Saint Paul School of Business and Law

Campetic, Palo, Leyte

Review Materials for Auditing Theory

AUDIT PROCESS
Audit process is the logical sequence of activities undertaken in an audit to accomplish audit objectives in
an efficient and effective manner and in accordance with PSAs. The emphasis and order of certain activities may
vary depending on the particular audit, but the fundamental steps are essentially the same in almost every
engagement. The audit process can be viewed as having three phases:
Phase 1 Pre-engagement Activities and Audit Planning Activities
Audit process begins with the preliminary arrangements with the client. Once the client has signed the
engagement letter, the planning process starts as the auditor concentrates his efforts in obtaining a detailed
understanding of the clients business and an overall audit strategy.
A. Pre-engagement
1) Perform new client investigation or consider change in circumstances of existing clients.
2) Determine skills, competence, and ethical requirements.
3) Establish terms of engagement, and prepare an engagement letter.
B. Audit planning
1) Obtain knowledge of the clients business.
2) Develop an overall audit strategy for the expected conduct and scope of the audit.
3) Review and preliminary evaluation of internal control
a)
Review the accounting system and related internal control to gain an understanding of
the transactions and specific control procedures.
b)
Identify internal controls on which it might be effective and efficient to rely in conducting
the audit.
c)
Make a preliminary determination of whether to rely on internal control.
4) Prepare an overall audit plan.
An audit plan provides an overview of the engagement, describing the characteristics of clients
business and industry, identifying special problems for the engagement, and outlining the overall
audit strategy.
5) Develop an audit program
An audit program contains the procedures designed to achieve the audit objectives.
Phase 2 Gathering and Evaluating Audit Evidence
A. Interim Audit Phase
In this phase, auditor focuses his attention on both the design and operation of aspects of the internal
control structure to determine whether necessary controls were functioning as intended. The tests of
controls involve the following: (1) inquiries of client personnel, (2) inspection of documents and records, (3)
observation of the application of specific policies and procedures, and (4) reperformance of the application of
specific policies and procedures. Tests of controls precede substantive testing and performed to reduce the
assessed level of control risk below the maximum level.
B. Final Audit Phase
This phase involves substantive tests of transactions, tests of details of balances and analytical
procedures. Substantive testing is the process of obtaining evidence in support of transactions and
balances. The nature, timing and extent of substantive testing is a function of the auditors judgment
concerning audit risk and materiality.
The final audit phase will also include accumulation of some additional evidence for the financial
statements, summarization of the results that will enable the auditor to prepare his audit report. This will
include:
a)
Review for contingent liabilities
d) Evaluating going concern assumption
b)
Review for subsequent events
e) Obtaining client representation letter
c)
Performing final analytical procedures
Phase 3 Issuing the Audit Report
The culmination step in the audit process is the preparation of the audit report. Expressing an audit
opinion is the auditors overriding goal. The type of audit report issued depends on the evidence accumulated and
the audit findings.

Pre-engagement Phase
Pre-engagement planning includes procedures that are employed before the auditor begins to review the
internal control structure or to gather evidential matter. A CPA firm needs to establish policies and procedures for
A17 AT (003)

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 clients management could reflect on the reliability on
representations and accounting records and on the CPA firms own reputation.
Acceptance and Continuance of Clients
(Quality Control for Audits of Historical Financial Information PSA 220 revised par. 14 18 & PSQC 1 par.
28 35)

The engagement partner should be satisfied that appropriate procedures regarding the acceptance and
continuance of client relationships and specific audit engagements have been followed, and that conclusions
reached in this regard are appropriate and have been documented.

Acceptance and continuance of client relationships and specific audit engagements include considering:

The integrity of the principal owners, key management and those

charged with governance of the entity;

Whether the engagement team is competent to perform the audit

engagement and has necessary time and resources; and

Whether the firm and the engagement team can comply with ethical
requirements.

Deciding whether to continue a client relationship include

consideration of significant matters that have arise during the current or previous engagement, and their
implications for continuing the relationship.

With regard to the integrity of a client, matters that the firm considers include, for example:

The identity and business reputation of the clients principal owners, key management, related
parties and those charged with governance.

The nature of the clients operations, including its business practices.

Information concerning the attitude of the clients principal owners, key management and those
charged with governance towards such matters as aggressive interpretation of accounting
standards and the internal control environment.

Whether the client aggressively concerned with maintaining the firms fees as low as
possible.

Indications of an inappropriate limitation in the scope of the work.

Indications that the client might be involved in money laundering or other criminal activities.

The reasons for the proposed appointment of the firm and non-reappointment of the
previous firm.

Information on such matters that the firm obtains may come from, for example:

Communications with existing or previous providers of professional accountancy services

to the client in accordance with the Philippine Code, and discussions with other third parties.

Inquiry of other firm personnel o third parties such as bankers, legal counsel and industry
peers.

Background searches of relevant databases

In considering whether the firm has the capabilities, competence, time and resources to undertake a new
engagement from a new or an existing client, the firm reviews the specific requirements of the
engagement and the existing partner and staff profiles at all relevant levels. Matters the firm considers
include whether:

Firm personnel have knowledge of relevant industries or subject matters;

Firm personnel have experience with relevant regulatory or reporting

requirements, or the ability to gain the necessary skills and knowledge effectively;

The firm has sufficient personnel with the necessary capabilities and
competence;

Experts are available, if needed;

Individuals meeting the criteria and eligibility requirements to perform

engagement quality control review are available, where applicable; and

The firm is able to complete the engagement within the reporting deadline.

The firm also considers whether accepting an engagement from new or

an existing client may give rise to an actual or perceived conflict of interest.

Where the engagement partner obtains information that would have

caused the firm to decline the audit engagement if that information had been available earlier, the
engagement partner should communicate that information promptly to the firm, so that the firm and the
engagement partner can take the necessary action. Its policies and procedures should include consideration
of:
The professional and legal responsibilities that apply to the circumstances, including whether
there is a requirement for the firm to report to the person or persons who made the appointment or, in
some cases, to regulatory authorities; and

A17 AT (003)

 The possibility of withdrawing from the engagement or from both the engagement and the client
relationship.

Policies and procedures on withdrawal from an engagement or from both

the engagement and the client relationship address issues that include the following:
Discussing with the appropriate level of the clients management and those charged with its
governance regarding the appropriate action that the firm might take based on the relevant facts and
circumstances.
If the firm determines that it is appropriate to withdraw, discussing with appropriate level of the
clients management and those charged with its governance withdrawal from the engagement or from
both the engagement and the client relationship, and the reasons for withdrawal.
Considering whether there is a professional, regulatory or legal requirement for the firm to remain in
place, or for the firm to report the withdrawal from the engagement, or from both the engagement and
the client relationship, together with the reasons for the withdrawal, to regulatory authorities.
Documenting significant issues, consultations, conclusions and basis for the conclusions.

Terms of Audit Engagement (PSA 210 amended)

The auditor and the client should agree on the terms of the engagement. The agreed terms would need to
be recorded in the audit engagement letter or other suitable form of contract.
Audit Engagement Letters
A letter from the CPA to the client clearly stating the mutual understanding of the nature of the
engagement
Written agreement between the auditor and client that serves to minimize misunderstandings, alert the
client to the purpose of the engagement and the role of the auditor , and help minimize legal liability for
services neither contracted for nor performed
Documents and confirms the auditors acceptance of the appointment, the objective and scope of the
audit, and the extent of the auditors responsibilities to the client and the form of any reports.
A.

Addressee should be addressed to the body or person responsible for engaging and retaining firms
services. In the case of incorporated bodies, addressed either to the board chairman, the board of directors or
the appropriate representative of senior management.
B.
Principal Contents the form and contents of audit engagement letters may vary for each client, but
they would generally include reference to:

The objective of the audit of financial statements

Managements responsibility for the financial statements

The financial reporting framework adopted by management in preparing the financial statements

The scope of the audit, including reference to applicable legislation, regulations, or

pronouncements of professional bodies to which the auditor adheres.

The form of any reports or other communication of results of the engagements.

The fact that because of the nature and other inherent limitations of an audit, together with the
inherent limitations of any accounting and internal control system, there is an unavoidable risk that even
some material misstatement may remain undiscovered.

Unrestricted access to whatever records, documentation and other information requested in

connection with the audit.
C.
Other Contents

The auditor may also wish to include in the letter:

Arrangements regarding the planning of the audit

Expectation of receiving from management written confirmation concerning

representations made in connection with the audit

Request for the client to confirm the terms of the engagement by acknowledging
receipt of the engagement letter or by affixing the clients signature on the space provided for in the
engagement letter for his conforme for the convenience of both the auditor and client

Description of any other letters or reports the auditor expects to issue to the client

Basis on which fees are computed and any billing arrangements

When relevant, the following points could also be made:

Arrangements concerning the involvement of other auditors and experts in some aspects of the
audit

Arrangements concerning the involvement of internal auditors and other client staff

Arrangements to be made with the predecessor auditor, if any, in case of an initial audit

Any restrictions of the auditors liability when such possibility exists

A reference to any further agreements between the auditor and the client
D.
Audits of Components

When the auditor of a parent entity is also the auditor of its subsidiary, branch or division
(component), the factors that influence the decision whether to send a separate engagement letter to the
component include:

Who appoints the auditor of the component

A17 AT (003)

E.

F.

Whether a separate audit report is to be issued on the component

Legal requirements

The extent of any work performed by other auditors

Degree of ownership by parent

Degree of independence of the components management

Agreement on the Applicable Financial Reporting Framework
The terms of engagement should identify the applicable financial reporting framework.
The auditor should accept an engagement for an audit of financial statements only when
the auditor concludes that the financial reporting adopted by the management is acceptable or when it is
required by law or regulation.
When law or regulation requires use of financial reporting framework fro general purpose
financial statements that the auditor considers to be unacceptable, the auditor should accept the
engagement only is the deficiencies in the framework can be adequately explained to avoid misleading
users.
Recurring Audits
On recurring audits, the auditor should consider whether circumstances
require the terms of the engagement to be revised and whether there is a need to remind the client of the
existing terms of the engagement.
The auditor may decide not to send a new engagement letter each
period. However, the following factors may make it appropriate to send a new letter:

Any indication 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 nature or size of the clients business

Legal requirements and other government agencies

pronouncements

A change in the financial reporting framework adopted by

management in preparing the financial statements

Acceptance of a Change in Engagement

An auditor who, before the completion of the engagement, is requested to change the engagement to one
which provides a lower level of assurance, should consider the appropriateness of doing so.
The change in engagement may result from a:
Change in circumstances affecting the need for the service
Misunderstanding as to the nature of the audit or related service originally requested
Restriction on the scope of the engagement whether imposed by management or caused by
circumstances
Where the terms of the engagement are changed, the auditor and the client should agree on new
terms.
The auditor should not agree to a change of the engagement where there is no reasonable justification for
doing so.
If the auditor is unable to agree to a change of the engagement and is not permitted to continue the
original engagement, the auditor should withdraw and consider whether there is any obligation, either
contractual or otherwise, to report to other parties, such as the board of directors or shareholders, the
circumstances necessitating the withdrawal.

MULTIPLE CHOICE QUESTIONS

1) Engagement letters include all of the following except
A.
A list of additional services that will be provided. C. A list of adjusting journal entries.
B.
Information about the audit fee.
D. Arrangements involving the use of
specialists.
2) A successor auditor should request the new client to authorize the predecessor auditor to allow a review of
the predecessor's
Engagement Letter
Audit Documents
A.
Yes
Yes
B.
Yes
No
C.
No
Yes
D.
No
No
3) The preengagement activities of a public accounting audit engagement does not include
A.
investigating new and existing clients.
B.
obtaining knowledge of the client's business.
C.
obtaining an engagement letter.
A17 AT (003)

D.

assigning partner, manager, and staff to engagement.

The independent auditors' audit program prepared prior to the start of fieldwork is appropriately
considered documentation of
A. planning.
C. supervision.
B. information evaluation.
D. quality assurance.
5) The scope and nature of an auditors contractual obligation to client is ordinarily set forth in the
A. management representation letter
C. engagement letter
B. scope paragraph of the auditors report
D. opening paragraph of the auditors report
6) Which of the following factors most likely would cause a CPA to reject a new audit engagement?
A. the prospective client has already completed its physical inventory count
B. the CPA lacks an understanding of the prospective clients operations and industry
C. the CPA is unable to review the predecessor auditors working papers
D. the prospective client is unwilling to make all financial records available to the CPA
7) Tikki, CPA, is succeeding Nante, CPA, on the audit engagement of GG Corp. Tikki plans to consult Nante and
to review Nantes prior year working papers. Tikki may do so if
A. Nante and GG Corp. consent
C. GG Corp. consents
B. Nante consents
D. Tikki and Nante consent
8) An auditors engagement letter most likely will include
A. managements acknowledgement of the responsibility for maintaining effective internal control
B. a reminder that management is responsible for illegal acts committed by employees
C. the auditors preliminary assessment of the risk factors relating to misstatement arising from fraudulent
financial reporting
D. a request for permission to contact the clients lawyer for assistance in identifying litigation, claims and
assessments
9) An auditor is required to establish an understanding with a client regarding the services to be performed for
each engagement. This understanding generally includes
A. managements responsibility for errors and the illegal activities of employees that may cause material
misstatement
B. the auditors responsibility for ensuring that the audit committee is aware of any reportable conditions that
come to the auditors attention
C. managements responsibility for providing the auditor with an assessment of the risk of material
misstatement due to fraud
D. the auditors responsibility for determining preliminary judgments about materiality and audit risk factors
10) Which of the following factors most likely would cause an auditor to decline a new audit engagement?
A. an inadequate understanding of the entitys internal control
B. the close proximity to the end of the entitys fiscal year
C. concluding that the entitys management probably lacks integrity
D. an inability to perform preliminary analytical procedures before assessing control risk
11) In assessing whether to accept a client for an audit engagement, a CPA should consider the
Clients Business Risk CPAs Business Risk
Clients Business Risk CPAs Business Risk
A.
Yes
Yes
C.
No
Yes
B.
Yes
No
D.
No
No
12) Before accepting an engagement to audit a new client, an auditor is required to
A. make inquiries of the predecessor auditor after obtaining the consent of the prospective client
B. obtain the prospective clients signature to the engagement letter
C. prepare a memorandum setting forth the staffing requirements and documenting the preliminary audit
plan
D. discuss the management representation letter with the prospective clients audit committee
13) A successor auditor ordinarily should request to review the predecessors working papers relating to
Contingencies
Internal Control
Contingencies
Internal Control
A.
Yes
Yes
C.
No
Yes
B.
Yes
No
D.
No
No
14) Upon discovering material misstatements in a clients financial statements that the client would not revise, an
auditor withdrew from the engagement. If asked by the successor auditor about the termination of the
engagement, the predecessor should
A. state the he found material misstatements that the client would not revise
B. suggest that the successor ask the client
C. suggest that the successor obtain the clients permission to discuss the reasons
D. indicate that a misunderstanding occurred
15) In making decision to accept or continue with a client, the auditor should consider
A
B
C
D
Its own independence
Yes
No
Yes
No
Its ability to serve client properly
Yes
Yes
No
Yes
The integrity of the clients management
Yes
Yes
Yes
No
16) Which of the following should an auditor obtain from the predecessor auditor prior to accepting the audit
engagement?
A. Analysis of the balance sheet accounts
B. Analysis of the income statement accounts
C. All matters of continuing significance
D. Facts that might bear on the integrity of management
17) Before accepting an audit engagements, a successor auditor should make specific inquiries of the
predecessor auditor regarding predecessors
A17 AT (003)
5
4)

A. opinion of any subsequent events occurring since the predecessors audit report was issued
B. understanding as to the reasons for the change in auditors
C. awareness of the consistency in the application of GAAP between periods
D. evaluation of all matters of continuing accounting significance
18) Appointing the independent auditor early will enable
A. a more thorough audit to be performed
B. a sufficient understanding of internal control to be obtained
C. sufficient, competent evidential matter to be obtained
D. a more efficient audit to be planned
19) Before accepting an audit engagement, a successor auditor should make specific inquiries of the predecessor
regarding
A. disagreements the predecessor had with the client concerning auditing procedures and accounting
principles
B. the predecessors evaluation of matters of continuing accounting significance
C. the degree of cooperation the predecessor received concerning the inquiry of the clients lawyer
D. the predecessors assessments of inherent risk and judgments about materiality
20) Which portion of an audit may not be completed before the balance sheet date?
A. Tests of controls
C. Issuance of management letter
B. Substantive testing
D. Assessment of control risk
21) Which of the following audit procedures would generally performed last?
A. obtaining management representation letter
C. testing the purchasing function
B. reading the minutes of directors meetings
D. confirming accounts payable
22) A prospective clients refusal to grant a CPA permission to communicate with the predecessor auditor will bear
directly on the CPAs ability to
A. study and evaluate the clients system of internal control
B. determine the integrity of the management
C. determine the beginning balances of the current years financial statements
D. establish consistency in application of GAAP between years
23) If the auditor has concerns about the integrity of management, which of the following would not be an
appropriate action?
A. refuse to accept the engagement because a client does not have an inalienable right to an audit
B. expand audit procedures in areas where management representations are normally important by
requesting outside verifiable evidence
C. raise the audit fees to compensate for the risk inherent in the audit
D. plan the audit with a higher degree of skepticism including specific procedures that should be effective in
uncovering management fraud
24) After preliminary audit arrangements have been made, an engagement letter should be sent to the client. The
letter usually would not include
A. a reference to the auditors responsibility for the detection of errors and irregularities
B. an estimate of time to be spent on the audit work by staff & management
C. a statement that management advisory services would be made available upon request
D. a statement that management letter will be issued outlining comments and suggestions as to any
procedures requiring the clients attention
25) Which of the following is not included in the engagement letter?
A. restriction on cash balances, lines of credits or similar arrangements
B. accessibility to all financial records
C. client imposed limitation in the scope
D. limitation in the scope of examination as imposed by circumstances
26) Which of the following statements would least likely appear in an auditors engagement letter?
A. Fees for our services are based on our regular per diem rates, plus travel and other out-of-pocket
expenses
B. During the course of our audit we may observe opportunities for economy in, or improved controls over
your operations
C. Our engagement is subject to the risk that material errors or irregularities, including fraud and
defalcations, if they exist, will not be detected
D. After performing our preliminary analytical procedures we will discuss with you the other procedures we
consider necessary to complete the engagement
27) Assuming a recurring audit, in which of the following situations would the auditor be unlikely to send a new
engagement letter to the client?
A. Recent change in partner involved in the audit engagement
B. Change in the terms of the engagement
C. Recent change of the clients management
D. Significant change in the nature or size of the clients business
28) Which of the following audit procedures would generally be performed during the year-end field work?
A. Count of petty cash
B. Analysis of cut-off bank statement
C. Comparison of data on purchase orders and payment vouchers
D. Examination of lease agreements
29) Which of the following procedures is least likely to be performed before the balance sheet date?
A. Confirmation of accounts receivable
B. Search for unrecorded liabilities
A17 AT (003)
6

C. Observation of inventory
D. Review of internal accounting control over cash disbursements
30) To be proficient as an auditor, a person must first be able to accomplish which of these tasks in a decisionmaking process:
A.
Identify evidence relevant for the audit of assertions management makes in its unaudited financial
statements and notes.
B.
Formulate evidence-gathering procedures (audit program) designed to obtain sufficient,
competent evidence about assertions management makes in financial statements and notes.
C.
Recognize the financial assertions made in management's financial statements and footnotes.
D.
Evaluate the evidence produced by the performance of procedures and decide whether
management's assertions conform to generally accepted accounting principles and reality.

A17 AT (003)