Chapter 4:
Accuracy and valuation
Audit process – Preliminary engagement activities
Financial statement audit generally begins with the financial
statements of the client entity.
 because there would be no audit to perform without
these said financial statements
General approach to financial statement audit:
 requires consideration of the (1) financial statement
assertions, (2) audit evidence, and (3) audit procedures
(1) Financial statement assertions
Management:
 responsible for the fair presentation of the financial
statements that reflect the nature and operations of the
client entity
 implicitly or explicitly makes assertions regarding the
recognition, measurement, presentation and disclosure
of the various elements of the financial statements and
related disclosures
Financial statement assertionsare categorized as follows:
1.assertions about classes of transactions and events for the
period under audit - COCAC
1. Completeness
 all transactions and events that should have
been recorded are recorded
2. Occurrence
 the transactions and events that have been
recordedhave occurred and pertained to the
entity
3. Classification
 transactions and events have been recorded
in the proper accounts
4. Accuracy
 amounts and other data relating to recorded
transactions and events have been recorded
appropriately
5. Cut-off
 Transactions and events have been recorded
in the correct accounting period
2.assertions about account balances at the period end under
audit: - ERoVaC
1. Existence
 assets, liabilities, and equity interests exist
2. Rights and obligations
 entity holds or controls the rights to assets
and liabilitiesare obligations of the entity
3. 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 properly and
appropriately recorded
4. Completeness
 all assets, liabilities, and equity interests
that should have been recorded have been
recorded
3.assertions about presentation and disclosure - COCA
1. Completeness
 all disclosures that should have been included in
the financial statements have been included
2. Occurrence and rights and obligations
 disclosed events, transactions, and other
matters have occurred and pertained to the
entity
3. Classification and understandability
 financial information has beenappropriately
presented and described and disclosures are
clearly expressed
4.
 financial and other information are disclosed
fairly and at appropriate amounts
(2) Audit evidence
Audit evidence:
 refers to the information obtained by the auditor in
arriving at the conclusions on which the audit opinion is
actually based
 will either prove or disprove the validity of the client
management’s assertions
 at the conclusion of the audit:
 auditor should carefully evaluate the audit
evidence gathered in order to come up with
an appropriate audit opinion
 audit evidence comprises:
1. source documents and accounting records
underlying the financial statements
2. corroborating information
 from other relevant sources
(3) Audit procedures
Auditor uses the financial statement assertions tin assessing the
risks by considering the different types of potential misstatements
that may occur:
 thereby designing the audit procedures that are
responsive to the assessed risks
Audit procedures selected should enable the auditor to gather
sufficient appropriate audit evidence about some particular
assertion:
 regardless of the audit procedures selected
Commonly-used audit procedures include: - COICAI
1. Confirmation:
 consists ofresponse to an inquiry to confirm or
corroborate information contained in the
accounting records
2. Observation
 consists of looking at the process or
procedurebeing performed by others
3. Inspection
 involves examining the records, documents, or
tangible assets of the entity being audited
4. Calculation or computation
 consists of checking the arithmetical accuracy
of source documents and accounting records or
performing independent calculations
5. Analytical procedures
 consists of the analysis of significant ratios and
trendsincluding the resulting investigation of
fluctuations andsome relationships that are
inconsistent with other relevant information or
deviate from predicted amounts
6. Inquiry
 consists of the seeking of information from
knowledgeable persons inside or outside the
entity being audited
Audit process
Audit process:
 sequence of different audit activities
Emphasis and order of certain activities may vary depending
upon a particular audit, but basically this process should
include the following audit activities: - PACPCI
1. Preliminary engagement activities
2. Audit planning
3. Considering the internal control system
4. Performing substantive tests
 5. Completing the audit Refusal of the prospective client’s management to permit this:
 willraise serious questions as to whether or not the
6. Issuing the audit report
engagement will be accepted!

1.Preliminary engagement activities

Once permission of the client is obtained, the incoming auditor
 refer to PSA 300
should inquireinto matters that may affect the decision to
 undertaken to determine whether or not to accept the
accept the engagement, which includes:
audit engagement!
1. predecessor auditor’s understanding as to the reasons
for the change of auditors
Preliminary engagement activities:
2. any disagreement between the predecessor auditor
 performed (1) to know if the auditor is qualified to
and the client
handle the engagement and (2) to evaluate whether the
3. facts that might have bearing on the integrity of the
financial statements are auditable or not
prospective client’s management like fraud or non-
 in making this assessment, the auditor should
compliance with laws and regulations
consider the following:
Code of Ethicsrequires the predecessor auditor to respond fully
1. his competence
to the incoming auditor’s inquiry and advise the incoming auditor
2. his independence
if there are any professional reasons why the engagement should
3. his ability to serve the client
not be accepted.
4. integrity of the prospective client’s
management
Retention of existing clients:
I. Auditor’s competence
Clients should be evaluated(1) at least once a year or (2) upon
Code of Ethics mandates that the auditors should not portray
occurrence of major events such as changes in management,
themselves as having expertise which they do not possess.
directors, ownership, nature of client’s business, or other
 auditor should obtain a preliminary knowledge of the client’s changes that may affect the scope of the examination.
business and industry to know if (1)he has the necessary
In general:
skills and the competence to handle the engagement or
 conditions which would have caused an accounting firm
(2) whether such competence can be obtained before
to reject a prospective client may also result or lead to
the completion of the audit
a decision of terminating an audit engagement
 competence can be acquired through a
combination of education, training, and expertise Before performing any significant audit activities, PSA 300
requires the auditor to undertake the following preliminary
II. Auditor’s independence
engagement activities: - PEE
Code of Ethics states that essential to the credibility of the
1. Performing procedures regarding the continuance of the
auditor’s report is the concept of independence
client relationship and the specific audit engagement
 auditor should consider if there are any threats to the
2. Evaluating compliance with ethical requirements, including
audit team’s independence and objectivity, and if so,
independence
whether adequate safeguards can be established
3. Establishing an understanding of the terms of the
III. Auditor’s ability to serve the client properly (PSA 220) engagement
 engagement should not be accepted if there are not
Performing the preliminary engagement activities at the beginning
enough qualified personnel to perform the audit
of the current audit engagementassists the auditor in: - PI
 audit work should be assigned to personnel who have
 Planning the audit, and
the appropriate capabilities, competence, and timeto
 Identifying areas that may affect the auditor’s ability to
perform the audit engagement in accordance with the
perform the audit engagement adversely
professional standards
 there should be sufficient direction, supervision, and
Engagement letter:
review of work at all levels to provide reasonable
Engagement letter:
assurance that the firm’s standard of quality is maintained
 written contract between the auditor and the client
in the performance of the engagement
Engagement letter should be prepared:
IV.Integrity of the prospective client’s management (PSA 220)  after accepting the audit engagement
 auditors should conduct a background investigation of Engagement letter sets forth: - OMS-FFR
the prospective client in order to minimize the likelihood 1. objective of the audit of financial statements
of association with clients whose management lacks  which is to express an opinion on them
integrity 2. management’s responsibility for the fair presentation
This task would involve: of the financial statements
(1) Inquiringappropriate parties in the business community 3. scope of the audit
 inquiring the prospective client’s banker, legal counsel, 4. forms or any reports or other communication that the
or underwriter to obtain information about the reputation auditor expects to issue
of the prospective client 5. fact that there is an unavoidable risk that material
misstatements may remain undiscovered
(2) Communicating with the predecessor auditor
 because of the limitations of the audit
Communication with the predecessor auditor is not only a matter
6. responsibility of the client to allow the auditor to have
of courtesyto the predecessor auditor:
unrestricted access to whatever records, information,
 it also allows the incoming auditor to obtain info.
or documentation requested in connection with the
about the prospective client to determine whether to
audit
accept or reject the engagement
Engagement letter may also include: - BEAR
But before the incoming auditor can contact the predecessor 1. billing arrangements
auditor of the prospective client: 2. expectations of receiving management letter
 incoming auditor should obtain prospective client’s 3. arrangements concerning the involvement of others
permissionto communicate with the predecessor auditor (experts, other auditors, internal auditors)
because the Code of Ethics prevents an auditor from 4. request for the client to confirm the terms of the
disclosing any information obtained about the client engagement
without the client’s explicit permission
Importance of the engagement letter:
 to avoid misunderstanding with respect to the audit
engagement, and
 to document and confirm the auditor’s acceptance of
the appointment
4.Performing substantive tests
 involves examining the documents and the evidence
supporting the amounts and disclosures in the financial
statements

Using the information obtained in the audit planning and in the

Recurring audits:
 auditor does not normally send new audit engagement
letter every year
The following factors may cause the auditor to send a new
engagement letter: - LIARS
1. legal requirements and other government agencies’
pronouncements
2. indication that the client misunderstands the objective
and scope of the audit
3. any revised or special terms of the engagement
4. recent change of senior management, BODs, or of
ownership
5. significant change in the nature or size of the client’s
business
If the auditor decides not to send a new engagement letter:
 it may be appropriate for the auditor to remind the
client of the original arrangements
Audit of components:
If the auditor of a parent entity is also the auditor of its
subsidiary, branch, or division (component):
 auditor should consider the following factors in making
a decision of whether to send a separate letter to the
component:
1. who appoints the auditor of the component
2. whether a separate audit report is to be
issued on the component
3. legal requirements
4. extent of work performed by other auditor
5. degree of ownership by parent
6. degree of independence of the component’s
management
2.Audit planning
In audit planning, auditor obtains sufficient understanding of the
entity and its environment:
 to understand the transactions and events affecting
the financial statements, and
 to identify potential problems
consideration of internal control system:
 auditor performs substantive tests to determine if the
entity’s financial statements are presented fairly and
in accordance with the financial reporting standards
Extent of substantive tests is highly dependenton the results of the
auditor’s consideration of the internal control system.
 if the entity’s internal control system is functioning as
intended, the scope of the auditor’s substantive tests
can be reduced
 if the entity’s internal control system cannot be relied
upon, the scope of the auditor’s substantive tests will
be expanded and will be more extensive
5.Completing the audit
 involves performing additional audit procedures to
complete the audit and to become satisfied that the
evidence gathered is consistent with the auditor’s
report, after the auditor has completed testing the
account balances in the financial statements
Completing the audit procedures include: - RAPO
1. Review of subsequent events and contingencies
2. Assessing the going concern assumption
3. Performing overall analytical procedures
4. Obtaining written representations from management
Auditor must have sufficient appropriate audit evidencein order
to reach a conclusion about the fairness of the entity’s financial
statements.
6.Issuing a report
On the basis of audit evidence gathered and evaluated:
 auditor forms a conclusion about the givenfinancial
statements
 this conclusion is communicated to various
interested users through an audit report

A preliminary assessment of risk and materiality is made:

 to develop an overall audit strategy, and
 to develop a detailed approach for the expected conduct
and scope of the examination

3.Considering the internal control system

 involves obtaining an understanding of the entity’s
control systems and assessing the level of control risk

Control risk:
 risk that the client’s internal control may not prevent
or detect material misstatements in the financial
statements

Auditor considers the entity’s internal control system because

the condition of the entity’s internal controldirectly affects the
reliability of the financial statements
 i.e. the stronger the internal control system, the more
assurance it provides about the reliability of the entity’s
financial statements

If auditor wants to assess control risk at less than high level:

 sufficient appropriate audit evidence must be obtained
to prove that the internal control is functioning as intended
(i.e. effectively) and that it can be relied upon
 sufficient appropriate audit evidence can be
obtained by performing tests of controls