Chapter 4 - Overview of the Audit Process and Preliminary Activities CHAPTER 4 OVERVIEW OF AUDIT PROCESS AND PRELIMINARY ACTIVITIES ep rere gag Chapter Overview and Objectives: a This Chapter discusses the audit process in detail and presents the activities during its preliminary phase. At the end of this chapter, readers should be able to discuss: 1 open The activities conducted in performing financial statements audit The different categories and types of assertions made by the entity The major preliminary engagement activities The activities involved in client acceptance The process of agreeing the terms of the audit engagement The considerations taken in accepting a change in an engagement ss Relevant references: PSA 200 - Overall Objectives of the Independent Auditor and the Conduct of an Audit in accordance with International Standards on Auditing PSA 210 - Agreeing the Terms of Audit Engagement PSA 500 - Audit Evidence 121 Aim. Believe.. Claimiminary Activities Chapter 4 — overview of the Audit Process and Preliminary INTRODUCTION ind Audit of financial statements is normally Se feeds ahe me | qualified auditor:on an annual basis to meet the I’ UN fina financial statement users. The entity is en reporting tramewoner statements by complying with applicable financial reper 7S Tewari | PERS, PERS for SME, PFRS for Small Entities). To uel’ Tt DAY fang | statements, auditors must adhere to applicable auditing s ePoay | process of objectively obtaining ang | .s about economic actions and Events ty tween these assertions ay Its thereof. As defined, an audit\is a systematic evaluating evidence regarding assertion: ascertain the degree of correspondence b established criteria and communicating the resu Basically, the logic and objective of audit of financial statements are similar in ay audits of financial statements. In order to attain the objective of the audit, the auditor needs to undergo a systematic process comprising certain activities, Being a systematic process, an audit engagement is performed by means of ay ordered or structured series of steps. This process is commonly called as “AupT | PROCESS”. AUDIT PROCESS: A GENERAL APPROACH A general overview of the audit process may be best represented by the following_| diagram: Entity ‘The auditor a eH Prepares and performs apeatcios Deas Tene ae gathers audit ‘expresses an. financial procedures ene audit opinion statements Entity prepares and presents financial statements An audit in accordance with PSAs is conducted on the premise that management and, where appropriate, those charged with governance hate responsibilities that are fundamental to the conduct of the audit. The financial statements subject to audit are those of the entity, prepared até presented by management of the entity with Oversight from those charg with governance. The audit of the financial statements does not reli management or those charged with governance of those responsibilities Page 22Chapter 4 — Overview of the Audit Process and Preliminary Activities salen The financial statements are considered as assertions or ialedaar wei made by the entity, through its management and those charge Hck governance, as appropriate, These assertions may be explicitly or implicitly included in the financial statements and may fall into the following categories (TAP): Category Assertions Classes of | ¥ Occurrence - transactions and events that Transactions and have been recorded have occurred and pertain events for the to the entity. period under audit | VY Completeness - all transactions and events (Toccac) that should have been recorded have been recorded, i Y Cutoff - transactions and events have been recorded in the correct accounting period. v Accuracy - amounts and other data relating to recorded transactions and events have been recorded appropriately. v Classification - transactions and events have been recorded in the proper accounts. Completeness - all assets, liabilities and equity interests that should have been recorded have been recorded. Account balances | ~ at the period end (ACERV) Y Existence - assets, liabilities, and equity interests exist. ¥ — Rights and obligations - the entity holds or controls the rights to assets, and liabilities are the obligations of the entity. v Valuation and allocation - assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded. Presentation and| “ Occurrence and rights and obligations ~~ disclosure disclosed events, transactions, and other (Pocac) matters have occurred and pertain to the entity. ¥ Completeness - all disclosures that should have been included in the financial statements have been included. ¥ Accuracy and valuation - financial and other information are disclosed fairly and at appropriate amounts. Aim... Believe... Claim... Page 123Chapter 4 ~ Overview of the Audit Process and Pre! el Br ~ | ¥ Classification an abil -Fngas) information is appropriately presenteg i described, and disclosures are git | expressed. | oe ~_ expressed —~ | Additional responsibilities Moreover, pan provides that management and, where PPropriat those charged with governance have responsibility: , a. For the preparation and presentation of the financial statements , accordance with the applicable financial reporting framework, this includes the design, implementation and maintenance Of “internal control relevant to the preparation and presentation of finangjy statements that are free from material misstatement, whether due to fraud or error; and b. To provide the auditor with: i. All information, such as records and documentation, and othe matters that are relevant to the preparation and presentation ofthe financial statements; ii. Any additional information that the auditor may request from management and, where appropriate, those charged with governance; and ili. Unrestricted access to those within the entity from whom the auditor determines it necessary to obtain audit evidence. As part of their responsibility for the preparation and presentation of the financial statements, management and, where appropriate, those charged with governance are responsible for: * The identification of the applicable financial reporting framework, the context of any relevant laws or regulations. © The preparation and presentation of the financial statements it accordance with that framework. * An adequate description of that framework in the financdl statements. The preparation of the financial statements requires management © exercise judgment in making accounting estimates that are reasonable intté circumstances, as well as to select and apply appropriate accounting policies These judgments are made in the context of the applicable finan! reporting framework. 1, The auditor performs audit procedures 'n conducting an audit of financial statements, the overall objectives oft auditor are: 4 page ;Chapter 4 — Overview of the Audit Process and Preliminary Activities ‘a, 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; and b. To report on the financial statements, and communicate as required by the PSAs, in accordance with the auditor's findings. To achieve the overall objectives of the audit, the auditor shall design and perform audit procedures which enable the gathering of audit evidence. Such evidence will be used as a basis in expressing the opinion required by the audit of financial statements. When selecting procedures, the auditor considers various factors including assertions made by the entity, assessed level of risks, and materiality. Procedures to be performed may be categorized into (1) major audit procedures and (2) specific audit procedures. Major audit procedures 1. Risk assessment procedures. The audit procedures performed to obtain an understanding of the entity and its environment, including the entity's internal control, to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels. 2. Test of controls. An audit procedure designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level. 3. Substantive procedure. An audit procedure designed to detect material misstatements at the assertion level. Substantive procedures comprise: i. Tests of details (of classes of transactions, account balances, and disclosures), and ji, Substantive analytical procedures. Specific audit procedures 1. Inspection of Records or Documents. It consists of examining records or documents, whether internal or external, in paper form, electronic form, or other media. 2. Inspection of Tangible Assets. It consists of physical examination of the assets. 3. Observation. It consists of looking at a process or procedure being performed by others. 4. Inquiry. It consists of seeking information of knowledgeable persons, both financial and non-financial, throughout the entity or outside the ae Aim... Believe... Claim. Page 125Chapter 4 — Overview of the Audit Process and Preliminary Activities | entity, This procedure may be used extensively throughout the aude a complement of other audit procedures. 5. Confirmation. A specific type of inquiry that is the Process OF obtain @ representation of information or of an existing condition directly fog a third party, : 6. Recalculation, It consists of checking the mathematical accu a documents or records. This procedure may be performed Manually electronically. 7. Reperformance. It involves the auditor’s independent execution a Procedures or controls that were originally performed as part of i, entity's internal control. 8. Analytical Procedures, Procedures consist of evaluations of financg information made by a study of plausible relationships among bos financial and non-financial data. Analytical procedures also encompis, the investigation of identified fluctuations and relationships that ae inconsistent with other relevant information or deviate Significant from predicted amounts. 2. The auditor gathers audit evidence Through the procedures performed, the auditor obtains sufficer appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion. Audit evidence refers to information used by the auditor in arriving at te conclusions on which the auditor's opinion is based. Audit evidence includes both information contained in the accounting records underlying te financial statements and other information. 3. The auditor expresses an audit opinion The auditor provides a written audit report containing a conclusion or opinion regarding the fairness of preparation and presentation of statements in accordance with the applicable financial reporting framewot Opinion to be expressed by the auditor May include either of the followine a, Unmodified opinion. The opinion expressed by the auditor when t® auditor concludes that the financial statements are prepared, in material respects, in accordance with the applicable financial report’ framework. This type of apinion is also known as unqualified opinion: b. Modified opinion. A qualified opinion, an adverse opinion disclaimer of opinion. The auditor shall modify the opinion in auditor's report when: 1. A choice between Qualified and Adverse. The auditor concit that, based on the audit evidence obtained, the financial as a whole are not free from material misstatement; or lieve... CleChapter 4 — Overview of the Audit Process and Preliminary Activities 2. Achoice between Qualified and Disclaimer of opinion. The auditor is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole are free from material misstatement. Sub-phases of audit process The above audit process may be divided into two sub-phases, the investigative phase and the reporting phase. Investigative phase includes performance of audit procedures and gathering of audit evidence. On the other hand, reporting phase includes the expression of opinion, preparation of the report, and communication of the results to the different users of the audited financial statements. AUDIT PROCESS: A MORE DETAILED APPROACH The specific sequence or order of activities in performing financial statements audit may vary from firms to firms depending on their own policies and procedures. However, such sequence of different activities normally will include the following steps: Preliminary Planning an audit of ‘engagement financial statements activities oe 7 aiond ee internal control Issuanceofthe ) audit report AUDIT PROCESS: A MORE DETAILED APPROACH PHASE DESCRIPTION 1. Preliminary This phase will require a decision from the auditor ‘engagement whether or not to accept a new client or continue activities relationship with an existing one. This process would Ll require evaluation not only of the auditor's qualification, Aim... Believe... Claim... Page 127Pre Chapter 4 ~ Overview ofthe Aust Process and P™ of financial statements Planning an audit | Audit pl eliminary Activities but also the integrity and auditabilty Of the ig financial statements. imize the likelihood of objective: To minimiz! te Primary el "client whose management lacks into ny ining involves the development of an oye plan and audit program, .d more detailed knowledge apo, i ral’ audit strategy, audit auditor usually obtained n the client's business and industry in order to understang the transactions and events affecting the financigy statements. Preliminary assessment of risk and materiality is aj,, made during this phase. Primary objective: To assess the different rig, associated with the audit to determine the nature, | timing and extent of further audit procedures necessary to be performed 3. Study and evaluation of internal control Since entity's internal control directly affects the reliability of the financial statements, it is appropriateto study and evaluate these controls. Primary objective: To establish a basis for reliance on internal controls, in determining the nature, timing and extent of audit procedures to be performed 4. Evidence- gathering (Substantive testing) Using the information obtained in audit planning and consideration of internal controls, the auditor performs substantive test to determine whether entity's financial statements are presented fairly in accordance with financial reporting standards. Substantive procedures could either be analytical procedures or test of details of transactions and balances | This phase will always be performed by the auditor. Primary objective: To ascertain the degree of correspondence between the financial statements Prepared by client’s management and the financial | reporting framework. With this, the auditor will be ale to conclude whether or not the financial statements 2 | Presented fairly in accordance with financial reporti"é | standards | 5. Completing the audit nh eS are performed; conclusio” ‘ed; and an overall opinion is fo! Wrapping-up procedur reached are review, during this phase. i28Chapter 4 — Overview of the Audit Process and Preliminary Activities Primary objective: To assist the auditor in assessing conclusion reached is consistent with evidence gathered 6. Issuance of the | In this stage, auditor prepares and issues audit report audit report which describes the scope of the audit and states the auditor’s conclusion regarding the fairness of the financial statements. Primary objective: To communicate the conclusions reached by the auditor to various intended users 7. Post-audit ‘After completion of the audit engagement, auditor responsibilities | performs procedures that will enable him/her identify areas for improvement in the current and future engagements. Primary objective: To assess and evaluate the quality of services delivered by the engagement team PRELIMINARY ENGAGEMENT ACTIVITIES MAJOR AUDIT PROCEDURES In making a decision whether to accept or reject an engagement, the auditor's firm should consider the following: 1. Its competence; 2. Its independence; 3. Its ability to serve the client properly; and 4. The integrity of the prospective client’s management. To adequately address the above items, the auditor is expected to perform the following: 1. Obtain a preliminary knowledge of the client’s business and industry to determine whether the auditor has the degree of competence. required by the engagement. As prescribed by Code of Ethics for Professional Accountants, a professional accountant in public practice should agree to provide only those services that the professional accountant in public practice is competent to perform. This means that auditor can only accept engagements whose requirements are within auditor's capacity and capability. Ordinarily, to determine whether ‘the auditor has the degree of competence required by the engagement, auditor obtains a preliminary knowledge of the client’s business and industry. Aim... Believe... Claim... Page 129iminary Activities Chapter 4 — Overview of the Audit Process and Preliminary ‘s 2. hreats to the firm’s independence nd objectivity, and if so, whether adequate 1 er ocomnsiien Before accepting a specific audit engagement, the 20" objectivity “whet there are any threats to the firm’s independence a Y and if whether adequate safeguards can be established. Independence consists of both independence of mind and independence in appearance. independence of mind is the state of mind that Permits the expression of a conclusion without being affected by influences th3, compromise professional judgment, allowing an individual to act wit, integrity, and exercise objectivity and professional skepticism. On the othe, hand, independence in appearance is the avoidance of facts ang circumstances that are so significant that a reasonable and informed thirg party, having knowledge of all relevant information, including safeguards applied, would reasonably conclude a firm’s, or a member of the assurance team’s, integrity, objectivity or professional skepticism had been compromised. Consider whether there are any t her $0, In an audit engagement, the Code of Ethics for Professional Accountants requires all members of the audit team to be independent from the client. Audit team includes members of the engagement team, the firm, and its network firm/s. Evaluate the firm’s ability to serve the prospective client. Prior to acceptance of an engagement, the firm considers its resources (e.g. personnel) in evaluating whether the firm has the ability to serve the Prospective client properly. Evaluate auditability. In an audit engagement, auditor gathers sufficient appropriate evidence to form and express an opinion as to the fairness of preparation and presentation of the client's financial statements. For the auditor to do this, accounting records, documents and other information that supports the client's financial statements should be made available to the auditor. Absence of records, documents and other information raises significant doubt about client’s auditability. Investigate the integrity of the prospective client’s management The proposed auditor (previously called Successor auditor) considers whether acceptance of a new or continuing an existing client relationshiP would create any threats to compliance with the fundamental principles: Potential threats to integrity or professional behavior may be created from, for example, questionable issues associated with the client {its owners page 13