
Steps
Preliminary
Required

Compare
Develop them with
Investigate Substantive testing
significant
expectations. the recorded
amount.
differences. Optional

Final Review
Required
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ANALYTICAL PROCEDURES - Sources of Information
Analytical Procedures Sources of Information
Comparison of current-year account balances to those of one or Financial account information
more comparable periods for comparable periods.

Comparison of the current-year account balances to anticipated Company budgets and

results found in the company’s budgets and forecasts. forecasts.

Evaluation of the relationships of current-year balances to other Financial relationships among

current-year balances for conformity with predicable patterns accounts in the current period
based on the company’s experience. (ratios).

Comparison of the current-year account balances and ratios Industry statistics.

with similar industry information.

Study of the relationships of current-year balances with relevant Nonfinancial information, such
nonfinancial information (e.g., production statistics). as production statistics.
43
 COORDINATION, DIRECTION, SUPERVISION
AND REVIEW

Establishment of Consideration of work

engagement performed by other
team auditors/parties

Predecessor
Other CPAs Specialists Client’s staff Internal auditors
auditor

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OTHER MATTERS

• Assessment of going concern assumption

• If there is substantial doubt about entity’s ability to continue in operation, add
a paragraph in audit report calling attention to the fact that the statements
have been prepared assuming that entity will continue as a going concern
• Identification of related parties
• Required for disclosure in financial statements if transactions with related
parties are material
• Client’s legal obligations
• Obtained through review of minutes of meetings, changes to articles of
incorporation/by-laws, significant contracts executed during year

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PLANNING THE AUDIT WORK
• Complete initial audit program
• List of audit procedures to be performed so that auditor will have evidence as
basis for expressing opinion on financial statements
• Prepare time budget
• Estimate of total hours an audit is expected to take
• Assign personnel to engagement
• Need for continuity from year to year to help auditor firm to maintain familiarity
with technical requirements and closer interpersonal relations with client
personnel
• Schedule audit work
• Interim period – consideration of internal control, issuance of management letter,
early substantive tests
• Near at/after year end – substantive tests and other analytical procedures
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 Audit procedures performed to obtain an
understanding of entity and its environment,
including the entity’s internal control, to identify
RISK and assess the risks of material misstatements,
whether due to fraud or error, at the financial
ASSESSMENT statement and assertion levels
PROCEDURES
Inquiries of
Analytical Observation and
Management and
Procedures Inspection
others within entity
FINANCIAL STATEMENT ASSERTIONS
representations by management,
explicit or otherwise, regarding Existence or occurrence
recognition, measurement,
presentation and disclosure of various Rights and obligations
elements of financial statements and
related disclosures Completeness

Valuation and allocation

Presentation and disclosure

 FINANCIAL STATEMENT ASSERTIONS
Existence • An asset or a liability exists at a given date.

• A transaction or event took place which pertains to the

Occurrence entity during the period.

Rights and obligations • An asset or a liability pertains to the entity at a given date.

• There are no unrecorded assets, liabilities, transactions or

Completeness events or undisclosed items.
• An asset or a liability is recorded at an appropriate carrying
Valuation value.
• A transaction or event is recorded at the proper amount
Allocation and revenue or expense is allocated to the proper period.
• An item is disclosed, classified, and described in accordance
Presentation and disclosure with the applicable financial reporting framework.
 CLASSES OF EVENTS ACCOUNT PRESENTATION AND
AND TRANSACTIONS BALANCES DISCLOSURE

Occurrence and rights

Occurrence Existence
and obligations
CATEGORIES
Completeness Completeness Completeness
OF
FINANCIAL Valuation and
STATEMENT Accuracy Accuracy and valuation
allocation
ASSERTIONS
Cut-off

Classification and
Classification
understandability
Rights and
obligations
FURTHER READINGS
1. Financial statement audit
http://docshare01.docshare.tips/files/23900/239004330.pdf
Louwers, et al., Chapters 3 and 4
2. Risk-based audit
file:///C:/Users/User/AppData/Local/Temp/G10487-
EC_Audit-and-Assurance-Primer.pdf

3. Materiality
https://www.cpajournal.com/2016/07/06/the-materiality-
mystery-2/

4. Importance of planning and materiality

https://theaccountant.org.mt/importance-planning-
materiality/ AUDPRIN / 51
FURTHER READINGS
5. Risk
https://www.youtube.com/watch?v=-P9C6pFzGyw

6. Risk assessment
https://www.icaew.com/technical/audit-and-
assurance/audit/risk-assessment-internal-control-
and-response/1-understanding-the-requirements-
in-risk-assessment

7. Financial statement assertions

https://www.accaglobal.com/gb/en/student/exam-
support-resources/fundamentals-exams-study-
resources/f8/technical-articles/assertions.html
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SELF-TEST QUESTIONS
1. Compare and contrast the different approaches in the independent
audit of financial statements.
2. Describe the different phases in a risk-based audit approach.
3. Comment on the following statement: “Throughout the audit, for
all purposes, we will define a “material amount” as “P100,000”.
4. Explain briefly the audit risk model and its components.
5. Discuss the nature and importance of an audit engagement letter.
6. Why does the auditor need to obtain a preliminary understanding
of the client and its environment?
7. Differentiate audit strategy, audit plan, and audit program.
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LEARNING ACTIVITY
A. Sarah, the sole owner of a small hardware business, has been told that
her business should have financial statements audited by an
independent CPA. Having some bookkeeping experience, Sarah has
personally prepared the financial statements of the business and does
not understand why such statements should be audited by a CPA.
Sarah heard that you are a CPA and she requested a meeting with you to
discuss the audit.
Required:
1. What are the objectives of an independent audit?
2. What benefits might Sarah derive from having the financial
statements of her business examined by an independent CPA?

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LEARNING ACTIVITY
B. Paolo has been asked to accept an engagement to audit BET Finance
Co., a small financial institution. Paolo has no experience in the
audit of a financial institution.
Required:
What types of knowledge about BET and its environment should
Paolo obtain to plan the engagement? How may Paolo obtain such
knowledge?

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As a rule, men worry more about
what they can’t see than about
what they can.
—Accredited to Julius Caesar

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