Auditing Theory

Second Evaluation Exam

1. Audit planning involves a general audit strategy and a detailed approach for the expected
conduct of the audit
2. The auditor’s main objective in planning the audit is to determine the scope of the audit
procedures to be performed
3. PSA 315 requires the auditor to obtain sufficient understanding of the entity and its
environment including its internal control. Such understanding, involves obtaining knowledge
about the entity’s:
1. Industry, regulatory, and other external factors, including financial reporting
framework;
2. Nature of the entity including entity’s selection and application of accounting
policies;
3. Objectives and strategies and the related business risks that may result in a material
misstatement of the financial statements;
4. Measurement and review of the entity’s performance; and
5. Internal control
4. Understanding the entity and its environment
The auditor should obtain a sufficient level of knowledge of the entity’s business to
identify and understand the events, transactions, and practices that may have a significant
effect on the financial statements.
5. Sources of information
1. Review of prior year’s working paper
2. Tour of client’s facilities
3. Discussion with people within and outside the entity
4. Reading books, periodicals, and other publications related to the client’s industry
5. Reading corporate documents and financial report
6. The auditor should also ensure that assistants assigned to an audit engagement obtain
sufficient knowledge of the client’s business and industry to enable them to carry out the
work delegated to them.
7. Uses of information obtained
Knowledge of the client’s business is a frame of reference within which the auditor exercises
professional judgment. Understanding the business and using this information appropriately
assists the auditor in:
1. Assessing risks and identifying potential problems
2. Planning and performing the audit effectively and efficiently
3. Evaluating audit evidence as well as the reasonableness of client’s representations and
estimates
4. Providing better service to the client
Obtaining understanding of the client’s business is a continuous and cumulative process.
8. Additional consideration on new engagements
A first-time audit requires more work than a repeat engagement because of the problem
associated with the verification of the opening balances of the balance sheet accounts. In
this regard, PSA 510 requires the auditor to obtain sufficient appropriate audit evidence
that:
1. The opening balance does not contain misstatements that materially affects the current
year’s financial statements;
2. The prior period’s closing balances cave been correctly brought forward to the current
period or, when appropriate, have been restated; and
3. Appropriate accounting policies are consistently applied or changes in accounting
policies have been properly accounted for and adequately disclosed
The auditor may be able to obtain sufficient appropriate evidence regarding opening balance
by reviewing the predecessor auditor’s working papers. In these circumstances, the auditor
would also consider the independence and professional reputation of the predecessor auditor
9. Understanding the internal control
The auditor should obtain an understanding of the entity’s accounting and internal control
systems sufficient to plan the audit and develop an effective audit approach.
10. Developing and overall audit strategy
The best audit strategy is the approach that results in the most efficient audit, that is,
and effective audit performed at the least possible cost. An audit plan should be made
regarding:
1. How much evidence to accumulate; and
2. How and when this should be done
When developing an audit strategy, the auditor must consider carefully the appropriate
levels of materiality and audit risk
11. Materiality
In designing an audit plan, the auditor should make a preliminary estimate of materiality
for use during the examination. Materiality may be viewed as:
1. The largest amount of misstatement that the auditor could tolerate in the financial
statements; and
2. The smallest aggregate amount that could misstate the financial statement
12. Materiality is a matter of professional judgment and necessarily involves quantitative
factors and qualitative factors.
13. There is an inverse relationship between materiality and evidence. This means, more evidence
will be required for a low peso amount of materiality than for a high peso amount.
14. According to PSA 320, materiality should be considered by the auditor:
1. In the planning stage, to determine the scope of audit procedures; and
 2. In the completion stage of the audit, to evaluate the effect of misstatements on the
financial statements
15. Using materiality levels
1. Determine the overall materiality (financial statement level)
The auditor should determine the amount of misstatement that could be material to the
financial statements taken as a whole. When establishing materiality levels on a
financial statement level, the auditor should consider that the financial statements
are interrelated. For this reason, the auditor should consider materiality in terms of
the smallest aggregate level of misstatement that could distort any of the financial
statements.
A common method of estimating materiality at the financial statement level is to multiply
a statement base by a certain percentage.
2. Determine the tolerable misstatement (account balance level)
This is done by allocating the overall materiality to the financial statement account
balances. This allows the auditor to determine the audit procedures that will be applied
to specific accounts. The allocated materiality to an account is called the tolerable
misstatement for that account. This is also known as performance materiality.
This process is highly subjective and requires the exercise of great deal of judgment
by the auditor.
3. Compare the aggregate amount of uncorrected misstatements with the overall materiality
After performing audit procedures, the auditor will have to compare the aggregate amount
uncorrected misstatements with the overall materiality (preliminary estimate of
materiality or revised materiality level) to determine whether the financial statements
are materially misstated or not.
16. The auditor uses alternative bases (since annual financial statements are usually not
available) for the materiality levels, such as:
1. Annualized interim financial statements
2. Prior year’s financial statements
3. Budgeted financial statements of the current year
17. Audit risk
After determining materiality levels, the auditor should design the audit to provide
reasonable assurance that the financial statements taken as a whole are free from material
misstatements.
The auditor should use professional judgment to assess audit risk and to design audit
procedures to ensure it is reduced to an acceptably low level. When designing substantive
audit procedures, the auditor should consider three main issues:
1. What level of assurance does the auditor wish to attain that the financial statements
do not contain material misstatements? (As this level of assurance increases, the scope
of the auditor’s substantive procedures increases)
2. How susceptible is the account to material misstatements? (As the susceptibility of the
account to material misstatement increases, the scope of the auditor’s substantive test
also increases)
3. How effective is the client’s internal control? (As the effectiveness of the client’s
internal control increases, the scope of auditor’s substantive procedures decreases)
18. Audit risk model
Audit risk is the product of inherent risk, control risk, and detection risk
19. Audit risk defined
Audit risk refers to the risk that the auditor gives inappropriate opinion on the financial
statements. This occurs when the auditor believes that the financial statements are fairly
stated when in fact the financial statements are materially misstated.
20. Audit risk is the complement of audit assurance.
21. Because of inherent limitations of the audit, the auditor cannot totally eliminate the audit
risk. The auditor should, therefore, perform audit procedures in order to limit his or her
exposure to this risk to low level.
22. As the desired level of risk decreases, the auditor should design more effective substantive
procedures.
23. Inherent risk defined
Inherent risk is the susceptibility of an account balance or class of transactions to a
material misstatement assuming that there were no related internal controls. This concept
recognizes that some account balances, by nature, are more susceptible to misstatement than
others.
24. PSA 315 requires the auditor to assess inherent risk at the financial statement and account
balance levels.
Factors affecting the risk of misstatement at the financial statement level:
1. Management integrity
2. Management characteristics
3. Operating characteristics
4. Industry Characteristics
Factors affecting inherent risk at the account balance level:
1. Susceptibility of the account to theft
2. Complexity of calculations related to account
3. The complexity of underlying transactions and other events
4. Degree of judgment involved in determining account balances
25. As the assessed level of inherent risk increases, the auditor should design more effective
substantive procedures.
26. Control risk defined
Control risk is the risk that a material misstatement that could occur in an account balance
or class of transactions will not be prevented or detected and corrected on a timely basis
by accounting and internal control systems. Control risk related to the effectiveness of
 the client’s internal control. If the entity’s internal control is effective, the assessed
level of control risk decreases. Like inherent risk, control risk exists independently of
the audit of financial statements and is assessed using the auditor’s judgment.
27. As the assessed level of control risk increases, the auditor should design more effective
substantive procedures
28. Detection risk defined
Detection risk is the risk that an auditor’s substantive procedure will not detect a material
misstatement. Detection risk is a function of the effectiveness of the auditor’s substantive
procedures.
29. As the acceptable level of detection risk decreases, the assurance directly provided from
substantive tests increases. Hence, the auditor should design more effective audit
procedures in order to achieve the desired level of assurance.
30. Unlike, inherent and control risks, the auditor can control the level of detection risk by
performing more effective substantive procedures. The acceptable level of detection risk is
inversely related to the assessed level of both inherent and control risks.
31. Using the audit risk model
1. Set the desired level of audit risk— audit planning
The auditor uses his judgment in determining the risk that he is willing to take if
accepting an assertion as fairly stated when in fact, it is materially misstated.
2. Assess the level of inherent risk— audit planning
When assessing inherent risks for each account the auditor must consider specific factors
related to the client that may affect the risk of a material misstatement for a
particular account. In making this assessment, the auditor will rely on his knowledge
of the client’s business and industry, and the results of his preliminary analytical
procedures.
3. Assess the level of control risk— consideration of internal control
Assessment of control risk would involve studying and evaluating the effectiveness of
the client’s accounting and internal control systems
4. Determine the acceptable level of detection risk— performing substantive tests
5. Design substantive tests
Detection risk can be looked at as the complement of the assurance provided by
substantive tests. Thus, a lower acceptable level of detection risk increases the
assurance to be provided by the substantive tests. To obtain greater assurance, the
auditor will have to modify the scope of his substantive tests such as: performing more
effective substantive procedures (nature), performing year-end procedures (timing), and
using larger sample size (extent).
32. 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).
33. Risk assessment procedures
These are the procedures performed by auditors to obtain an understanding of the entity and
its environment including its internal control and to assess the risks of material
misstatements in the financial statements. These include:
1. Inquiries of management and others within the entity;
2. Analytical procedures; and
3. Observation and inspection
34. Analytical procedures defined
Analytical procedures involve analysis of significant rations and trends, including the
resulting investigation of fluctuations and relationships that are inconsistent with other
relevant information or deviate from predicted amounts.
35. PSA 520 requires the auditor to use analytical procedures in the planning and overall review
stages of the audit.
36. Applying analytical procedures
1. Develop expectations regarding financial statements using:
1. Prior year’s financial statements
2. Anticipated results such as budgets or forecasts
3. Industry averages
4. Non-financial information
5. Typical relationships among financial statement balances
2. Compare the expectations with the financial statements under audit
3. Investigate significant unexpected differences (unusual fluctuations)
Investigation of unusual fluctuations ordinarily begins with inquiries of management,
followed by corroboration of management responses and applying other appropriate audit
procedures.
37. Uses of analytical procedure
1. As a planning tool to determine the nature, timing, and extent of other audit procedures
2. As a substantive test to obtain corroborative evidence about particular assertions
related to the account balances or transaction class
3. An overall review of the financial statements in the completion stage of the audit
38. Analytical procedures in planning an audit
Analytical procedures used in planning should focus on:
1. Enhancing the auditor’s understanding of the client’s business
2. Identifying areas that may represent specific risks
39. Documenting the audit plan
The final step in the planning process is the documentation of the audit planning process
by preparing and overall audit plan, audit program, and time budget.
40. Audit plan defined
Audit plan is an overview of the expected scope and conduct of the audit. The overall audit
plan sets out in broad terms the nature, timing, and extend of the audit procedures to be
 performed. While the audit plan varies for each client, it should be sufficiently detailed
to guide in the development of an audit program.
41. Audit program defined
Audit program sets out in detail the audit the audit procedures to be performed in each
segment of the audit. It serves as a set of instructions to assistants involved in the audit
and as a means to control and record the proper execution of the work. In effect, the audit
program executes the audit strategy.
42. Time budget defined
Time budget is an estimate of the time that will be spent in executing the audit procedures
listed in the audit program. This provides for estimating audit fees and assists the auditor
in assessing the efficiency of the assistants.

Auditing Theory (by Salosagcol, et. al.)

89.26%
1. A
2. C
3. C
4. B
5. A
6. D
7. C
8. D
9. A
10. D
11. B
12. B
13. D
14. D B
15. C
16. A
17. D
18. C
19. C
20. A
21. B
22. D B
23. C
24. D
25. D
26. B
27. D
28. A
29. B
30. D C
31. D
32. C
33. A B
34. A
35. D
36. C
37. D C
38. B
39. A
40. A C
41. C
42. B
43. A
44. D
45. B
46. D
47. D
48. D
49. B
50. B
51. B
52. B
53. D
54. D A
55. D
56. A
57. C
58. B
59. B D
60. B
61. B C
62. A
63. A
64. C
65. A
66. C
67. A D
68. D A
69. D
70. D
71. B
72. D
73. D B
74. B
75. D
76. C
77. A B
78. A
79. D
80. A
81. A C
82. D
83. D
84. A
85. B
86. A
87. C
88. B
89. C
90. B
91. A
92. D
93. C
94. D
95. B
96. D
97. A
98. D
99. A
100. A
101. A
102. C
103. A
104. D
105. B
106. C A
107. B A
108. D
109. C D
110. C
111. C
112. A
113. D