MODULE 1: OVERVIEW OF THE AUDIT PROCESS

I. Description
This module discusses the nature of financial statements audit, the objective of auditing and the
major phases of audit process.

II. Objectives
After completing the module, the students are expected to:
✓ Describe audit
✓ Understand the overall objectives of the audit
✓ Define the different requirements of audit
✓ Enumerate and understand the different phases of audit
✓ Define Internal Audit and identify

III. Duration
Start: Week 1
End: Week 1

IV. Learning Contents

PART 1 – AUDIT OVERVIEW

A. DEFINING AUDIT

Systematic process of objectively obtaining and evaluating evidence regarding assertions about
economic actions and events to ascertain the degree of correspondence between these
assertions and established criteria and communicating the results thereof. (American Accounting
Association)

B. OVERALL OBJECTIVES OF THE INDEPENDENT AUDITOR AND THE CONDUCT OF AN

AUDIT IN ACCORDANCE WITH PHILIPINE STANDARDS ON AUDITING

In conducting an audit of financial statements, the overall objectives of the auditor are:

(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.

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C. REQUIREMENTS

1. Ethical requirement relating to audit of financial statements

a. Integrity
b. Objectivity
c. Professional Competence
d. Confidentiality
e. Professional Behavior

2. Professional Skepticism

An attitude that includes a questioning mind, being alert to conditions which may indicate
possible misstatement due to error or fraud, and a critical assessment of audit evidence.

The auditor should plan and perform the audit with an attitude of professional skepticism
recognizing that circumstances may exist that cause the financial statements to be
materially misstated.

An attitude of professional skepticism means that the auditor makes a critical assessment,
with a questioning mind, of the validity of the audit evidence obtained and is alert to audit
evidence that contradicts the reliability of documents and responses to inquiries and other
information obtained from management and those charged with governance

3. Professional Judgement

An attitude that includes a questioning mind, being alert to conditions which may indicate
possible misstatement due to error or fraud, and a critical assessment of audit evidence.

This is necessary in particular regarding decisions about:

✓ Materiality and audit risk

✓ The nature, timing and extent of audit procedures used to meet the requirements
of the PSAs and gather evidence

✓ Evaluating whether sufficient appropriate audit evidence has been obtained, and
whether more needs to be done to achieve the objectives of the PSAs and
thereby, the overall objectives of the auditor.

✓ The evaluation of management’s judgments in applying the entity’s applicable

financial reporting framework.

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 ✓ The drawing of conclusions based on the audit evidence obtained, for example,
assessing the reasonableness of the estimates made by management in
preparing the financial statements.

4. Sufficient appropriate audit evidence and audit risk

To obtain reasonable assurance, the auditor shall obtain sufficient appropriate audit
evidence to reduce audit risk to an acceptably low level and thereby enable the auditor
to draw reasonable conclusions on which to base the auditor’s opinion.

5. Conduct of an audit in accordance with PSAs.

The PSAs, taken together, provide the standards for the auditor’s work in fulfilling the
overall objectives of the auditor. The PSAs deal with the general responsibilities of the
auditor, as well as the auditor’s further considerations relevant to the application of those
responsibilities to specific topics.

D. CONDUCT OF AUDIT

The auditor should conduct an audit in accordance with the Philippine Standards on Auditing
(PSA).

PSAs contain basic principles and essential procedures together with the related guidance in
the

E. SCOPE OF AN AUDIT

The audit procedures deemed necessary in the circumstances to achieve the objective of the
audit.

F. RESPONSIBILITES

Auditor – responsible for forming and expressing an opinion on the financial statements.

Management – responsible for the preparation and presentation of the financial statements in
accordance with the applicable financial reporting framework.

Those Charged with Governance – overseeing of the management

The audit of the financial statements does not relieve the management or those charged with
governance of their responsibilities.

F. SEVEN (7) PHASES OF THE AUDIT

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 PHASE OBJECTIVE DESCRIPTION
To minimize the likelihood of being Requires the decision whether to
1. Pre-engagement associated to a client whose accept or not a new client or
management lacks integrity. continue relationship with an
existing one.
2. Audit Planning To assess the different risks Development of overall audit
associated with the audit to strategy, audit plan and audit
determine the nature, timing and program.
extent of audit procedures
necessary to be performed. Obtaining detailed knowledge of
client’s business and industry to
understand the transactions and
events affecting the financial
statements.

3. Consideration of To establish a basis for reliance Study and evaluation of internal

Internal Controls on internal controls in determining controls whether it can prevent,
the nature, timing and extent of detect or correct material
audit procedures to be performed. misstatements in a timely manner.
4. Evidence Gathering To detect material misstatement To ascertain the degree of
(Substantive Testing) as a basis in concluding whether correspondence between the
the entity’s financial statements financial statement prepared by
are presented fairly in accordance the client’s management and the
with financial reporting standards. financial reporting framework
5. Completing the Audit Communication of the results of Wrap-up procedures &
the work of the auditor to various Conclusions reached are
intended users. reviewed.
6. Issuance of Audit Communication of the results of Draft and issue the audit report
Report the work of the auditor to various that states the opinion regarding
intended users. the fairness of the financial
statements.
7. Post-audit Assessment and evaluation of the Post-completion of the audit
responsibilities quality of the audit services engagement.
delivered by the engagement
team.

PART 2 – PRE-ENGAGEMENT ACTIVITIES

Acceptance of an Engagement

In evaluating whether to accept or not an engagement, the auditor should perform the following:

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 1. Evaluate pre-conditions for an audit
2. Evaluate accountability of the prospective client
3. Investigate the integrity of the client’s management
4. Evaluate compliance with ethical requirements including independence
5. Evaluate the firm’s ability to serve the prospective client
6. Obtain preliminary knowledge of the client’s business and industry to determine the
degree of competence required.
7. Agree on the terms of the engagement and preparation of engagement letter.

In evaluating the continuance of the previous engagement, the auditor should consider
significant matters that have arisen during the current or previous engagement and their
implications for continuing the relationship.

Agreeing on the Terms of the Audit Engagement

Agreeing on the terms of the audit engagement should be documented/ recorded in an Audit
Engagement Letter or other suitable form of contract.

Contents of an Engagement Letter:

1. Presence of audit risk

2. Unrestricted access to records in relation to the audit
3. Financial reporting framework used
4. Objective of the audit
5. Form of any reports or other communication
6. Management responsibility
7. The scope of the audit

Other content:

1. Basis of fees computation and billing arrangements

2. Expectation of receiving representation letter
3. Acknowledgement of management of terms of the engagement
4. Arrangements regarding the planning of the audit
5. Letters or reports

Audit of Components

When the auditor of a parent entity is also an auditor of its subsidiary, branch or division.
Factors to consider whether to send a separate engagement letter:

1. Who appoints the component auditor

2. Legal requirements
3. Degree of ownership by the parent

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 4. Whether a separate auditor’s report is to be issued to the component
5. Degree of independence of the management of the component from the entity

Recurring Audit

The auditor should consider whether circumstances require the terms of the engagement to be
revised and whether there is a need to remind the client of the existing terms of the
engagement.

The following factors may make it appropriate to send a new engagement letter:

1. If there is an indication that the client misunderstands the objective and scope of the
audit
2. Any revision or special terms of the engagement
3. A recent change in the top-level management or Board of Directors
4. A significant change in ownership
5. A significant change in the size or nature of the client’s business
6. A change in legal or regulatory requirements
7. A change in the financial reporting framework adopted in the preparation of the
financial statements
8. A change in other reporting requirement

Acceptance of a Change in Engagement

The parties shall identify if there is a reasonable justification as to the cause of the change in the
engagement. Upon providing and acceptance of the reasonable justification, the parties shall
stop performing and referring to the old engagement. The new engagement shall be performed
and the auditor will provide the report based on the new engagement.

PART 3 – AUDIT PLANNING – INTRODUCTION AND RISK

ASSESSMENT PROCEDURES

A. AUDIT PLANNING

Primary Objective: Plan the audit for an effective audit performance.

Role and Timing of Planning: Establishing an overall audit strategy for the engagement
and developing an audit plan.

Factors affecting the Nature, Timing and Extent of Audit

1. Size and Complexity of the entity

2. Previous experience with the entity

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 3. Changes in circumstances that occur during the audit
4. Timing of the appointment of the auditor

Activities conducted during audit planning:

1. Obtaining an understanding of the client and its environment

2. Determining the need for experts
3. Determining the appropriateness of the use of going concern assumption
4. Establishing materiality and assessing risk
5. Assessing possibility of non-compliance
6. Identifying related parties
7. Performing preliminary analytical procedures
8. Development of overall audit strategy and detailed audit plan
9. Preparation of preliminary audit programs

Overall Audit Strategy and Audit Plan

Sets the scope, nature, timing and direction of the audit. It also guides the development of audit
plan.

1. Identify the characteristics of the engagement that define its scope.

2. Ascertain the reporting objectives of the engagement to identify the timing of the audit
and nature of the communications required.
3. Considering the factors significant in directing the engagement team’s efforts

Audit plan can be developed after the overall audit strategy has been established. This is to
address various matters identified in the overall audit strategy to achieve the audit objectives
through the use of the auditor’s resources.

Audit plan is more detailed than the audit strategy because is includes the ff:
1. Nature of the audit procedures
2. Timing of the audit procedures
3. Extent of the audit procedures

Audit Program

Documentation of the audit program.

1. Set of instructions to assistants involved in audit
2. Time-budget for various audit procedures or audit areas.

Changes to Planning Decisions During the Course of the Audit

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The overall audit plan and audit program should be revised as necessary during the course of the
audit. Planning is continuous throughout the engagement because of the changes in the
circumstances or unexpected result of the audit procedures.

Completing the Overall Strategy and Audit Plan

Preferably, the audit plan should be initially completed prior to consideration of internal controls
or performance of procedures. Audit strategy and audit plan are closely interrelated since changes
in one may result in consequential changes to the other.

Planning Documentation

1. Overall audit strategy

2. Audit Plan
3. Any significant changes made during the audit engagement to the overall audit strategy
and/or audit plan, and the reasons for such changes.

B. ADDITIONAL CONSIDERATION FOR INITIAL AUDIT

1. Arrangements to be made with the Predecessor Auditor

2. Any major issues discussed with management in connection with the initial selection as
auditors, the communication of these matters to those charged with governance and how
these matters affect the overall audit strategy and audit plan.
3. The planned audit procedures to obtain sufficient appropriate audit evidence regarding
opening balances
4. Other procedures required by the firm’s system of quality control for initial audit
engagement

C. DIRECTION, SUPERVISION AND REVIEW

The auditor should plan the nature, timing and extent of direction and supervision of engagement
team members and review of their work.

1. The assessed risk of material misstatement

2. Size and complexity of the entity
3. The area of the audit
4. Capabilities and competence of the personnel in the team

A. RISK OF MATERIAL MISSTATEMENTS

The auditor should identify the risk of material misstatements whether due to fraud or error; at
the financial statement and assertion levels, through understanding the entity and its

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 environment, including the entity’s internal control, providing a basis for designing and
implementing responses to the assessed risk of material misstatements.

Required understanding of the entity and its environment

1. Relevant industry
2. Regulatory factors
3. Other external factors including the financial reporting framework

4. Nature of entity
a. Operations
b. Ownership
c. Governance structure
d. Types of investments (current and future plans)
e. The way the entity is structured
f. Financing of the entity

5. Entity’s selection and application of accounting policies, and reasons for changes if
applicable

6. Entity’s objectives and strategies

7. Related business risks that may result in risk of material misstatement

8. Measurement and review of the entity’s financial performance

9. Internal control

B. RISK ASSESSMENT PROCEDURES

Audit procedures performed to obtain an understanding of an entity and its environment,

including the entity’s internal controls, to identify and assess the risks of material
misstatement, whether due to fraud or error, at the financial statement and assertion levels.

1. The auditor shall identify the risks throughout the process including relevant controls
that relate to the risks and consider the classes of transactions, account balances and
disclosures in the financial statements.

2. The auditor shall relate the identified risks and its effect at the assertion level

3. The auditor shall consider whether the risk could result in a material misstatement in
the financial statement

Different Risk Assessment Procedures:

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 1. Inquiries of the management, and of others within the entity who in the auditor’s
professional judgement may have information relevant in identifying risks of material
misstatement due to fraud and error.

2. Analytical procedures

3. Observation and inspection

ANALYTICAL PROCEDURES – Planning Stage

Evaluations of financial information made by a study of plausible relationships among financial

and non-financial data. It includes investigation of identified fluctuations and relationships that are
consistent with other relevant information or that differ from expected values by a significant
amount.

Analytical procedure is required to be performed during planning stage and overall review stage
of the audit. Analytical procedure during the planning stage is designed to:

1. Enhance auditor’s understanding of the entity’s business and transactions to help plan
the nature, timing and extent of the substantive audit procedures that will be used to
gather audit evidence.

2. Identify areas that may represent specific risks that the auditor may need to investigate
further.

C. AUDIT RISK AND MATERIALITY

The auditor must make judgements about audit risk and materiality to determine the nature,
timing and extend of procedures to apply and in the evaluation of the results.

Materiality

Information is material if its omission or misstatement could influence the economic decisions
of users taken on the basis of the financial statements. Materiality depends on the size of the
item or error judged in the particular circumstances of its omission or misstatement.

The concept of materiality recognizes that some matters, but not all, are important for fair
presentation of the financial statements in conformity with PFRS.

At the planning stage, the auditor makes judgements about the size of misstatements that will
be considered material.

Types of Materiality

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 1. Financial Statement level materiality – the smallest aggregate amount of
misstatement applicable to all financial statements.

2. Assertion level materiality – materiality level for individual or particular class of

transactions, account balance or disclosure where appropriate. Also known as
Tolerable misstatement.

3. Performance materiality – amount/s set by the auditor at less than the materiality for
the financial statements as a whole, and if applicable, at less than materiality level/s
for particular classes of transactions, account balances or disclosures.

Audit Risk

The risk that the auditor gives an inappropriate audit opinion when the financial statements are
materially misstated.

Components of Audit Risk

Risk of Material Misstatements:

1. Inherent Risk – The susceptibility of an assertion about a class of transaction, account
balance or disclosure to a misstatement that could be material, either individually or
when aggregated with other misstatements, before consideration of any related
controls.

2. Control Risk – The susceptibility of an assertion about a class of transaction, account

balance or disclosure to a misstatement that could be material, either individually or
when aggregated with other misstatements, before consideration of any related
controls.

Risk of not detecting the Misstatement

3. Detection Risk – The risk that the procedures performed by the auditor to reduce audit
risk to an acceptably low level will not detect a misstatement that exists and that could
be material, either individually or when aggregated with other misstatements.

PART 4 – INTERNAL CONTROL CONSIDERATION AND

RESPONSE TO ASSESSED RISK

A. ACCOUNTING AND INTERNAL CONTROL SYSTEM

Accounting System – series of task and records of an entity by which transactions are
processed as a means of maintaining financial record.

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 Internal Control Systems – all policies and procedures adopted by management to assist in
achieving management’s objectives of ensuring:

• Orderly and efficient conduct of its business

• Adherence to management policies
• Safeguarding of assets
• Prevention and detection of fraud and error
• Accuracy and completeness of accounting records
• Timely preparation of financial records

B. INTERNAL CONTROL

Internal Control – process effected by those charged with governance, management and
other personnel, designed to provide reasonable assurance regarding the objectives of:

• Operational Objective - Effectiveness and efficiency of operations

• Reporting Objective – Reliability of financial reporting
• Compliance Objective – compliance with the applicable laws and regulations

Internal Control can only provide reasonable assurance because of the inherent limitations that
may affect the effectiveness of internal controls.

1. Cos benefit consideration

2. Management overriding control
3. Changes in condition
4. Human error potential
5. Controls are anticipated (routinary)

Areas of Internal Control

1. Administrative – plan of the organization that are concerned with the decision
processes leading to management’s authorization of transactions

2. Accounting - plan of the organization and the procedures and records that are
concerned with the safeguarding of assets and the reliability of financial record.

Components of Internal Control

1. Control Environment
2. The entity’s risk assessment process
3. The information system
4. Control activities
5. Monitoring of controls

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C. INTERNAL CONTROL CONSIDERATIONS

The auditor should obtain an understanding of the accounting and internal control systems
sufficient to plan the audit and develop an effective audit approach.

1. Obtain an understanding of the internal controls

2. Preliminary assessment of control risk
3. Determination of overall response to assessed risk
4. Performance of test of controls
5. Reassessment of control risk
6. Determination of the nature, timing and extent of the substantive tests necessary to
restrict Detection risk to an acceptably low level.

V. References
• Auditing and Assurance Concepts and Applications by Darrell Joe O. Asuncion, Mark
Alyson B. Ngina and Raymund Francis A. Escala

• PSA 200 - Overall Objectives of the Independent Auditor and the Conduct of an
Audit in Accordance with Philippine Standards on Auditing

• Auditing and Assurance, Concepts and Applications by Ma. Elenita Balatbat Cabrera
and Gilbert Anthony B. Cabrera

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