Chapter 1 BASIC CONCEPTS : REEKERER ERE REE REE E ER EERE E EERE EERSTE TET EXPECTED LEARNING OUTCOMES After reading this chapter, you should be able to ; its (3) recall the nature of a financial statement audit by stating “purpose; 2 . «b) identify the management's assertions when presenting the financial . statements; | (c) describe each major phase in financial statement audit; , (d) ~ identify and discuss the most common procedures applied in. financial statement audit; (e) explain the purpose of audit documentation; . fy state the type appropriate type of audit report for each conclusion drawn based on assessment of audit documentation; (9) formulate appropriate audit adjusting entries; and (h) complete a working trial balance. THE PURPOSE OF FINANCIAL STATEMENT AUDIT AND MANAGEMENT'S ASSERTIONS Financial statements are primarily the responsibility of the ' entity’s management who makes the following assertions: * existence or occurrence of transactions that result to reported assets, liabilities and equity at the reporting date and income and expenses for the reporting period. + ~ completeness of information presented in the financial statements that are . the results of the transactions and other events that actually occurred during the reporting period. * rights or contro! over ail reported assets, and obligatioy ‘ fiabilities at the reporting date. ligations for reported * "appropriate use of measurement bases for assets, liabilities and equity and ria 5 ju » recognition of income and expenses in accordance with the revenues ond expense recognition principles applicable; and© Chapter 1= Basie Concerts % oe ser a see i financiel . sratement appropriate presentation and. : i : mens 4 company notes to WE jegal. form ‘of the recorded eS re substance and not merely the © eff . icated to the users." transactions is communi stakeholders, use the oo . 4 ther 4 inly investors and other. ents about the oe ‘edacnatee ortained fn the financial statements making Seta eae 4 i isi re may it ation nee enterprise fo fom Oe ae my be in conflict ve whether the Gf the users. Thus, an external audit is necessary = Seer and are prepared financial statements issued by the management are free of Sa this reporting i accordance with the appropriate finances One ie retible for the decision framework aims to present information that is relevant and reli neads of the external users. : examination of the financial independent The external auditor conducts an indeper f the management. statements to address each of the foregoing assertions o! * THE AUDIT PROCESS The audit process starts when a reporting entity engages the services of an ~ independent auditor for an independent examination of its financial statements and condudes when an auditor issues an audit opinion based on the assessment of the evidence gathered in the course of the conduct of audit procedures and assessment of evidence gathered therefrom, ‘The following are the major phases in a financial statement audit: (a). _ pre-engagement activities; (5) audit planning and evaluation of internal control; (©) ~ evidence gathering; and . © (4). reporting. . (@) - Pre-Engagement Activities Pre-engagement activities are procedures A ‘or not fo accept a new engagement br rein monet to determine whether "assessment a8 to i sting client. I it Should consider the dents besnne oo CS 2 prospective cient, the sur or management and the client’ reportage stanges in client's ownership etermine whether he or she and his or her aul team posse aletacad should ou a " ‘sary skills, thnaae rent, The pre-engagement activities are desinnar Ped Specified by the ¢ s Z 5 gs # z o 5 g 2 2 & zgFepeat engagements, subsequent relationships established shall be assessed to determine whether independence has not been compromised. If the engagement is accepted or retained, the terms shall be documented in'an engagement letter, (b) . - Audit Planning ‘Audit planning involves evaluation of. intemal control to determine the extent of audit procedures necessary to be performed. The audit planning phase requires active involvement of the whole audit team, from the partner in charge down to the audit staff, It includes the following tasks: (1) obtaining an understanding of the client, its business, industry and accounting policies; . (2) obtaining an understanding of the client's internal control system; (3) assessing materiality and audit risk; br TR SED epee tt (4) identifying audit objectives; (S) determining whether reliance can be placed on certain controls in + the system; (6) determining the nature, extent and timing of substantive tests to be performed; and (7) designing and finalizing the audit program, (©) Evidence-Gathering or Audit Documentation The evidence-gathering (audit documentation) phase must accomplish the objective of documenting the fact that the audit was adequately planned and sufficient, competent evidential matter is obtained that serves as the basis for the audit opinion reached (International Standards. on Auditing 230 Audit Documentation par. 5). The evidence gathered must both be sufficient and competent. Sufficiency refers to the quantity of evidence an auditor acquires and competence refers to the relevance, validity and reliability of the evidence acquired. Audit evidence consists of. both accounting’ data (business documents, journals and ledgers) and corroborating information (cancelled checks, Invoices, contracts, promissory notes, written representations from customers and vendors, etc.) that supports accounting data. Because of the time element involved in completing the audit, the examination of evidence is made on a test basis. The auditors test samples of transactions and generalize the results to the population from which the samples + were drawn. This requires that the evidence gathered be persuasive rather than merely convincing. : ¥ ___,. The audit procedures applied by the auditor are selected based on the audit ; Objectives, the quantity and types of evidence avallable/“ materiality and the assessed level of audit risk, An audit evidence acquired mat Faddress one or more CP kyif Chi B ement Fi tate Concepts of Finane! St apter 1 - Basic ! jes of audi ost com: i series © are the ™ 'm0n, > gut objectives, and in some neve. ate following uit necessary to address one 2! raft “i fied by the auditor . : ‘audit procedures applied by trom a ted party; ‘il ment + ‘Confirmation — obtaining written seater fe «Physical count and observation; ** ia 4S Inquiry = obtaining written and oral “it employees and others; ternat evidence and external Prigenee Me entation — ing in . 1S, nl z ns comple: On ae nites ‘of meetings, vouche' : con onships of int . Sores establishing trends and an vos and * Recalculations — establishing correctness 0! aa mcucy of accounting + Mechanical tests of data ~ verifying mathematical data (tracings, footings and cross-footings)- . mation from management, formation; audit procedures are carried out to perform tests of esr ae tanta teak Tests ‘of controls are conducted to assess the ability of the company’s internal controls to prevent or detect material misstatements, Substantive tests, on the other hand, are tests of details and analytical procedures performed to detect material misstatements in account balance, transaction class or financial statement presentation and disclosure. ‘Substantive tests may be classified into tests of details or analytical procedures. ‘Tests of details are intended to detect material misstatement and allow an auditor to test aggregated data. Analytical procedures are evaluations of financial “information made by a study of plausible relationships among both financial and ‘non-financiat data. Analytical procedures allow the auditor to test, aggregated data to reach a conclusion. Documentation must’ be iatel Doe made immediately after Completing an audit wae Typical examples of audit documents are (2). information that enables 3 client (information ret Ho eee or members of 4 feject an entity as _imsinests Of the Board of Directors, duct lent industry, red, etc.); 4pepearrteeninctin gs nangemnee em Chapter 1 - Basic Concepts of Financial Statement Audit p25 4°" (by information that enables the auditor to determine the audit approach (information relating to the effectiveness of internal control procedures and whether or not such procedures are being complied with); . ££. 5 CO_ information as to whether 2 particular financial statement account me balance is complete, valid and accurate and ‘+ (d)_ information relating to the completeness, validity and accuracy of : the financial statements taken as a whole Including information relating to the consistency of the financial statements with the auditor’s knowledge of the business The form, content and extent of audit documentation depend on factors, such as (ISA 230 A2) + the size and complexity of the entity; = the nature of the audit procedures to be performed; «the identified risks of material misstatements; «the significance of the audit evidence obtained; + the nature and extent of exceptions identified; » the need to document a conclusion or the basis for 2 conclusion not readily determinable from the documentation of the work performed or evidence obtained; : : + the audit methodology and tools used. Specifically, the audit file documentation serves to: (a) organize and coordinate all phases of the audit engagement; (0) provide evidence to demonstrate that the planned audit procedures were in fact performed; (©) aid partners in reviewing the work performed by audit staff members; (d) provide ‘evidence that the auditors complied with the auditing standards; (e) dociiment the! judgments involved in forming the audit opinion; (A) aid in plarining and conducting future audits of the client; and (a) provide information in rendering additional services to the audit client (say, in preparing income tax returns and in making recommendations for improvement of the client’s internal control procedures.) In the risk’ response’ phase, typical audit i i Eee phase, documentation normally includes the following items: an audit plan that addresses all material financial ‘Statement einen nani enamels:hapten L= Basie Concerts of ** financial statement ang ag ment at further audit procedure, 7 = isks identity : = risk sxtent nificant FiSks | eg, “areas, the psa ature, timing and CFT. and sid ith others, Significanc assertion levels, d to the assessed 2U" sutration W ing tested, a cles, espon of bei i : a retod are the nature and extent or exceptions followed y ¢ ined at He A excep! , and nature of the evidence obtains ge test and OT the overall aus, an sion of the results obtaine ores, crags A evaluah aa as a result of eas “applied in performing Seo ony tne mn maragement oF SOIC Gf assumptions. establish, iets of aon stabishment of ay dence that the financig details of Se mSnentation a? d = ss references : . : Statements agree with the underlying accounting recor of audit documentation for each ily maintain two files ertain client: 0 att tes for each. year’s engagement and p ‘ i nent file of documentation relating to that year’s examination and (2) pe a . felatively unchanging data (for example, articles of | The following are examples of current files in the audit documentation: working trial balance; . a Summary of audit adjusting and classifying entries; lead schedule; . bank reconciliation; aged accounts receivable; minutes of meetings during the reporting period; and Narrative documentation summarizing bases for resolutions involving uncertainties, Examples of permanent file in audit documentation are as follows: * articles of incorporation; * corporate by laws; +» by of pension contract with fundi * ~ Copy of trust indentures for long-ter * + Copy of the effective Collective ba: ing agency; rm debt; and : : Fgaining agreement, The audit, documentation, which team members, The working ee a oe located ind sees “Seapine ver gn yen es DUM Be raed ngagem tner, quality reviewer/monitor, ring by the manager, generally is in : -. Audit documents are th ; information in ‘work ne een of se auc oe WOFKING papers is confi Suit frm, 4 Bvalable to outsiders without the consent ee ci generally mace nme : se och on : ent. = =m: Chapter 1 - Basic Concepts of Financial Statement Audit Under no circumstances should the working papers be destroyed after they have been subpoenaed or after an announcement has been made for litigation involving an engagement. If the auditors are charged with negligence, their audit working papers serve as a major basis to refute or substantiate such a charge. The major types of audit working’ papers include administrative working papers, supporting schedules, adjusting journal entries and reclassification entries, supporting schedules, analyses, reconciliations and other computational working papers, and corroborating documents. Administrative working papers aid the auditors in the planning and administration of engagements, and include the audit plans and audit programs, time budgets, internal control questionnaires and flowcharts and engagement letter. They may take the form of a narrative documentation that summarizes the phases of audit work performed on the engagement. In the risk assessment phase, the documentation relates to preengagement" procedures, independence and ethics assessment, terms of engagement, materiality consideration, overail audit strategy, audit team discussions which may inctude possible causes of material misstatements in the financial statements, risk assessment procedures performed and the results, assessed risk of material misstatement identified based on the understanding of the entity and related interna! control, significant risks, and communication with management and those charged with governance. (Guide to Using ISAs in the Audits of SMEs) (d) "Reporting The auditor should review and assess the conclusions drawn from the audit evidence obtained as the basis for the expression of an opinion on the financial i statements. The auditor's report should contain a clear written expression of an ~ uy opinion on the financial statements taken as a whole. b fe a Based on the results of the evaluations made, the auditor would determine : - what form of audit report is appropriate in the circumstances. . i types of audit Reports 3 Be e _- The auditor should evaluate the conclusions drawn from the audit evidence : ‘obtained as the basis for forming an opinion on the financial statements. (ISA 700, |. |The Independent Auditor's Report on the Financial Statements, pat. 4). There are ‘ ‘two general types of audit report: unmodified and modified. £2"): Unmodified opinion peo . Boo, When the auditor conctudes that the financial statements are presented E fairly, in all material respects, with the applicable financial reporting framework (at 4 : : . 7: Chapter Le Basle’ an the the present tine, Stan Intemational Financial Reperling nian woul lu he an unmodified (or equate) oj opinion should be expresses fair view i and cable fits * statements give a tue respects) In accordance with the appl ISA 700). (2) Modified opinion When based on the audit whole are not free from materi evidence could not be obtained to conch are free from material misstatement, & ™ » opinion may take the form. of a qualified, op! aby peta gp OM ay opinion. 4,- ‘ misstatements exist, individually or In pervasive. to the financial statements or peial See wes of Lote ment Ait (late ting standards or Financial Repo Medium Sized Entitieg ial nh Internation ids gma ropriate An UNQUalifigg p des that the finangy the avcitor ord fairly, In all mater; ae iting framework (par, 35 aanciat FPO financial statements ag q i the t execs sufficient appropriate augi, iat miss : i tements as a whol at the financial sta' hole hi ed opinion is expressed. A modified inion, adverse opinion or disclaimer of essed when either (1) sufficient A qualified opinion should be. expr appropriate audit evidence was obtained, but the auditor concludes that the aggregate, that are material but not (2) the auditor is unable to obtain sufficent appropriate audit evidence on which to base the opinion and that the possible effects on the financial statements of undetected misstatements, if any, could be material but not pervasive, A qualified opinion should be worded as being “except for the effects (or the possibie effects) of the matter to which the qualification relates. An adverse opinion should be expressed when the effects of misstatements . 2? are both material and pervasive. This opinion applies where sufficient appropriate erence “a obtained, but the auditor concludes that misstatements, individually igregate, are both material and pervasive to the financial statements. ‘An adverse opinion states that the fin: financial position, financial performance, , Circumstances where in conditi + on the financial statements, isn citions of major uncertains: itis not possible to fons es and their possible effects ‘ancial statements do not i Present fairly the and cash flows of the entity audited. to obtain sufficient a opinion is expressed ANY, | + concludes that the eben duct evidence on which nee auctor is unable both material and pervasive, ie wetected mi the opinion, and t itements, if pinic 5 eae Be On also applies to extremely rare an opinion,: ‘The Working Trial Balance and the Audit Adjusting Entries. The working trial balance is a schedule listing the balances of accounts in the general tedger for the ‘current and previous year, with columns for adjusting entries, reclassification ‘entries, and the financial statement amounts. The working trial balance Is of two types: {4} one-section triat balance, which looks like an ordinary worksheet and lists all ledger accounts. A pair of columns is maintained for each of the following: trial balance, adjustments and reclassifications, adjusted profit or foss accounts and adjusted financial position accounts. ‘ (2) two-section trial balance, which is divided into two components: the working comprehensive income and the working financial position, Each section provides a separate column for unadjusted balances, adjustments and reclassifications and adjusted balances. The working trial balance shows the results of all adjustments and reclassifications made as a result of detailed audit of account balances. Thus, audit adjusting entries developed from a cash count of petty cash, bank reconciliation statement, confirmation and analysis of accounts receivable, anatysis of property, plant and equipment, etc. are summarized in the working trial balance. Adjusting and reclassifying entries are a list of auditors’ adjustments in the client prepared financial statements to bring the account balances to correct balances. When the auditors discover errors or irregularities in the accounting records of a client, they propose adjusting entries to correct the accounting records, Also, the auditors develop reclassification entries for Items that, although correctly recorded in the accounting records, must be reclassified for fair presentation of the financial statements. A lead schedule Is used to combine several amounts which total to a line item in the financiat statements. For example a lead schedule is prepared to list the different cash on hand and cash in bank that is shown as a single line item “Cash” on the face of the statement of financial position.1: The Cash Pea sh account Included et “inure ‘Working Tal Balance ora of arty Come TS Pay 31,2 Below is the tial | balance as of Decent by its accountant. ~ . i ; arity company 6° tal Balance pecember 34, 2018 pebit Credit op 491,000 © died 615,000 ecoonts receivable 2 P 21,009 ~ ‘allowance for doubtful accounts 584,000 Inventory, December 31, 2017 8,000 + Prepaid expenses 410,000 Investments Fumiture and Equipment 312,008 Miscellaneous Equipment * 90.090 Accumulated Depreciation 76,400 Accounts Payable 533,000 Accrued Expenses . 51,000 Unearned Rent Income - 12,800 Orcinary Share Capital 600,000 * ir , Retained Earnings 182,800 Rent Income aes 5, Rest Ine ; 48,000 Cis . : 2,424,000 Gs . 400,000 = Commit ene — 124,000 Utilities Expense 80,000 Supplies Expense . 32,000 " Transportation Expense 12,000 J ees and Maintenance 14,000 iscellaneous Expenses 5 m 16,000 So eer “You hi 2 000 TF 505, ave gathered the following Information foy aa T adjustment: ,000, quipm ent acquisition fung amounting ‘0 ‘ Goods purchased under shipped FOB mcs Supplier on bog Poi Int, MV on aruary 4 aon 2, Sane to have beet 19, ps Were ‘received are Chapter 1 - Basic Concepts of Financial Statement Audit 4, ‘The allowance for doubtful accounts should be adjusted to 5% of accounts receivable. 5 The company purchased 100 shares of its P100 par value ordinary share capital for P30,000, the amount having been charged to the Investment account. 6. Except for equipment purchased on June 30, 2018 for P20,000 cash, ali equipment were acquired at the inception of the company three years ago. Depreciation for 2018 has not been recorded. 7. Prepaid expenses include P4,800 insurance premium on a one-year insurance policy taken on October 1, 2018. 8. Unearned rent income on December 31, 2018 amounted to P10,000. 9. ‘Accrued expenses on December 31, 2018 amounted to P54,000. REQUIRED: (a) Prepare audit adjusting entries. (0) Prepare a working trial balance to facilitate the preparation of the financial ‘statements for the year ended December 31, 2018. Solutions: (a) Audit Adjusting Entries: Equipment Acquisition Fund 60,000 Cash 60,000 ~ Purchases ars % 50,000 Accounts Payable Z 50,000 Doubsful Accounts Expense : 9,750 30,000 39,200402,000 (20,00) 10% 1,200 1,200 2.800 3,000 3,000 74,000 184,000 IS are still effected Gient, regardless as to , because as previously ‘ed financial statements. trial balance, listing in € sheet audit 11 are appropriately