DEFINING AUDITING

The process through which an independent auditor plans for, obtains, summarizes, and
evaluates sufficient, competent, relevant, and material evidence on the audit objective of whether
an entity’s management or employees have or have not accepted and carried out in a fair, legal,
efficient, economical, or effective manner appropriate standards (management or operational
standards and requirements, laws, policies, or other managerial standards) for which they are
accountable. From the evidence on the audit objective, the auditor comes to an opinion or
conclusion, and then reports this opinion or conclusion to a third party to provide it with
adequate assurance that the second party has or has not carried out the appropriate standards
necessary to achieve the desired results.

Authorities agreed that there must be three parties to an audit before it should be called an
audit. Likewise, there must be an accountability relationship between two of the three - the audit
recipient and the auditee. There also must be an evaluation made of the accountable activities by
an independent examiner - - the auditor - - in order to provide an acceptable level of assurance to
the third party on the second party’s accountability. Not only is the above true for audits of
private but also for governmental activities Thus, for an activity to be properly called an audit the
following factors must be present:

1. An auditor, auditee, and audit recipient;

2. An accountability relationship between the auditee (subordinate) and

the audit recipient (higher authority);

3. Independence between the auditor and auditee; and

4. An examination and evaluation of certain of the auditee’s accountable

activities by the auditor for the audit recipient.

So, let us label each of these three parties and define the characteristics of each of them.
They will be called:

1. The First Party - - The auditor, who provides to the third party an acceptable
level of assurance on the accountability of the second party.

2. The Second Party - - The party being audited and accountable to the third party.

3. The Third Party - - The party to whom the second party is accountable and to
whom the auditor reports on that accountability.

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THE ELEMENTS OF AN AUDIT

From the definition of auditing, one finds that all audits have similar characteristics.
From these characteristics, one can determine that each audit has four elements on which the
auditor gathers evidence in order to come to a conclusion:

1. An appropriate standard or standards for management action

2. Management’s actions (or lack of actions) in regard to carrying out those standards,
and,
3. The reason for the condition why something happened and who or what is
responsible.
4. The good or bad results from following (or not following) the appropriate standard or
standards.

Since the auditor must evaluate these elements in every type of audit he makes, then, let
us illustrate these elements for each of the various kinds of audits.

The Elements in a Financial Statement Audit

The opinion section of the AICPA’s standard short form report states:

In our opinion, the financial statements referred to above present fairly the
financial position of X Company as of (at) December 31, 20xx, and the results of
its operation and the changes in its financial position for the year then ended, in
conformity with generally accepted accounting principles applied on a basis
consistent with that of the preceding year.

By analyzing this standard short form opinion, one finds that the appropriate standard is
“the generally accepted accounting principles applied on a basis consistent with that of the
preceding year.” The actions of the management and employees would be those of the “X
Company in the preparation of the financial statements that present the financial position of X
Company as of December 31, 200xx, and the results of its operations and the changes in its
financial position for the year then ended.” The reason would be “in conformity with” and the
results would be that the financial statements were presented “fairly.”

In qualified opinions the appropriate standards would be the same - - generally accepted
accounting principles consistently applied. Certain actions of management, such as not following
a particular generally accepted accounting principles, or not consistently applying a principle,
would require that the fairness of the presentation be qualified for those actions. Adverse
opinions state that all actions of management are such that the statements are not fairly presented
in accordance with generally accepted accounting principles. When the actions of management
are such that an opinion cannot be expressed, or when the auditor cannot obtain evidence
sufficient to warrant the expression of an opinion, then the auditor would disclaim an opinion.

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 In the following illustrations for the other kinds of audits, the elements of the audit will
be isolated and pointed out distinctly in the conclusion given.

The Elements in a Compliance Audit

The following illustration, taken from the audit reports of Agency A, shows that the
agency did not comply with the provisions of law governing overtime services.

Management of Agency A incurred additional cost of Pesos: Eighty-Nine

Thousand Five Hundred Forty Seven & 56/100 (management action) for overtime
services rendered (reason) thus, did not comply (result) with Section 1 (d) of
Administrative Order No. 103 implemented by CSC-DBM Joint Circular No. 2 s.
2004 which provide that overtime services has to be compensated through
compensatory time-off (appropriate standard).

The elements (shown in parenthesis) are easily identified in this conclusion of the
compliance audit. This audit, while obviously a traditional in nature, could also be an efficiency
and economy audit, since there could be a reduction in cost. For example, a conclusion for an
efficiency and economy audit would be:

The agency did not comply (management action) with the provision of
Administrative Order No. 103 implemented by CSC-DBM Joint Circular No. 2 s.
2004 which provide that overtime services rendered has to be compensated
through compensatory time-off (appropriate standard) because overtime services
rendered by its officers and employees was paid in cash (reason) thus incurring
additional cost in the amount of pesos: Eighty-Nine Thousand Five Hundred
Forty Seven & 56/100 (the result).

The result in a compliance audit is that the action of management and its employees did
not comply with the required standards. When peso values are placed on the lack of compliance,
then the audit becomes an efficiency and economy audit. The lack of compliance creates an
illegal act or an act that does not fulfill the intent of a law, rules or regulations, much as in an
effectiveness audit, where the result is ineffective operation.

The Elements in an Efficiency and Economy Audit. In an audit of large institutions in

several areas requisitioning foodstuffs, the auditor reported the following conclusions on
inefficient and uneconomical operations:

Government institutions in seven provinces covered by the audit did not

follow instructions given to them (actions of management or employees) to
requisition commodities in the most economical size packages to the maximum
extent possible – the large size packages - - (appropriate standard) instead, they
requisitioned foodstuffs for large users in small size packages (reason) thus,
incurring additional costs of P1.6 million for the year (result).

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 Note that this audit conclusion could be from either an efficiency or economy audit or
from a compliance audit, depending upon the emphasis on the results. If the emphasis is on lack
of compliance with the regulations, then it would be a financial compliance audit; if the emphasis
is on the incurring of additional costs, then it would be an efficiency and economy audit. In this
case it is fairly easy to see from the standards that they were presented to managers in order to
have more efficient operations.

The Elements in an Effectiveness Audit

In determining effectiveness of a program, management either accomplishes or fails to

accomplish the goal of the program. The goal of the program in this illustration was to reduce
energy consumption in the country by developing and using procurement techniques that are
energy efficient. The elements are shown in parentheses in the following conclusion:

The Energy Regulatory Board did not provide (management action/inaction)

satisfactory guidance to procuring entities in the form of life cycle costing,
energy efficiency standards and design vs. performance specifications
(appropriate standards) because of poor research program (reason) thus, the goal
of reducing energy consumption in the country was not effectively accomplished
(result).

Audit Terminology for the Elements of Audit

As has been seen, each type of audit has the same elements as every other type: the
appropriate standard, the actions (or lack of actions) or management or employees, the reason of
the action or inaction of management or its employees and the results. Authorities have
developed some generally accepted terminology for these elements:

1. Criteria is the term used for the appropriate standard or standards.

2. Condition means the actions (or lack of actions) of management or employees.
3. Cause the reason for the condition; why something happened and who or what
is responsible, and
4. Effect is the same as results, the difference between the standard that should
be used and the action that is taking place.

The word “criteria” as an audit standard or standards applies either to a single standard or to
multiple standards. Thus, “criteria” will be used as a singular word in both a singular or a
plural sense.

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THE PHASES OF THE AUDIT

Similar to what is done in solving any logical problem, the auditor identifies a possible
problem, considers alternative problems, selects the problem he will solve, gathers evidence on
the problem in order to come to an answer or conclusion, and then reports his conclusion to a
third party. But in solving an audit problem, the auditor must consider the factors that are directly
related to auditing. Instead of solving a problem he is coming to a conclusion on an audit
objective. He does this by stating the elements in the objective, gathering evidence to define the
objective, coming to a conclusion on it, and then reporting the conclusion to a third party.

This process of selecting, defining, and developing the audit objective, gathering
evidence on it in order to come to a conclusion, and reporting the conclusion to a third party is
not done all at one time, but in phases. This conceptual process, which consists of the ideas
concerning the solution to an audit questions by phases, will be identified and stated in the
succeeding pages that follows.

THE AUDIT PROCESS

The actual audit is undertaken by following the audit process that may be broken down
into the following stages:

THE SURVEY PHASE – involves the gathering of information, w/o going into detailed
verification about the transactions of the agency, and its programs, projects and activities;
review of legal and policy framework; preliminary testing of controls; identification of audit
area; determination of the overall scope; and the preparation of the audit program.

a. Gathering/updating general information about the agency

 The Auditor may perform the following:

1. Interview with agency officials

2. Obtain basic documents
3. Physical inspection

 The survey should provide information on:

1. Legislation, charters and other documents relative to the creation of the

agency

2. History, background and purposes of programs and projects

3. Organizational Structures
a. Statement of duties & responsibilities
b. Principal delegation of authority

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 4. Nature, investments and location of agency assets

5. General objectives and policies

6. Operating methods and stds. and in measuring or evaluating agency

operations and performance

7. Description of major, existing problems

8. Copies of internal agency reports

b. Review of Legal and Policy Framework

Significance: To obtain a general knowledge of the legislation and policies applicable to

agency objectives, programs, projects and operating standards.

To establish the reason for creation of the agency its history, delegated
authorities, principal functions and responsibilities, any legal and/or policy
restrictions imposed on its operations and the sources and methods of its
finances.

c. Preliminary testing of controls

Significance: To determine the adequacy of controls over programs, projects and

activities or operations of the agency.

d. Identification of audit area

The result of the preliminary testing will be one of the bases for the
identification of audit priority areas.

e. Determination of overall audit scope

Significance: To determine the extent of the audit procedures, period covered and the
type of examinations to be performed.

To keep the audit work in focus

To correctly formulate the objectives & procedures to be included in the

audit programs.

f. Preparation of the audit program

Significance: Serves as guide during the conduct of actual audit.

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 Enables the auditor to keep his objectives in sight.
Provides systematic basis for the division/distribution of work among the
audit staff.
Serves as a record of work done or as a measure of the progress of work as
it indicates completion of steps performed.

CONTENTS OF THE AUDIT PROGRAM

1. Scope – the coverage of the audit work

2. Objectives – what the audit aims to achieve
3. Audit procedures – set forth in specific terms the steps to be followed for each audit
objectives
4. Staff assignment – those who will carry out each procedures
5. Time budget – the estimated time required to carry out each audit procedures
6. Working paper reference – to facilitate cross referencing

THE EXECUTION PHASE – primarily involves the implementation of the audit program. The
main activities are:

a. Carrying out the audit procedures – the audit program already spells out the
procedures, how to carry them out, when to do so, and who will do the task. What the
auditor does at this point is to follow the program.

b. Evaluating the evidence – After the procedures to attain one objective are carried out,
the auditor may now be in a position to make a conclusion on the particular area
covered by that objective. He must then determine whether the evidence he has on
hand are adequate to support his conclusion. In such a task, he should be guided by
Section 55 of PD 1445, the fourth examination and evaluation standard.

c. Finalizing the audit working papers – as the audit progresses, raw data are generated
in the form of evidence and or records thereof, and materials gathered and collected
by the auditor. These are potential audit working papers, and the task of the auditor at
this point is to analyze, evaluate and compile them so they can be used to support AO,
conclusions & recommendations.

d. Determining causes and effects – As the audit progresses the auditor forms some
tentative findings and recommendations regarding the condition of the agencies
accounts, systems, procedures, etc. Such findings will be firmed up after the
evaluation of the evidence and finalization of the audit working papers. When the
condition is found to be a deviation form the criteria, the auditor determines the
causes and effects of such deviations.

The “cause” identifies the reasons for the deviation and who and what are
responsible for the state of affairs.

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 The “effect” is the result of the deviation. May be intended or unintended;
beneficial or more usually adverse.

NOTE:
1. Determining causes and effects requires the ability to make a logical
inferences and value judgments from data collected during the survey and
execution phases;
2. Causes and effects are interrelated and the knowledge of one assists the
understanding of the other;
3. They may be isolated occurrence or part of a pattern indicating potential
breakdown of the system;
4. They should be quantified to give emphasis and underscore the significance
of the findings.

e. Developing audit Findings and Recommendations. Requires:

1. organizing the data gathered from the previous steps;

2. analysis of findings and recommendations, respectively; and
3. formulating statements which communicate the auditor’s findings and
recommendations.

QUALITIES OF MEANINGFUL AUDIT FINDINGS:

1. A statement of condition – a fact, booked up by evidence and verifiable, as opposed

to a mere supposition or opinion. It may be an actual occurrence or an existing state
of affairs.
2. A statement of criteria – the standards against which a condition is compared with.
3. A statement of effect – the result, usually adverse of the discovered condition. The
extent and the seriousness of the effects largely determine the significance of the
condition.
4. A statement of cause – the reason for the condition; why something happened and
who or what is responsible.

Audit recommendations – are courses of actions or sets of procedures that must be performed to
correct deficiency/ies which a specified person or persons must carry
out.

QUALITIES OF A GOOD RECOMMENDATION:

1. It is practical. It can be implemented readily and economically.

2. It eliminates the cause(s) of the condition(s).

3. It will prevent the recurrence of the condition(s).

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 4. It is clearly worded and specifies what action should be taken and who should do it.

5. It is in accordance with laws and regulations.

REPORTING PHASE – involves the reporting of the results of the audit through audit reports
to the audited agency and other authorized bodies, such as regulatory
or supervisory agencies, the legislature, and special interest groups.

The activities in the reporting phase are:

a) Drafting the report – the initial draft of the audit report is the responsibility of
the auditor who prepares the draft on the basis of the updated permanent file,
audit working papers, analyses of the findings and recommendations. The draft is
discussed with the staff to assure the accuracy of the report as well as the
reasonableness of its findings and recommendations.

b) Conducting the exit conference – Except where the possibility of fraud or other
compelling reasons required otherwise the auditor then arranges for the holding of an
exit conference with the agency head and his staff. The purpose of the conference is
to inform management of the auditor’s findings and recommendations and for
management to have “its day in court”. Areas of disagreement are resolved or, at
least, management responses are noted down for reconsideration and possible
inclusion in the final report.

c) Finalizing the audit report – The final draft incorporating the matters discussed
or agreed upon in the exit conference, as well as relevant facts arising hereafter, is
prepared by the auditor and discussed with his staff to evaluate the proposed report’s
conformity with the prescribed reporting standards and requirements. The auditor is
responsible for the preparation of the audit report in its final form.

d) Preparing the transmittal letter – After the audit report has been finalized and
prepared, the letters transmitting the same to the intended users are prepared by the
auditor, for the signature of the appropriate COA official. The transmittal letter
summarizes the salient features of the report, preferably beginning with the agency’s
accomplishments, followed by the findings, and ending with the recommendations.

e) Submitting the report – The auditor submits to his designated supervisor

sufficient copies of the audit report together with the corresponding transmittal letters.
Such submission is made under a covering memorandum which specifies the nature
of the audit conducted and the authority therefore. The reports are received by the
supervisor and transmitted to the proper end users. If the final report needs revisions,
it will be returned to the auditor for rewriting.

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 f) The follow-up - The auditor’s responsibility extends beyond the submission and
transmittal of the report. He is required to see to it that his recommendations are
implemented by the agency. Non-implementation of recommendations is monitored
and reported to higher COA authorities, together with the agency’s reasons for the
non-implementation.

TYPES OF AUDIT AND THEIR OBJECTIVES

The expanded scope of auditing a government organization, a program, an activity, or a

function should include:

Traditional Auditing

Financial audit is the analytical and systematic examination and verification of financial
transactions, accounts, and reports of any government agency for the purpose of determining
their accuracy, integrity and authencity.

The objective of financial auditing is to determine whether the financial statements of an

audited entity present fairly the financial position and the results of financial operations in
accordance with generally accepted accounting principles

Compliance audit is an examination intended to evaluate an organization’s compliance

with applicable laws and governmental regulations and policy in the handling of its finances and
of its operation in general.

The objectives of compliance auditing are (1) to determine whether the entity has
complied with laws and regulations that may have a material effect upon the financial statements
and (2) to determine the extent by which the entity has complied with the legal and statutory
requirements in carrying out its operations

Economy and Efficiency Auditing

Economy audit is the review of managerial operation with the end view of determining
wasteful operation and developing recommendations to eliminate the cause/s of such wasteful
operation.

Its objectives are (1) to determine whether the entity is managing and utilizing its
resources economically; (2) to determine the causes of uneconomical operations and (3) to
determine whether the entity has complied with laws and regulations concerning matters of
economy.

Efficiency audit is the review of managerial efficiency with the end view of promoting
efficient use of public resources. It is concerned with the relationship between inputs (costs) and
outputs (benefits). Efficient operations include: (1) holding the costs constant while increasing

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the benefits, (2) holding the benefits constant while decreasing the costs, (3) increasing the costs
at a slower rate than benefits, and (4) decreasing costs at a faster rate than benefits. Thus,
economy and efficiency, as they both pertain to reduction or elimination of costs, are equivalent
in meaning. Only when costs remain constant or increase in relation to increasing benefits are the
meaning different.

In the efficiency audit, then, the auditor would examine any operation in an organization -
- such as planning, production or service, purchasing, selling, accounting, research, marking,
advertising, personnel, etc. - - to determine whether:

1. increased results could be accomplished from the same costs.

2. the same results could be accomplished for less costs.
3. the rate of increase of results would be greater than that for the costs, and
4. the rate of decrease of costs would be greater than that for the results.

For all practical purposes, then, economy audits fit within the framework of efficiency
audits.

The objectives of efficiency audit are the following: To determine (a) whether the
entity is managing and utilizing its resources (such as personnel, property, space)
efficiently, (b) the causes of inefficiencies, and (c) whether the entity has complied with
laws and regulations concerning matters of efficiency.

Effectiveness Auditing

Effectiveness auditing is concerned with the relationship between the outputs (benefits)
to the goals (objectives) of the program or organization. Goals and objectives often have the
same meaning, and are also defined as “intended results” and “program results.” The term
“program results audit” comes from this definition. The standards for measuring whether the
outputs achieve the desired results may be either financial or otherwise. For example, the goal of
a profit type organization may be either profits or return on investment of a specified amount or
rate. The closer the net income earned by the organization is to the goal, stated as profit or return
on investment, the more effective the organization becomes.

Effectiveness auditing aims to determine (a) whether the desired results or benefits
established by the legislature or other authorizing body are being achieved and (b) whether the
agency has considered alternatives that might yield desired results at a lower cost.

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