THE AUDIT PROCESS – Accepting an

Engagement
An audit of financial statements generally begins with the
financial statements prepared by the entity’s management.
Without these financial statements, there can be no audit to
perform. A general approach to auditing financial statements
would require consideration of financial statement assertions,
audit procedures, and audit evidence before forming an
audit opinion.

 Financial statement assertions

Management is responsible for the presentation of financial
statements that reflect the nature and operations of the
entity. In representing that the financial statements are in
accordance with the applicable financial reporting
framework, management implicitly or explicitly makes
assertions regarding recognition, measurement, and
presentation of classes of transactions and events, account
balances and disclosures.
The auditor uses these assertions to consider the different
types of potential misstatements that may occur in the
financial statements.

Financial statement assertions can be classified into:

 Rights and obligation
That the entity has rights over the reported assets and that
it has valid obligation to settle the reported liabilities. An
example of an audit procedure to test this assertion is to
examine ownership documents such as certificate of title
for real property.
 Valuation and allocation
That assets and liabilities are properly valued and that the
revenues and the expenses are properly measured. A
typical audit procedure to test this assertion includes
recalculation of financial statement values such as
depreciation, accrued interest and amortized costs of
financial assets and liabilities.
 Presentation and disclosure
That assets and liabilities are properly classified and that
disclosures in the notes to the financial statements are
adequate. Testing this assertion will require the application
of the relevant accounting standards. In addition, the
auditor may review major contracts such as loan
agreements to identify important information that needs to
be disclosed in the notes to the financial statements.
 Existence or occurrence
That assets and liabilities exists as of the financial statement
date and that revenues and expenses occurred during
the reporting period. One of the most effective audit
procedures to test the existence of an asset is the physical
examination or ocular inspection of the asset. In
circumstances where physical examination is not feasible,
the auditor may obtain evidence about the existence of
asset through external confirmation.
 Completeness
That all items that should be reported in the financial
statements are so included. A typical procedure to satisfy
this assertion is to start with a source documents such as
sales invoice and determine if it is recorded in the sales
journal.

Existence and completeness emphasize two opposite

audit concerns. Existence/occurrence assertion is
concerned with the potential overstatement of accounts
while completeness assertion is concerned with potential
understatement of accounts. When designing audit
procedures, the direction of test is a crucial step in
satisfying the completeness or the existence/occurrence
assertions.

When the auditor traces, items from the source documents

to the accounting records, the auditor is obtaining
evidence that all transactions (as represented by the
source documents) have been completely recorded.
On the other hand, when the auditor works from the
accounting records back to the supporting documents,
the auditor is obtaining evidence that the recorded item
exist and are supported documents.

Tracing forward from the source documents to the

accounting records is performed primarily to test for
understatement. This procedure will satisfy the
completeness assertion. In contrast, tracing backwards or
vouching is performed primarily in order to satisfy the
existence/occurrence assertion. It is performed to test for
possible overstatement of an account.

The PSA 500 classifies the financial statement assertions

according to the categories of the financial statements
affected:
Assertions about the classes of transactions and events for
the period under audit:

 Occurrence – transactions and events that have been

recorded have occurred and pertain to the entity.
 Completeness – all transactions and events that should
have been recorded .
 Accuracy – amounts and other data relating to
recorded transactions and events have been recorded
appropriately.
 Cutoff – transactions and events have been recorded in
the correct accounting period.
 Classification - transactions and events gave been
recorded in the proper accounts.
Assertions about account balances at the period end:
 Existence – assets, liabilities, and equity interest exist.
 Rights and obligations – the entity holds or controls the
rights to assets, and liabilities are the obligations of the
entity.
 Completeness – all assets, liabilities and equity interests
that should have been recorded are in fact recorded.
 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 appropriately recorded.

Assertions about presentation and disclosure:

 occurrence and rights & obligations – disclosed events,
transactions, and other matters have occurred and
pertain to the entity.
 Completeness – all disclosures should have been included
in the financial statements are in fact included.
 Classification and understandability – financial information
is appropriately presented and described, and disclosures
are clearly expressed.
 Accuracy and valuation – financial and other information
are disclosed fairly and at appropriate amounts.

The auditor may use the above categories of assertions or

may express the differently so long as all aspects described in
the assertions have been covered.

 Audit procedures
The objective of the audit is to determine the validity of the
financial statement assertion. To accomplish this, auditors
normally develop specific audit objectives for each of the
relevant assertions. These audit objectives serve as a guide
auditors in assessing risks of material statement and in
designing the appropriate audit procedures a to be
performed.
The selection of the appropriate procedures, to satisfy a
particular objective, is affected by a number of factors
including the auditor’s assessment of materiality and risk.
Regardless of the procedures selected, there is only one
basic criterion. The procedures selected should enable the
auditor to gather sufficient appropriate evidence about the
validity of an assertion.

Some of the common audit procedures used by the

auditor to gather sufficient appropriate evidence include:
1. Inspection – involves examining of records, documents,
or tangible assets.
2. Observation – consists of looking at a process or
procedure being performed by others.
3. Inquiry – consists of seeking information from
knowledgeable persons inside or outside the entity.
4. Confirmation – consists of the response to an inquiry to
corroborate information contained in the accounting
records.
 Computation – consists of checking the arithmetical
accuracy of source documents and accounting
records or performing independent calculations.
 Analytical Procedures – consists of the analysis of
significant ratios and trends including the resulting
investigation of fluctuations and relationships that are
inconsistent with other relevant information or deviate
fro predicted amounts.

 Audit Evidence
Audit procedures are the means used by the auditor to
obtain sufficient appropriate evidence. Audit evidence
refers to the information obtained by the auditor in arriving
at the conclusions on which the audit opinion is based.
Audit evidence will comprise source documents and
accounting records underlying the financial statements
and corroborating information from other sources. This
evidence will either prove or disprove the validity of the
assertions made by management on the financial
statements.
 Audit Opinion
The results of the procedures performed and the audit
evidence obtained are carefully evaluated to arrive at the
appropriate opinion about the fair presentation of the
financial statements.

 THE AUDIT PROCESS

The audit process is the sequence of different activities
involved in an audit. The emphasis and order of certain
activities may vary depending upon a particular audit, but
this process would basically include the following audit
activities.
 Accepting an Engagement
The first step in the audit process is to make a decision of
whether to accept or reject an audit engagement. This
process requires evaluation of the auditor’s qualification as
well a the auditability of the prospective client’s financial
statements. A preliminary understanding of the client’s
business and the background investigation of a prospective
client are usually performed at this stage of the audit.
the procedures performed at this stage of the audit are
referred to in PSA 300 as the “preliminary planning activities”
and would involve:

a. Performing procedures regarding the continuance of the

client relationship and the specific audit engagement;
b. Evaluating compliance with ethical requirements,
including independence; and
c. Establishing an understanding of the terms of the
engagement.

 Audit Planning
In planning an audit, the auditor obtains more detailed
knowledge of the client’s business and industry is important
because it helps the auditor in understanding the transactions
and events affecting the financial statements. In addition,
such knowledge also helps in the early identification of the
potential problems that might be encountered in the audit.
The auditor’s understanding of the client, combined with
the assessment of risk and materiality, should enable the
auditor to develop an overall plan and a detailed
approach for the expected conduct and scope of the
audit.

 Considering the Internal Control

The auditor is required to give adequate consideration to
the entity’s internal control because the condition of the
entity’s internal control directly affect the reliability of the
financial statements. The stronger the internal control is,
the more assurance it provides about the reliability of the
accounting data and the financial statements.

Consideration of internal controls involves obtaining

understanding of the entity’s internal control systems and
assessing the level of control risk – that is, the risk that the
client’s internal control may not prevent or detect material
misstatements in the financial statements.
If the auditor decides to assess control risk at less than high
level, sufficient appropriate audit evidence must be
obtained to prove that the internal control is functioning
effectively and that it can be relied on. This evidence can
be obtained by performing tests of controls.

 Performing Substantive Tests

Based on the results of audit planning and the
consideration of internal control, the auditor designs and
performs substantive tests to obtain reasonable assurance
that the financial statements are presented fairly in
accordance with the applicable financial reporting
frameworks. Substantive tests are audit procedures
designed to detect material misstatements in the financial
statements.
 Completing the Audit
The auditor must have sufficient appropriate evidence in
order to reach a conclusion on the fairness of the financial
statements. After the auditor has completed testing the
account balances the auditor performs additional audit
procedures to complete the audit and become satisfied that
the evidence gathered is consistent with the opinion to be
expressed in auditor’s report. Some of the common
procedures performed at this stage of the audit include
review of subsequent events and contingencies, assessing the
appropriateness of the use of the going concern assumption,
performing overall analytical review procedures, and
obtaining written representations from the client’s
management.

 Issuing a Report
On the basis of audit evidence gathered and evaluated, the
auditor forms a conclusion about the financial statements. This
conclusion (in the form of an opinion) is communicated to
various interested users through an audit report.
 Accepting an Engagement
An important element of the firm’s quality control policies and
procedures is a system for deciding whether to accept or
reject an audit engagement. In making this decision, the firm
should consider:
 Its competence;
 Its independence;
 The integrity of the prospective client’s management; and
 The adequacy of the accounting records

 Competence
One of the primary considerations before accepting an audit
engagement is to determine whether the auditor has the
necessary skills and competence to handle the engagement.
According to the Code of Ethics, professional accountants
should not portray themselves as having expertise which they
do not possess. Competence is acquired through a
combination od education, training and experience.
 Independence
Essential to the credibility of the auditor’s report is the
concept of independence. Before accepting an audit
engagement, the auditor should consider whether there
are any threats to the audit team’s independence and
objectivity and, if so, whether adequate safeguards can
be established.

 Ability to serve the client properly

Closely related to competence is the auditor’s ability to
serve the client properly. An engagement should not be
accepted if there are enough qualified personnel to
perform the audit. PSA 220 requires that audit work be
assigned to personnel who have the appropriate
capabilities, competence and time to perform the audit
engagement in accordance with the professional
standards.
 Integrity of management
The recent wave of litigation involving auditor’s has made
pre-acceptance investigation procedures very important.
PSA 220 requires the firm to conduct a background
investigation of the prospective client in order to minimize
the likelihood of association with the clients whose
management lacks integrity. This task would involve:

1. Making inquiries of appropriate parties in the business

community such as prospective client’s banker, legal
counsel, or underwriter to obtain information about the
reputation of the client.
2. Communicating with the predecessor auditor.
Communication with the predecessor auditor. This
communication allows the successor auditor to obtain
information about the client that will be useful in
determining whether the engagement will be
accepted.
But before the successor auditor contacts the predecessor
auditor, the successor audit should obtain the client’s
permission to communicate with the predecessor auditor.
This is necessary procedure because the Code of Ethics
for Professional Accountants prevents an auditor from
disclosing any information obtained about the client
without the client’s explicit permission. Refusal of the
prospective client’s management to permit this will raise
serious questions as to whether the engagement will be
accepted.

Once permission of the client is obtained, the successor

auditor should inquire into matters that may affect the
decision to accept the engagement. This includes
questions regarding:
 The predecessor auditor’s understanding as to the reasons
for the change of auditors;
 Any disagreement between the predecessor auditor and
the client; or
 Any facts that might have a bearing on the integrity of the
prospective client’s management.

The predecessor auditor should respond fully to the successor

auditor’s inquiry and advise the successor auditor if there are
any professional reasons why the engagement should not be
accepted.

 Adequacy of the Accounting Records

The audit of the financial statements is performed on the
assumption that the financial statements are verifiable.
Therefore, the client’s accounting records and documents
supporting the amounts and disclosures in the financial
statements must be adequate enough to permit examination
of the accounts. Inadequacy of the accounting record is
sufficient reason for the auditor to decline an audit
engagement.
 Retention of Existing Clients
The auditor’s evaluation of clients is not a one-time
consideration. Clients should be evaluated at least once a
year or upon occurrence of major events , such as
changes in management, directors, ownership, nature of
client’s business, or other changes that may affect the
scope of the examination. In general, conditions which
would have caused the auditor to reject a prospective
client may also or lead to a decision of terminating an
audit management.

 Engagement letter
According to PSA 210, the auditor and the clients should
agree on the terms of the engagement and the agreed
terms will have to be recorded in an engagement letter.
The engagement letter serves as the written contract
between the auditor and the client. This letter sets forth:
in addition, the auditor may also include the following
items in the engagement letter:
 Billing arrangements;
 Expectations of receiving management representation
letter;
 Arrangements concerning the involvement of others
experts, other auditors, internal auditors and other client
personnel); and
 Request for the client to confirm the terms of the
engagement.

A sample format of an audit engagement letter is

presented at the end of this Chapter.

 Importance of the engagement letter

It is in the interest of both the auditor and the client that
the auditor sends engagement letter in order to:
1. Avoid misunderstandings with respect to the
engagement; and
2. Document and confirm the auditor’s acceptance of
the appointment.
 Recurring audits
Engagements, an auditor does not normally send new
engagement letter every year. However, the following
factors that may cause the auditor to send a new
engagement letter:

 Any indications that the client misunderstands the

objective and scope of the audit;
 Any revised or special terms of the engagement;
 A recent change of senior management, board of
directors or ownership;
 A significant change in the nature or size of the client’s
business; or
 Legal requirements and other government agencies’
pronouncements.
 Audits of Components
When the auditor of a parent entity is also auditor of its
subsidiary, branch or division (component), the auditor
should consider the following factors in making a decision
of whether to send a separate letter to the component:
 Who appoints the auditor of the component;
 Whether a separate audit report is to be issued on the
component;
 The extent of any work performed by other auditor;
 Degree of ownership by parent; or
 Degree of independence of the component’s
management.