OBE-Based

Auditing Theory
Review
A Course Module for Students

Burauen Community College

For Internal Use Only

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Auditing Theory
Review
A Course Module for Students

Burauen Community College

Written and Designed by

Burauen Community College
Burauen, Leyte
[email protected]

Prepared by:
Angeli B. Baclea-an, CPA
[email protected]

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 BCC VISION
Burauen Community College shall emerge as the
premier local public educational institution in
Eastern Visayas which is responsive to the needs of
the community, and develops students to meet the
economic, social, and environmental challenges as
active participants in shaping the world of the
future.

BCC MISSION
Burauen Community College offers holistic, and
outcomes-based experiential learning to develop
the youth to be responsible individuals with
integrity and service as agents of equality. It will
serve as a venue for the development of individuals
in the areas of academics, research, community
extension, and innovative technology.

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Auditing Theory Review
A Course Module for Students

Burauen Community College

© 2021

ALL RIGHTS RESERVED. No part of this publication All rights are reserved. No part of
this publication may be reproduced, stored in a retrieval system or transmitted in any
form or by any means, electronic, mechanical, photocopying, recording or otherwise,
without prior permission of the institution.

This module contains information obtained from highly regarded resources. A wide
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For students who want to purchase additional copies of this module, you may
send your request to [email protected] or you may visit the institution
for an in-person request.

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 TABLE OF CONTENTS
Preface vi

Course Outline vii

Prelims
FUNDAMENTALS OF ASSURANCE AND
Module 1 9-21
AUDITING SERVICES
Nature and objective of assurance engagements 10
Elements of assurance engagements 11-13
Types of assurance engagements 13-14
Nature and objective of auditing 15
Factors that affects the need for auditing 15
Theoretical framework of auditing 16
Types of Audit 16
Assessment 17-21
THE RISK-BASED AUDIT 22-31
Module 2 23
Management Assertions 24
Overview of the audit process 25
Preliminary Activities 26
Agreeing on the terms of the engagement 27-31
Assessment
32-41
Module 3 PLANNING THE AUDIT
\

Understanding of the entity and its environment

Assess risk of material misstatement
Planning materiality 33
Preliminary analytical procedures 33-34
Overall audit strategy, audit plan and audit 35
program 36
37

Assessment 38-41

References 42

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 Preface

This learning module is intended as a reference material for the course

Auditing Theory Review. It is important to note that this material
contains only summary discussions since the topics in this module has
been extensively discussed under the Auditing and Assurance Concepts
course.

In the past consecutive CPALE exams, the questions on auditing covers

mostly those which relates to topics on auditing theories. Thus, students
must be equipped with enough knowledge and understanding on the
course. The main focus of this material are the assessments prepared
at the end of each chapter. These assessments are expected to help the
students recall various auditing concepts and help them develop their
ability to think critically. Also, to facilitate effective and longer retention
of various concepts, the author introduced codes and acronyms in some
discussions.

The first chapter discusses the fundamental concepts on assurance and

auditing services and the philosophy underlying audits.

The remaining chapters will focus on the discussion of the steps in the
audit process, starting with client acceptance, up to the preparation of
the audit report.

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 COURSE OUTLINE
Auditing Theory Review

PRELIMS
I. Fundamentals of Auditing and Assurance Services
A. Introduction to assurance engagements
B. Introduction to auditing
II. Introduction to the audit process
A. Overview of the audit process
B. Assertions
III. Pre-engagement considerations
A. Pre-engagement considerations
B. Engagement letter and its contents
IV. Audit Planning
A. Understanding the Entity & its Environment
B. Performing analytical procedures8
C. Fraud risk factors
D. Concept of materiality
E. Assessment of Audit Risk
F. Audit plan, audit strategy and audit program

MIDTERMS

V. Fraud, Error and Noncompliance

VI. Consideration of internal control
VII. Auditing in a Computerized Environment
VIII. Performing Substantive Tests
IX. Audit Sampling

FINALS

X. Completing the Audit

XI. Audit Reports and Financial Statements
XII. Transaction Cycle
XIII. Assurance and Related Services
XIV. Professional Standards
XV. The Code of Ethics

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PART I: PRELIMS
Fundamentals of Assurance
and Auditing Services

8 Baclea-an ‖ Auditing Theory Review

 1
Assurance and Auditing
Services

CONTENTS
1.1 Introduction to
Assurance Services
1.2 Introduction to
Auditing

OUTCOME/S
LO1. Discuss and explain
the basic concepts and
principles of audit and
assurance.
LO2. Explain how The demand for a dependable financial
financial statement information has essentially evolved throughout
audit affects the the years. Many decision makers rely a lot upon
decision making information provided by others. This need of
process of various various users for more reliable information has
users. increased the demands for the work of
accountants.

Accountants perform a wide variety of services

OBJECTIVES
such as, but is not limited to, audit, review,
1.1 Define assurance
compilation, agreed-upon procedures,
services and discuss its
key elements consultancy and all other accounting-related
1.2 Distinguish services. However, not all of these
engagements falls under the category of
assurance, attestation
assurance services. Assurance engagements
and auditing services
encompasses all those services that improves
1.3 Define auditing and
the quality of information with the purpose of
discuss its importance. adding credibility to help intended users in
1.4 Identify and contrast their decision making. Financial statement
the different types of audit is actually one of those engagements
audit. that falls under assurance engagement since
its primary function is to lend credibility to the
financial statements prepared by the entity.
RELEVANT STANDARDS The auditor’s opinion enhances the value and
& PRONOUNCEMENTS: usefulness of the financial statements. By
Philippine Standards on attaching a report to the financial statements,
Assurance Engagements the auditor provides increased assurance to
(PSAE) users that the financial statements are
reliable.

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 Introduction to Assurance Engagements Module 1

INTRODUCTION TO ASSURANCE ENGAGEMENTS

Assurance Engagements are engagements in which the practitioner
expresses a conclusion designed to enhance the degree of
confidence of the intended users other than the responsible party
about the outcome of the evaluation or measurement of a subject
matter against criteria.

ELEMENTS OF AN ASSURANCE ENGAGEMENT

To determine whether an engagement is an assurance engagement, the

framework enumerated certain elements that an engagement should possess
to qualify as an assurance engagement. These elements are :

1. Three-party relationship (Code: RIP)

Responsible Party Intended Users Practitioner

An individual or These refers to the Also termed as

representative of the entity person/s to whom “professional accountant”,
who is responsible for the the practitioner practitioner refers to the
subject matter or the prepares the professional performing
subject matter information. assurance report. the assurance engagement

2. Subject Matter
The subject matter, and subject matter information, of an assurance
engagement can take in many forms, such as, but not limited to the following:

Subject Matter/
Subject Matter Descriptions Examples
Information
Financial Subject matter information historical or
performance or may be the recognition, prospective financial
conditions measurement, position, financial
presentation and disclosure performance and
represented in financial cash flows
statements.

Non-financial Subject matter information performance of an

performance or may be key indicators of entity
conditions efficiency and effectiveness

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 Introduction to Assurance Engagements Module 1

Physical Subject matter information capacity of a facility

characteristics may be a specifications
document
Systems and Subject matter information entity’s internal
processes may be an assertion about control or IT system
effectiveness

Behavior Subject matter information Corporate

maybe a statement of governance,
compliance or a statement compliance with
of effectiveness. regulation, human
resource practices

3. Suitable Criteria

Criteria are the benchmarks used to evaluate or measure the subject matter
including, where relevant, benchmarks for presentation and disclosure. Sited
below are some of the suitable criteria commonly used in assurance
engagements:

 Philippine Financial Reporting Standards (PFRS) – suitable criteria when

performing financial statement audit
 Internal Control Framework - suitable criteria when reporting on internal
control
 Applicable Laws, Regulation or Contract – suitable criteria when
reporting on compliance

It must be given emphasis that the criteria to be used as a benchmark in the

conduct of the engagement must be suitable. Thus, the framework specified
the following characteristics of a suitable criteria:

(a) Relevance: relevant criteria contribute to conclusions that assist decision

making by the intended users.

(b) Completeness: criteria are sufficiently complete when relevant factors

that could affect the conclusions in the context of the

engagement circumstances are not omitted. Complete criteria include, where

relevant,

benchmarks for presentation and disclosure.

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(c) Reliability: reliable criteria allow reasonably consistent evaluation or

measurement of the subject matter including, where relevant, presentation
and disclosure, when used in similar circumstances by similarly qualified
practitioners.

(d) Neutrality: neutral criteria contribute to conclusions that are free from
bias.

(e) Understandability: understandable criteria contribute to conclusions that

are clear, comprehensive, and not subject to significantly different
interpretations. The evaluation or measurement of a subject matter on the
basis of the practitioner’s own expectations, judgments and individual
experience would not constitute suitable criteria.

4. Sufficient and Appropriate Evidence

Practitioners who plan and perform an assurance engagement are required to
obtain sufficient appropriate evidence on whether the subject matter
information is free from material misstatement. It is important to note that the
evidences to be gathered must be both sufficient and appropriate.

 Sufficiency is the measure of the quantity of evidence.

 Appropriateness is the measure of the quality of evidence. For an
evidence to be appropriate, it must be both relevant and reliable.

For reliability of evidence, the framework indicated the following

generalizations:

A. Evidences from independent sources. Evidence is more reliable

when it is obtained from independent sources outside the entity.
B. Internally-generated evidences. Evidence that is generated
internally is more reliable when the related controls are effective.
C. Direct versus indirect evidences. Evidence obtained directly by the
practitioner (for example, observation of the application of a control) is more
reliable than evidence obtained indirectly or by inference (for example, inquiry
about the application of a control).
D. Written versus oral representations. Evidence is more reliable when
it exists in documentary form, whether paper, electronic, or other media (for
example, a contemporaneously written record of a meeting is more reliable
than a subsequent oral representation of what was discussed).
E. Original documents versus photocopies. Evidence provided by
original documents is more reliable than evidence provided by photocopies or
facsimiles.

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 Module 1 Introduction to Assurance Engagements

5. Written Report
The practitioner expresses a conclusion that provides a level of assurance as
to whether the subject matter conforms in all material respects with
identified suitable criteria. The conclusion is documented through a written
report.

TYPES OF ASSURANCE ENGAGEMENTS

Under the Philippine Framework for Assurance Engagement, an auditor is permitted

to perform assurance engagements under the following classifications:

As to the Level of Assurance

A. Reasonable Assurance Engagement – the objective of this type of

engagement is a reduction in assurance engagement risk to an
acceptably low level in the circumstances of the engagement as the
basis for a positive form of expression of the practitioner’s conclusion.
(e.g. audit)

B. Limited Assurance Engagement – the objective of this engagement

is a reduction in assurance engagement risk to a level that is acceptable
in the circumstances of the engagement, but where the risk is greater
than for a reasonable assurance engagement, as a basis for a negative
form of expression of the practitioner’s conclusion. (e.g. review)

As to the Structure

A. Assertion-based Engagement– In this type of engagement, the

evaluation or measurement of the subject matter is performed by the
responsible party. The subject matter information is in the form of an
assertion by the responsible party that is made available to the
intended users.

B. Direct Reporting Engagement – In this type of engagement, the

practitioner either directly performs the evaluation or measurement of
the subject matter, or obtains a representation from the responsible
party that has performed the evaluation or measurement that is not
available to the intended users.

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 Introduction to Audit Engagements Module 1

ASSURANCE, ATTESTATION & AUDIT

Assurance Engagements

Attestation Engagements
Exhibit 1.2
The relationship among
Audit Engagements assurance, attestation, and
audit engagements

Audit is a form of an attestation service which

refers to expressing an opinion on a specific subject matter (e.g. financial
statements) and attestation refers more generally to expressing an opinion
on any type of information or subject matter that is the responsibility of
another party, assurance services include an even broader set of information,
including nonfinancial information.

INTRODUCTION TO AUDITING

Auditing is a systematic process of objectively obtaining and evaluating

evidence regarding assertions about economic actions and events to ascertain
the degree of correspondence between assertions and establish criteria and
communicating the results to intended users.

Factors That Affects the Need for an Independent Financial Statement

Audit (Code: FIRE)

 Financial Consequence
 Information Risk
 Remoteness
 Expertise

Theoretical Framework of Auditing

1. Verifiability of financial data
2. Auditors maintain independence
3. Presence of effective internal control system
4. No long term conflict between the auditor and the client management
5. Consistency in application of GAAP or PFRS
6. Evidences are persuasive rather than conclusive
7. An audit benefits the public

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Types of Audit

Audit engagements are categorized into two - as to assertion or data

and as to the type of auditor performing the engagement.

1. As to assertion or data:
A. Financial Statements Audit
B. Operational Audit
C. Compliance Audit

2. As to types of auditor
A. External Audit
B. Internal Audit
C. Government Audit
Comparisons among the types of audit

Operational Compliance
Differences Financial Audit
Audit Audit

Organization has Organizations

Financial
complied with operate
Assertions statements are
laws, rules and efficiently and
fairly presented
regulations effectively
Philippine Financial
Laws, rules,
Suitable Reporting Objectives set by
regulations and
Criteria Standards (PFRS) the board
contracts
An opinion about
whether the
Reports on the
financial
Recommendations degree of
statements are
Content of or suggestions on compliance with
fairly presented in
written report how to improve applicable laws,
conformity with an
operations regulations and
identified financial
contracts
reporting
framework
Auditors who
generally Government
External Auditors Internal Auditors
perform the Auditors
audit

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ASSESSMENT

Name: __________________________________ Score: ___________

Degree Program/Year/Section: ____________ Date: ____________

1. Which of the following statements B. Subject matter

best describes assurance C. Suitable criteria
services? D. An opinion about whether the
A. Independent professional services subject matter conform, in all
that are intended to enhance the material respects, with identified
credibility of information to meet criteria.
the needs of an intended user.
B. Services designed to express an 4. Broadly defined, the subject
opinion on the fairness of historical matter of any audit is consist of:
financial statements based on the A. Financial statement
results of an audit. B. Assertions
C. The preparation of financial C. Economic data
statements or the collection, D. Operating data
classification, and summarization
of other financial information. 5. The subject matter of an
D. Services designed for the assurance engagement may take
improvement of operations, in many forms including:
resulting in better outcomes.
Data Systems Behavior
A. YES YES YES
2. Which of the following is an
B. YES NO YES
example of assurance C. YES YES NO
engagement? D. NO YES YES
A. Management advisory services
B. Reporting on financial 6. Whenever a professional
statements prepared using other accountant is engaged in an
comprehensive basis of audit engagement, he is required
accounting to comply with the Philippines
C. Compilation of financial Standards on Auditing in order
information to:
D. Preparation of tax returns A. Completely eliminate audit risk
B. To reduce the auditor’s
3. Which of the following is not one responsibility
of the elements of an assurance C. To have a measure of quality of
engagements? audit performance
A. Sufficient appropriate evidence

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 Module 1 Introduction to Assurance and Auditing

D. To eliminate the use of relevant, benchmarks for

professional judgment in the presentation and disclosure.
conduct of the audit
engagement. A. False, true, false
B. True, false, false
7. What is the main reason why C. False, false, false
there is a need for financial D. False, false, true
statements to be audited by an
independent auditor? 10. I. Sufficiency is a measure of
A. In compliance with BIR’s quality of evidence.
requirement for an audited II. Appropriateness is a measure
annual financial statement as an of quantity and quality of
attachment to its income tax evidence.
return.
III. Evidences to be gathered
B. To help professional accountants
during the conduct of the
earn more profit from
assurance engagement need not
professional services.
be sufficient and appropriate
C. To lend credibility on the financial
statements and aid users in their
decision making process. A. False, true, false
D. To support all the assertions B. True, false, false
made by the management. C. False, false, false
D. False, false, true
8. All of the following are suitable
criteria of an assurance 11. In relation to the reliability of
engagement, except for: information, which among the
A. Philippine Financial Reporting following is false?
Standards (PFRS) A. An information obtained from
B. Internal control framework external sources are more
C. Personal assumptions of the reliable than those internally
auditor generated.
D. Laws and regulations B. Oral representations are less
reliable than written ones.
C. An internally generated evidence
is more reliable when it is
9. I. A suitable criterion is one that
obtained from an ineffective
is relevant, notwithstanding its
internal control system.
reliability
II. A criterion is relevant if it can D. All statements are true.
contribute to a conclusion that is
12. You are to perform an assurance
free from bias
engagement with BTS and
III. Criteria are the benchmarks used
Company. The evaluation or
to evaluate or measure the
measurement of the subject
subject matter including, where
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 Module 1 Introduction to Assurance and Auditing

matter is performed by BTS and “Based on our work described in

Co. and the subject matter this report, nothing has come to
information is in the form of our attention that causes us to
assertions that is made available believe that the financial
to intended users. What type of statements are not fairly stated,
assurance engagement are you in all material respects, in
engaged in? accordance with Philippine
A. Direct reporting engagement
Financial Reporting Standards.”
B. Assertion-based engagement
C. Non-assurance engagement What type of assurance engagement
D. Recurring engagement was performed?
A. Limited assurance engagement
13. In this type of engagement, the B. Reasonable assurance
practitioner either directly engagement
performs the evaluation or C. Negative assurance engagement
measurement of the subject D. Positive assurance engagement
matter, or obtains a
representation from the 16.Which of the following statement
responsible party that has is true?
performed the evaluation or A. Attestation is not an assurance
measurement that is not engagement.
available to the intended users. B. An audit engagement is an
A. Direct reporting engagement example of an attestation
B. Assertion-based engagement service.
C. Non-assurance engagement C. Attestation is broader in scope
D. Recurring engagement than assurance
engagements.
14. Na Hee Do, a practitioner D. All statements are true.
expressed a positive form of
conclusion on her assurance 17. This refers to the probability that
engagement with 2521 the information circulated by a
Corporation. What type of company will be false or
assurance engagement was misleading
performed by Na Hee Do? A. Business risk
A. Limited assurance engagement B. Risk of material misstatement
B. Reasonable assurance C. Financial Risk
engagement D. Information Risk
C. Negative assurance engagement
D. Positive assurance engagement 18. The following are factors that
affects the need for an
15. Back Yi Jin, a practitioner, issued independent financial statement
a report that contains the audit, except:
following conclusion: A. Financial Consequences
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 Module 1 Introduction to Assurance and Auditing

B. Information Risk of an entity’s operating activities

C. Remoteness in relation to specified objectives
D. Expenses for the audit is a(n):
A. External Audit
19. All of the following are theoretical B. Compliance Audit
framework underlying an audit, C. Operational Audit
which one is not? D. Financial Statement Audit
A. Verifiability of financial data
B. Presence of effective internal 23. The term “efficiency” in
control system operational audit is best
C. No short-term conflict described as
between the auditor and the A. Using resources to maximize
client management exists output for a given input, or to
minimize input for any given
D. An audit benefits the public
quantity and quality of output.
B. The achievement of intended
20. In a financial statement audit,
results of operations, programs
the engagement should be
or activities
conducted in accordance with
C. The achievement of objectives
the:
within a specified time frame.
A. Audit program
D. The acquisition of resources at
B. Philippine Standards on
appropriate times and within a
Auditing (PAS)
specified time frame.
C. Philippine Financial Reporting
Standards (PFRS)
24. In performing an operational
D. Generally Accepted
audit, the auditor primarily relies
Accounting Principles (GAAP)
on which of the following
procedures?
21. There are three major types of
A. Physical inspection
audit, namely:
B. Analytical procedures
A. External Audit, Internal Audit,
C. Inquiry and observation
Compliance Audit
D. Tracing and vouching
B. Tax Audit, Internal Audit,
Operational Audit
25. This type audit is typically
C. Financial Audit, Operational
designed to determine whether
Audit, Compliance Audit
the auditee has complied with
D. Internal Audit, Compliance
applicable laws and regulations
Audit, Government Audit
A. Operational Audit
B. Compliance Audit
22. An audit that involves obtaining
C. Financial Statement Audit
and evaluating evidence about
D. Internal Audit
the efficiency and effectiveness

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PART 2: PRELIMS
Overview of the Audit
Process and Preliminary
Activities

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 2 The Risk-based Audit

CONTENTS
2.1 Overview of the Audit
Process
2.2 Preliminary Activities

OUTCOME/S
LO1. Be able to create a
concept map showing
the flow of each step in
the audit process
LO2. Come up with a
The audit of financial statements
sample engagement generally begins with the financial
letter with all necessary statements prepared by the entity’s
contents. management. Without these financial
statements, there would be no audit to
OBJECTIVES perform. A general approach to auditing
2.1 Identify various financial statements would require
management assertions consideration of financial statements
2.2 Discuss the activities assertions, audit procedures, and audit
considered during the evidence.
preliminary stage of the
audit process. In the conduct of the audit, the auditor
2.3 Define engagement follows a series of steps, known as the
letter and enumerate its audit process. This process is initiated by
contents. performing preliminary activities. The
preliminary activities, also known as pre-
RELEVANT engagement activities, include procedures
PRONOUNCEMENT: regarding acceptance or continuance of
PSA 210: Agreeing on the client relationship, evaluating compliance
Terms of the Engagement with ethical requirements, including
independence, and establishing
PSA 210: Agreeing on the understanding of the terms of the
Terms of engagement.

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MANAGEMENT’S FINACIAL STATEMENT ASSERTIONS

Management is responsible for the fair presentation of financial

statements that reflect the nature and operations of the entity. In
representing that the financial reporting framework, management
implicitly or explicitly makes assertions regarding the recognition,
measurement, presentation and disclosure of the various elements of
financial statements and related disclosures.

Assertions are categorized in the following:

Assertion as to classes of transactions and events:

 Occurrence
 Completeness
 Accuracy
 Cut Off
 Classification
Assertions as to account balances:
 Existence
 Rights and Obligations
 Completeness
 Valuation and allocation

Assertions as to presentation and disclosure:

 Occurrence and rights and obligations
 Completeness
 Classification and understandability
 Accuracy and valuation

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OVERVIEW OF THE AUDIT PROCESS

1 This step involves deciding whether to accept or reject an

Preliminary
audit engagement. Auditors would usually consider the client’s
Activities integrity, the auditor’s competence and evaluate compliance
with ethical requirements, including independence.

2 This step involves obtaining a more detailed knowledge about

the client’s business and industry in order to understand the
Planning
transactions and events affecting the financial statements.
the Audit
Also, level of audit risk and materiality is assessed during
planning stage to be able to develop an overall audit strategy.
3
This step involves obtaining an understanding of the entity’s
Internal
Control
internal control system and assessing the level of control risk
Consideration – the risk that the client’s internal control may not prevent or
detect material misstatements in the financial statement.

4 During this phase, the auditor performs substantive tests to

test the assertions made by the management. This would
Evidence-
Gathering involve examination of documents and evidences supporting
the amounts and disclosures in the financial statement.

5 The auditor performs additional audit procedures to complete

Completing the audit. These procedures would include the review of
the Audit subsequent events and contingencies, assessing going
concern assumption, performing overall analytical review,
and obtaining written representation from management.
6
The auditor forms a conclusion about the financial statement
Issuance of
a Report based on the audit evidence gathered and evaluated. This
conclusion, in the form of an opinion, is communicated to
various interested users through an audit report.

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PRELIMINARY ENGAGEMENT ACTIVITIES

Accepting or Rejecting an Audit Engagement

A CPA firm needs to establish policies and procedures for deciding whether to
accept or continue a client in order to minimize the likelihood of association
with a client whose management lacks integrity. The reputation of a client’s
management could reflect on the reliability on representations.

In deciding whether to accept or reject an engagement, the auditor should

consider the following: (Code: ICE)

1. Integrity of Prospective Client

In assessing whether the prospective client has an integrity, the auditor usually
obtains information about its reputation through inquiry to parties within the
business community, such as the client’s banker, legal counsel or underwriter,
and from the predecessor auditor.

Communication with the predecessor auditor:

Communication with the predecessor auditor:

2. Competence & Capability of the Auditor

Before accepting the engagement, the auditor must ensure that he has enough
resources and must have sufficient knowledge about the industry to which the
prospective audit client belong.

3. Ethical Requirements & Independence (Code: COPPI+I)

The auditor must comply with the following ethical requirements, including
requirement on independence:

A. Confidentiality
B. Objectivity
C. Professional Behavior

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 The Risk-based Audit Module 2

D. Professional Competence and Due Care

E. Integrity
F. Independence

Agreeing on the Terms of the Engagement

After deciding to accept or continue the engagement, an agreement should be

reached with the client about the professional services to be rendered. The
auditor and the client must agree on the terms of the engagement, including
the type, scope, and timing of the engagement to reduce the risk that either
party may misinterpret what is expected from the other party. This
understanding between the client and auditor it documented in the audit
engagement letter.

Contents of the Audit Engagement Letter (Code: TIRA MISU)

1. Timetable and fees
2. Inherent limitation of the audit
3. Reports
4. Auditor’s responsibilities
5. Management and Those Charged with Governance’s Responsibilities
6. Involvement of internal auditors, experts and other auditors
7. Scope & objective of audit
8. Unrestricted access to document, records and asset

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ASSESSMENT

Name: __________________________________ Score: ___________

Degree Program/Year/Section: ____________ Date: ____________

1. The primary reason for an audit C. Users expect auditors to correct

by an independent, external management errors
audit firm is to D. Management relies on the
A. Satisfy governmental regulatory auditor to improve internal
requirements control.
B. Guarantee that there are no
misstatements in the financial 4. Which of the following is one of
statements and ensure that any the procedures in the audit
fraud will be discovered. acceptance phase?
C. Relieve management of A. Prepare the audit program
responsibility for the financial B. Perform audit procedures to
statements. understand the entity and its
D. Provide increased assurance to environment.
users as to the fairness of the C. Investigate legal information.
financial statements. D. Determine the need for other
professionals.
2. Independent CPAs perform
audits on the financial 5. Which of the following is least
statements of public companies. likely to influence the auditor’s
This type of auditing can be best decision to send a separate
described as engagement letter to a
A. An activity whose purpose is to component of parent entity
search for fraud. client?
B. A discipline that attests to A. Legal requirements.
financial information presented B. Degree of ownership over a
by management. component entity by parent
C. A professional activity that company.
measures and communicates C. Location of the principal place of
financial and business data. business of the component
D. A regulatory function that entity.
prevents the issuance of D. Who appoints the auditor of the
improper financial information. component?
3. Users of a public company’s
financial statements demand 6. Which of the following is least
independent audits because likely included in an audit
A. Users demand assurance that engagement letter?
fraud does not exist A. Management responsibility for
B. Management may not be the financial statements.
objective in reporting

26 Baclea-an ‖ Auditing Theory Review

 The Risk-based Audit Module 2

B. The form of any reports or other What is not a characteristic of

communication of the results of this general definition?
the engagement. A. Auditors are responsible for
C. Arrangement concerning the financial management and the
involvement of auditors or investment of corporate assets.
experts in some aspects of the B. Auditing is a systematic process.
audit C. Auditors are responsible for
D. The objective of financial objectively obtaining and
reporting evaluating evidence regarding
assertions about economic
7. Based on PSA 210, which of the actions and events.
following refers to the use by the D. Auditors are responsible for
management of an acceptable communicating the results of
financial reporting framework in audits to interested users.
the preparation of the financial
statements and the agreement of 11.Which of the following factors
management and, where, most likely is a reason why an
appropriate, those charged with auditor would not accept a
governance to the premise on prospective audit engagement?
which an audit is conducted? A. The auditor lacks adequate
A. Preconditions for an audit understanding of the entity’s
B. Reportable conditions internal control.
C. General financial reporting B. The client is close to the end of
framework its fiscal year.
D. Special purpose framework C. The auditor concludes that the
prospective management of the
8. The development of a general client lacks integrity.
strategy and a detailed approach D. The auditor’s inability to perform
for the expected nature, timing, analytical procedures before
and extent of audit refers to: assessing control risk
A. Supervision C.
Audit Procedures 12.An engagement letter is used
B. Directing D. primarily to
Planning A. Ensure a clear contractual
understanding of the services to
9. Which of the following is not an be provided by the CPA.
assertion relating to classes of B. Express an opinion on the
transactions? financial statements.
A. Accuracy C. C. Provide management
Consistency representations to be included in
B. Cutoff D. the audit evidence.
Occurrence D. Disclaim liability.

10.The American Accounting 13.An audit engagement letter least

Association has formulated a likely includes
general definition of auditing. A. A reference to the inherent
limitation of an audit that some

27 Baclea-an ‖ Auditing Theory Review

 The Risk-based Audit Module 2

material misstatements may C. Disclose adequately to proposed

remain undiscovered. auditor all noncompliance made
B. Identification of specific audit by the client.
procedures that the auditor D. Seek legal advice before
needs to undertake. responding to the proposed
C. Description of any letters or auditor.
reports that the auditors expect
to submit to the client. 16.Which of the following would a
D. Arrangements concerning the successor auditor normally
involvement of internal auditors perform after acceptance of an
and other client’s staff. audit client?
A. Inquiry of predecessor auditor
14.Warning signs that cause the regarding the client.
auditor to question management B. Review the SEC filings of the
integrity must be taken seriously client.
and pursued vigorously. Which of C. Inquiry of bankers regarding the
the following may lead the client.
auditor to suspect management D. Review of predecessor auditor
dishonesty? working papers.
A. The president and chief
executive officer of the client 17.Which of the following is
corporation has held numerous appropriately included in an audit
meetings with the controller for engagement letter?
the purpose of discussing I. Because of the test nature and
accounting practices that will other inherent limitations of an
maximize reported profits. audit, together with the inherent
B. The client has been named as a limitations of any accounting and
defendant in a product liability internal control system, there is
suit. an unavoidable risk that even
C. The client has experienced a some material misstatements
decrease in revenue from may remain undiscovered.
increased import competition. II. The audit will be made with the
D. A new federal regulation making objective of expressing an
customer licenses more difficult opinion on the financial
to obtain may adversely affect statements.
the client’s operations. III.An audit also includes assessing
the accounting procedures used
15.If permission from client to and significant estimates made
discuss its affairs with the by the management.
proposed auditor is denied by the
client, the predecessor auditor A. I and II C. II and III
should: B. I and III D. I, II and III
A. Keep silent of the denial.
B. Disclose the fact that the 18.When an independent auditor is
permission to disclose is denied approached to perform an audit
by the client for the first time, he or she
should make inquiries of the

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 The Risk-based Audit Module 2

predecessor auditor. Inquiries A B C D

are necessary because the A. Its YES YES YES YES
predecessor may be able to competence
provide the successor with B. Its YES NO YES NO
information that will assist the independence
successor in determining C. Its ability to YES YES YES NO
whether serve the
A. The predecessor’s work should client properly
D. The integrity YES YES NO YES
be used.
of client’s
B. The company rotates auditors.
management
C. In the predecessor’s opinion,
control risk is low.
D. The engagement should be
22.The scope and nature of an
accepted.
auditor’s contractual obligation
to a client is ordinarily set forth
19.The successor auditor is not
in the:
required to ask the predecessor A. Management representation
auditor about: letter
A. Facts that might bear on the
B. Scope paragraph of the auditor’s
integrity of management.
report
B. Disagreements the predecessor
C. Engagement letter
may have had with management
D. Introductory paragraph of the
about accounting principles and
auditor’s report
audit procedures.
C. The fees charged for the previous
23.An auditor’s engagement letter
audit.
most likely will include
D. The predecessor’s understanding
A. Management’s
about the reasons for the change
acknowledgement of its
of auditors.
responsibility for maintaining
effective internal control.
20.The pre-engagement activities of B. The auditor’s preliminary
a public accounting audit
assessment of the risk factors
engagement do not include:
relating to misstatements arising
A. Investigating new and existing
from fraudulent financial
clients.
reporting
B. Obtaining knowledge of the C. A reminder that management is
client’s business. responsible for illegal acts
C. Obtaining an engagement letter.
committed by employees.
D. Assigning partner, manager, and
D. A request for permission to
staff to engagement.
contact the client’s lawyer for
assistance in identifying
21.In making decision to accept or
litigation, claims, and
continue with a client, the auditor assessments.
should consider:
24.Before accepting an engagement
to audit a new client, an auditor
is required to
29 Baclea-an ‖ Auditing Theory Review
 The Risk-based Audit Module 2

A. Make inquiries of the predecessor

auditor after obtaining the 25.In assessing whether to accept a
consent of the prospective client. client for an audit engagement, a
B. Obtain the prospective client’s CPA should consider the
signature to the engagement
letter. Client’s CPA's
C. Prepare a memorandum setting Busine Busine
forth the staffing requirements ss Risk ss Risk
and documenting the preliminary A Yes Yes
audit plan. B Yes No
D. Discuss the management C No Yes
representation letter with the D No No
prospective client’s audit
committee.

30 Baclea-an ‖ Auditing Theory Review

PART 3: PRELIMS
Planning the Audit

31 Baclea-an ‖ Auditing Theory Review

 3
Planning the Audit
Engagement

Content: Relevant Pronouncements:

2.1 Audit Planning PSA 300: Planning an Audit of Financial
Activities Statement
PSA 315: Identifying and Assessing the
OUTCOME/S
Risks of Material Misstatement Through
LO1. Be able to
Understanding the Entity and Its
familiarize the activities
Environment
involved in the audit
PSA 320 (Revised and Redrafted):
planning stage.
Materiality in Planning and Performing an
Audit.
OBJECTIVES
3.1 Discuss the
importance of planning
the audit.
3.2 Determine Bthe
efore performing the audit
activities involvedfieldwork,
during the auditor must plan out the
the audit planningconduct
stage.of the audit so that it will be
3.3 Define auditperformed
risk, in an effective and efficient
identify its components,
manner. The extent of planning will vary
according to the size of the entity, the
and the relationship
complexity of the audit and the auditor’s
among these
experience with the entity, and the
components. knowledge of the business.
3.4 Define materiality
Adequate planning of the audit work is
and discuss its
important because planning helps ensure
relationship withthatauditappropriate attention is devoted to
risk. important areas of the audit, help identify
3.5 Distinguishpotential
auditproblems, allows work to be
strategy, audit plan, and expeditiously. Also, on the part
performed

audit program. of the audit team, it will assist in the proper

assignment and coordination of work
Relevant among members of the tea

Pronouncements:
PSA 300: Planning an Audit
of Financial Statement

32 Baclea-an ‖ Auditing Theory Review

 Planning the Audit Module 3

The planning phase involves the following general procedures:

 Obtain an understanding of the entity and its environment, including

internal controls, and assess inherent risk.
 Assess risk of material misstatement
 Establish planning materiality
 Perform preliminary analytical procedures
 Establish overall audit strategy, prepare detailed audit plan and draft
preliminary audit program

Understanding of the Entity and Its environment

This enables the auditor to identify and understand the events, transactions,
and practices that, in the auditor’s judgment, may have significant effect on
the financial statements. Obtaining knowledge of the entity and its
environment includes understanding of the following: (Code: INOMIn)

1. Industry, regulatory and other external factors

2. Nature of the company
3. Objectives and strategies
4. Measurement and review of performance
5. Internal Control

Assess the risk of material misstatement

The risk of material misstatement refers to the likelihood that material
misstatements may have entered the accounting system and not been
detected and corrected by the client’s internal control. It is the combination of
inherent risk and control risk.

Audit Risk Model

Audit risk is the risk that the auditor will express an inappropriate
opinion when in fact the financial statements are materially misstated. The
audit risk is broken down into three (3) separate components, namely the
inherent risk, control risk, and detection risk. The audit risk model is expressed
as follows:

Audit Risk (AR) = Inherent Risk (IR) x Control Risk (CR) x Detection Risk (DR)

33 Baclea-an ‖ Auditing Theory Review

 Planning the Audit Module 3

 Inherent Risk is the susceptibility of an account balance or class of

transactions to misstatement assuming that there were no related internal
controls.
 Control Risk is the risk that material misstatement that could occur in an
assertion will not be prevented or detected on a timely basis by internal
controls.
 Detection Risk is the risk that the auditor will not detect a misstatement
that exists in an assertion.

Risks Relationship

Inherent Risk & Control Acceptable Level of

Substantive Tests
Risk Detection Risk
Increase Decrease Increase
Decrease Increase Decrease

Based on the above illustration, there is an inverse relationship between the

risk of material misstatement and the acceptable level of detection risk. That
is, if there is a high assessed level of combined inherent and control risk, the
auditor sets the detection risk at a lower level. Thus, more evidences are
required to be obtained by the auditor.

Steps in assessing client’s business risk:

Auditor Sets Audit Risk

The risk is determined and controlled by the auditor

Auditor Assess the Risk of Material Misstatement

The risks are controlled by the client

Auditor Determines the Detection Risk

The risk is determined and controlled by the auditor

34 Baclea-an ‖ Auditing Theory Review

 Planning the Audit Module 3

Establish Planning Materiality

PSA 320 specified 3 main characteristics of materiality:

1) Misstatements are considered material if, individually or in the aggregate,

they could reasonably be expected to influence the economic decisions
of users based on the financial statements.
2) Judgments about materiality are made in context of surrounding
circumstances, and are affected by the size and/or nature of a
misstatement.
3) What is material to users depends on a consideration of their common
financial information needs and not their individual needs.

Materiality Views

 Auditor’s Perspective: The largest amount of misstatement that the

auditor could tolerate in the financial statements.
Management’s Perspective: he smallest aggregate amount that could
 misstate the financial statements When establishing the overall audit
strategy, the auditor shall determine materiality for the financial
statements as a whole.
Levels of Materiality

PSA 320 now clearly requires the auditor to determine three different levels of
materiality, as follows:

A. Materiality for the financial statements as a whole or Overall

Materiality
 This is the materiality determined at the overall financial statement
level. This materiality level helps the auditor determine whether the
proposed audit adjustments are significant or not. If the audit
adjustments exceed this level, the auditor may need to adjust the
financial statements.

The following steps are required in calculating overall materiality:

1. Identify an appropriate benchmark which could either be an element or

component of the financial statements (e.g. profit before tax, gross profit,
revenue/sales; or it can also be total assets or total equity).

2. Choose an appropriate percentage to be applied to that benchmark. In

determining the appropriate benchmark, the following factors are normally
considered by the auditor:

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 Planning the Audit Module 3

• components of the financial statements

• focus of the users of the financial statements
• nature of the entity
• ownership structure of the entity
• volatility of the benchmark identified

B. Performance materiality
 It means the amount or amounts set by the auditor at less than the
overall materiality to reduce to an appropriately low level the
probability that the aggregate of uncorrected and undetected
misstatements exceeds materiality for the financial statements as a
whole.

C. Materiality applied to specific classes of transactions, account

balance or disclosures or Specific Materiality
 This is the amount set by the auditor for particular classes of
transactions, account balances or disclosures for which misstatements,
well though lower than overall materiality could reasonably be expected
to influence the economic decisions of users of the financial statements.

Comparison of Materiality Levels

Overall Materiality % of Benchmark
Performance Materiality % of Overall Materiality
Specific Materiality Total of material amount per account
= Overall materiality

Materiality and Audit Risk

There is an inverse relationship between materiality and the level of audit risk,
that is the higher the materiality level, the lower the audit risk and vice versa.

Preliminary Analytical Procedures

The PSA require auditors to perform preliminary analytical procedures during

the planning stage. Analytical procedures involve evaluations of financial
information made by a study of plausible relationships among financial and
nonfinancial data. This include ratio and trend analysis to investigate identified

36 Baclea-an ‖ Auditing Theory Review

 Planning the Audit Module 3

fluctuations and relationships that are inconsistent with other relevant

information or deviate significantly from predicted amounts.

Develop expectations regarding financial

Steps in Applying Analytical Procedures: statements

Compare the expectations with the

financial statements under audit

Investigate significant differences

Overall Audit Strategy, Audit Plan and Audit Program

 Overall Audit Strategy – sets the scope, timing, and direction of the
audit and guide the development of a more detailed audit plan.

 Audit Plan – more detailed than the audit strategy. It sets the nature,
timing and extent of audit procedures to be performed by engagement team
members in order to obtain sufficient appropriate audit evidence to reduce risk
to an acceptably low level.

 Audit Program – a more detailed plan of the procedures to be used in the

audit of specific accounts and transactions. It includes detailed instructions
to audit team members and procedures to be performed in testing specific
accounts.

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 Planning the Audit Module 3

ASSESSMENT

Name: __________________________________ Score: ___________

Degree Program/Year/Section: ____________ Date: ____________

3. Which of the following procedures

1. I. Audit planning is a discrete would a CPA ordinarily perform
process during audit planning?
II. Planning need not be performed A. Obtain understanding of the
every engagement with the same client’s business and industry
client. B. Review the client’s bank
A. True, True C. True, False reconciliation
B. False, False D. False, True C. Obtain client’s representation
letter
2. What is the reason why auditors D. Review and evaluate client’s
perform audit planning? internal control
A. To predict the opinion to be issued
at the reporting phase of the audit 4. Which of the following is not a
B. To be able to perform the audit in component of audit planning?
an efficient and effective manner. A. Observing the client’s annual
C. To assist the management in physical inventory taking and making
improving their internal control the test counts of selected items.
system. B. Making arrangements with the
D. All of the above. client concerning the timing of audit
field work and use of the client’s staff
3.Adequate planning of the audit work in completing certain phases of the
helps to ensure that examination.
C. Obtaining an understanding of
A B C D
I. Appropriate
the business.
attention is D. Developing audit programs.
devoted to
YES NO YES NO
important 5. In developing the overall audit
areas of the
plan for a new client, which of the
audit
II. Potential
following factors will not be
problems are YES YES YES NO considered?
identified A. Materiality levels
III.The work is B. The client’s business, including
completed NO YES YES NO the structure of the organization
expeditiously
and accounting used

38 Baclea-an ‖ Auditing Theory Review

 Planning the Audit Module 3

C. The amount of estimated audit B. The entity’s application of

fee accounting policies.
D. The audit risks and procedures C. The audit fee and timeline for
to be performed to achieve audit completion of the work
objectives D. The entity’s business risks

6. In planning the audit engagement, 9. An auditor obtains knowledge

the auditor should consider each about a new client’s business and
of the following, except: its industry to
A. Matters relating to the entity’s A. Make constructive suggestions
business and the industries in concerning improvements in the
which it operates client’s internal control
B. The entity’s accounting policies B. Develop an attitude of
and procedures professional skepticism
C. Anticipated levels of control risk concerning management’s
and materiality financial statement assertions.
D. The kind of opinion that is likely to C. Evaluate whether the
be expressed aggregation of known
misstatements causes the
7. In performing an audit of financial financial statements taken as a
statements, the auditor should whole to be materially misstated.
obtain knowledge of the client’s D. Understand the events and
business sufficient to transactions that may have an
A. Make constructive suggestions effect on the client’s financial
concerning improvements in statements.
internal control
B. Identify transactions and events
that may affect the financial
statements 10. Which of the following is an
C. Develop an attitude of auditor least likely to perform in
professional skepticism planning a financial statement
D. Assess the level of control risk audit?
A. Coordinating the assistance of
8. Gaining an understanding of the entity personnel in data
client and its environment includes preparation.
all of the following areas except: B. Discussing matters that may
A. Regulatory issues unique to the affect the audit with firm
industry personnel responsible for non-
audit services to the entity.

39 Baclea-an ‖ Auditing Theory Review

 Planning the Audit Module 3

C. Selecting a sample of vendors’ B. Cost – benefit of gathering

invoices for comparison with evidence
receiving reports. C. Selected audit techniques
D. Reading the current year’s D. Financial statement assertions
interim financial statements.
14.Audit programs are modified to
11. In planning the audit suit the circumstances of
engagement, the auditor should particular engagements. An audit
consider each of the following program usually should be
except: developed
A. Matters relating to the entity’s A. Prior to beginning the actual audit
business and the industry in which work.
it operates. B. After the auditor has obtained an
B. Risks of material misstatements understanding of internal control
due to fraud. and assessed risks.
C. Anticipated levels of control risk C. After obtaining an understanding
and materiality. of the information and
D. The kind of opinion that is likely to communication and control
be expressed. activities components internal
control.
12.Which of the following factors does D. When the engagement letter is
a CPA ordinarily consider in the prepared.
planning stage of an audit
engagement? 15.One of the primary roles of an
I. Financial statement accounts engagement work program is to
likely to contain a misstatement. A. Serve as a tool for planning and
II. Conditions that require conducting engagement work
extension of audit tests. B. Document an internal auditor’s
A. I only evaluations of controls
B. II only C. Provide for a standardized
C. Both I and II approach to the engagement
D. Neither I nor II D. Assess the risk associated with the
activity under review
13. In designing written audit
programs, an auditor should 16.Some account balances are the
establish specific audit objectives results of complex calculations.
that relate primarily to the The susceptibility to material
A. Timing of audit procedures misstatements in these types of
accounts is defined as

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 Planning the Audit Module 3

A. Audit risk A. Assurance provided by

B. Detection risk substantive tests.
C. Sampling risk B. Risk of misapplying auditing
D. Inherent risk procedures.
C. Preliminary judgment about
17.As the acceptable level of materiality levels.
detection risk decreases, an D. Risk of failing to discover material
auditor may change the misstatements.
A. Timing of substantive tests by
performing them at an interim 20.Which model represents the
date rather than at a year end. overall allowable audit risk?
B. Nature of substantive tests from a A. AR = IR x CR x DR
less effective to a more effective B. AR = IR + CR + DR
procedure. C. AR = IR + (CR – DR)
C. Timing of tests of controls by D. AR = IR – (CR + DR)
performing them at several dates
rather than at one time. 21.Min Yongi Corporation has a few
D. Assessed level of inherent risk to a large accounts receivable which
higher amount totals P1,000,000. Jung Hoseok
Corporation has a great number of
18.The risk that an auditor’s small accounts receivable that
procedures will lead to the also has a total of P1,000,000. The
conclusion that a material importance of a misstatement in
misstatement does not exist in an any one account is therefore
account balance when, in fact, greater for Min Yongi than for Jung
such misstatement does exist is Hoseok. This is an example of the
A. Audit risk auditor’s concept of
B. Inherent risk A. Materiality
C. Control risk B. Comparative analysis
D. Detection risk C. Reasonable assurance
D. Audit risk
19.The acceptable level of detection
risk is inversely related to the

41 Baclea-an ‖ Auditing Theory Review

 REFERENCES

Gleim I.N., Hillison W.A. (Eleventh Edition) AUDITING & SYSTEMS Exam
Questions and Explanations

Johnstone K.M., Gramling A.A., Rittenberg L.E. (Eleventh Edition)

AUDITING: A Risk-based Approach

Louwers T.J., Blay A.D., Sinason D.H., Strawser J.R., Thibodeau J.C.
(Seventh Edition). Auditing & Assurance Services

Salosagcol, J.G., Tiu M.F., Hermosilla, R.E. (2014). Auditing Theory, A

guide in understanding PSA

Roque G.S., (2018 – 2019 Edition). CPA Examination Reviewer: Auditing

Theory

Auditing Theory Review ‖ Baclea-an 42