CHAPTER3

OVERVIEWOFAUDITING
Questions
1.

One definition of auditing is that it is a systematic process by which a

competent, independent person objectively obtains and evaluates evidence
regarding assertions about economic actions and events to ascertain the degree
of correspondence between those assertions and established criteria and
communicating the results to interested users.
The Philippine Standards on Auditing (PSA) 120 Framework of Philippine
Standards on Auditing states the objective of an audit as follows:
The objective of an audit of financial statements is to enable the auditor to
express an opinion whether the financial statements are prepared in all material
respects, in accordance with an identified financial reporting framework.

2.

This apparent paradox arises from the distinction between the function of
auditing and the function of accounting.
The accounting function is the process of recording, classifying and
summarizing economic events to provide relevant information to decision
makers.
The rules of accounting are the criteria used by the auditor for evaluating the
presentation of economic events for financial statements and he or she must
therefore have an understanding of Philippine Financial Reporting Standards
(PFRS), as well as Philippine Standards on Auditing (PSA).
The accountant need not, and frequently does not, understand what auditors do,
unless he or she is involved in doing audits, or has been trained as an auditor.

Purpose

Audits of
Financial
Statements
To determine
whether the
financial
statements are
presented in

Compliance
Audits

Operational
Audits

To determine
whether the client
is following
specific
procedures set by

To evaluate
whether operating
procedures are
efficient and
effective.

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accordance with
PFRS.

Audits of
Financial
Statements
Users of Audit Different groups
Report
for different
purposes many
outside entities.
Nature
Highly
standardized
Performed by:
CPAs
COA Auditors
BIR Auditors
Internal
Auditors

4.

Compliance
Audits

Operational
Audits

Authority setting
down procedures,
internal or
external
Not standardized,
but very specific
and usually
objective

Management of
organization

Occasionally
Frequently
Universally
Frequently

Frequently
Frequently
Never
Frequently

Highly
nonstandard;
often very
subjective

The major differences in the scope of audit responsibilities are:

1.

2.

3.

4.

5.

Almost universally
Occasionally
Never
Frequently

higher authority.

CPAs perform audits in accordance with Philippine Standards on

Auditing of published financial statements prepared in accordance with
identified and applicable Statements of Financial Accounting
Standards.
COA auditors perform compliance or operational audits in order to
assure the Congress of the expenditure of public funds in accordance
with its directives and the law.
BIR agents perform compliance audits to enforce the tax laws as
defined by Congress, interpreted by the courts, and regulated by the
BIR law.
Internal auditors perform compliance or operational audits in order to
assure management or the board of directors that controls and policies
are properly and consistently developed, applied and evaluated.

An independent audit is a means of satisfying the need for reliable information

on the part of decision makers. Factors of a complex society which contribute to
this need are:
1.

remoteness of information
a. owners (stockholders) divorced from management
b. directors not involved in day-to-day operations or decisions

Overview of Auditing
c.

6.

3-3

dispersion of the business among numerous geographic locations

and complex corporate structures

2.

bias and motives of provider

a. information will be biased in favor of the provider when his goals
are inconsistent with the decision maker.

3.

voluminous data
a. possibly millions of transactions processed daily via sophisticated
computerized systems
b. multiple product lines
c. multiple transaction locations

4.

complex exchange transactions

a. new and changing business relationships lead to innovative
accounting and reporting problems
b. potential impact of transactions not quantifiable, leading to
increased disclosures

The four primary causes of information risk are remoteness of information, bias
in motives of the provider, voluminous data, and existence of complex exchange
transactions.
The three main ways to reduce information risk are:
1.
2.
3.

User verifies the information itself.

The users share the information risk with management.
Have audited financial statements provided.

The advantages and disadvantages of each are as follows:

User
verifies
information

Users share
information
risk with
manageme
nt
Audited
financial
statements
are
prepared

Advantages
1. User obtains information
desired.
2. User can be more
confident of the
qualifications and
activities of the person
getting the information.
1. No audit costs incurred.

Disadvantages
1. High cost of obtaining
information.
2. Inconvenience to the
person providing the
information because large
number of users would be
on premises.
1. Users may not be able to
collect on losses.

1. Multiple users obtain the

information.
2. Information risk can
usually be reduced
sufficiently to satisfy users

1. May not meet needs of

certain users.
2. Cost may be higher than
the benefits in some
situations, such as for a

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at reasonable cost.
3. Minimal inconvenience to
management by having
only one auditor.

small company.

7.

Information risk is the possibility that information upon which a business

decision is made is inaccurate. Four causes of information risk are:
remoteness of information,
biases and motives of the provider,
voluminous data, and
complex exchange transactions.

8.

Three primary ways users of information can reduce information risk are:
users can verify the information themselves,
users can share information risk with management, and
users can obtain audited financial statements.

9.

Four factors that are likely to significantly reduce information risk in the next
five to ten years are:
technological advances,
more companies will go online, reducing the risk of investors
obtaining outdated information,
new accounting and auditing standards, and
auditors will find more efficient and effective audit techniques.

10. Refer to pages 84 and 85 of the textbook.

11. A report by an independent public accountant concerning the fairness of a
companys financial statements is commonly required in the following
situations:
(1) Application for a bank loan.
(2) Establishing credit for purchase of merchandise, equipment, or other
assets.
(3) Reporting operating results, financial position, and cash flows to
absentee owners (stockholders or partners).
(4) Issuance of securities by a corporation.
(5) Annual financial statements by a corporation with securities listed on a
stock exchange or traded over the counter.
(6) Sale of an ongoing business.
(7) Termination of a partnership.
12. To add credibility to financial statements is to increase the likelihood that they
have been prepared following the appropriate criteria, usually the relevant and

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3-5

applicable PAS. As such, an increase in credibility results in financial

statements that can be believed and relied upon by third parties.
13. Business risk is the risk that the investment will be impaired because a company
invested in is unable to meet its financial obligations due to economic conditions
or poor management decisions. Information risk is the risk that the information
used to assess business risk is not accurate. Auditors can directly reduce
information risk, but have only limited effect on business risk.
14. An operational audit attempts to measure the effectiveness and efficiency of a
specific unit of an organization. It involves more subjective judgments than a
compliance audit or an audit of financial statements because the criteria of
effectiveness and efficiency of departmental performance are not as clearly
established as are many laws and regulations or financial reporting standards.
The report prepared after completion of an operational audit is usually directed
to management of the organization in which the audit work was done.
15. The first quoted sentence overstates the case. Although annual audits by CPA
firms are universal practice for large corporations, they are not essential to many
small businesses. The financial statements of large corporations go to many
stockholders (often hundreds of thousands) who demand the assurance of
reliability supplied through independent audits by CPA firms. Moreover the
SEC and the stock exchanges require that listed companies have annual audits.
For a small business concern, the primary need for annual financial statements is
to support an application for a bank loan. If a small business does not need to
borrow, or can obtain borrowed funds without providing audited statements, the
cost of an audit may not be justified.
Often a small business can obtain from a CPA firm specialized services other
than an audit, which are more useful and may cost less. Examples are the
review or compilation of financial statements, installation of a computer based
accounting system, or a study of internal control. Thus, the second quoted
sentence, as well as the first, is too sweeping to be correct. A decision not to
have an audit is not always false economy.
16. (a) An example of possible bias on the part of the provider of financial
information is the situation in which an individual or business entity applies
for a bank loan. In such circumstances, there is an incentive to overstate
assets, income, and owners equity, and to overlook or minimize liabilities.
Distortions of this type give the appearance of greater financial strength.

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(b) A bank loan officer may insist that a prospective borrower provide audited
financial statements. This provides assurance that the data in the financial
statements have been examined by independent competent persons.
17. Financial statements audits, operational audits, and compliance audits are similar
in that each type of audit involves accumulating and evaluating evidence about
information to ascertain and report on the degree of correspondence between the
information and established criteria. The differences between each type of audit
are the information being examined and the criteria used to evaluate the
information. An example of a financial statement audit would be the annual
audit of ABS-CBN Corporation, in which the external auditors examine ABSCBNs financial statements to determine the degree of correspondence between
those financial statements and generally accepted accounting principles. An
example of an operational audit would be an internal auditors evaluation of
whether the companys computerized payroll-processing system is operating
efficiently and effectively. An example of a compliance audit would be a BIR
auditors examination of an entitys tax return to determine the degree of
compliance with the National Internal Revenue Code.
18. Refer to pages 83 to 84 of the textbook.
19. The text defines internal auditing as an independent appraisal activity in an
entity. Internal auditing is itself a control that operates by examining and
evaluating the adequacy and effectiveness of other controls. Independence is
such an important aspect of internal auditing that the fourth section of the
Statement of Responsibilities of Internal Auditing is devoted to independence.
Organizations create internal auditing to serve or benefit the organization.
The broad objective of internal auditing is to provide assistance to members of
the organization to enable the members to meet their responsibilities effectively.
Assistance may involve providing counsel or recommendations, analysis, or
information. One goal of internal auditing should be to achieve effective control
that is worth the cost.
In describing the nature of internal auditing, the Statement of Responsibilities of
Internal Auditing indicates that internal auditing functions by examining
controls. The scope limits internal auditings responsibility for examining and
evaluating performance to specific responsibilities that are assigned to
individuals or units. Internal auditing examines and evaluates performance to
compare the actual performance with plans, specified activities, standards,
objectives, policies, and goals. Such evaluations are really evaluations of
controls because plans, specified activities, standards, objectives, policies and
goals are controls. Internal auditors may be called on to examine areas for
which performance criteria have not been specified. When this occurs, internal
auditors may select measurable criteria and report their findings in terms of

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those measurable criteria. For example, if internal auditors were called on to

evaluate a credit department, they might present historical information as well as
industry information to management as a basis for evaluating the credit
department.
20. Independence is the essence of auditing and enables auditors to render impartial
and unbiased judgments. The two conditions that contribute to an internal
auditors independence are organizational status and auditor objectivity. The
internal auditors status must be such that they are respected throughout the
organization. Generally, the more respect management gives to the internal
audit function, the greater the attention the whole organization pays to their
findings and recommendations. Giving the highest-level person in internal
auditing the status of vice president and having that person report to the board of
directors audit committee give sufficient status to the internal audit function.
Objectivity requires that internal auditors have an independent mental attitude
and an honest belief in their work product.
21. COA auditors perform operational or performance audits, compliance audits,
and financial audits.
22. An independent auditor is usually a CPA who has received a license to perform
the attest function. To be a CPA, one generally must meet certain educational
requirements and pass an examination.
Internal auditors are employees of the organization for which they do audits.
They may perform financial auditing, compliance auditing, or operational
auditing. They are not independent in the sense that external auditors are,
although they may attain a degree of independence by their position in the
organization.
Governmental auditors are employees of various government agencies who
perform financial, compliance, and operational auditing. For example, local
governments employ auditors to verify that businesses collect and remit sales
tax as required by law.
Multiple Choice Questions
1.
2.
3.
4.
5.
6.
7.
8.

D
A
A
D
B
C
B
C

11.
12.
13.
14.
15.
16.
17.
18.

B
A
C
C
A
D
A
A

21.
22.
23.
24.
25.
26.
27.
28.

D
B
C
B
B
C
D
C

31.
32.
33.
34.
35.
36.
37.
38.

D
B
A
D
C
D
B
C

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9.
10.

B
D

19.
20.

D
C

29.
30.

A
A

39.
40.

A
B