20.1 Nature of Auditing, Assurance, and Information Risk

Nature of Auditing, Assurance, and Information Risk

Auditing in the Philippines gives credibility to financial statements, protects the public interest, and supports stable capital markets. This section covers the definition and objectives of an audit under PSA 200, reasonable assurance and the inherent limitations of an audit, the economic demand for audits (agency theory and information risk), and the types of audits and auditors.

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1. Nature, Objective, and Scope of Financial Statement Audits

Formal Definition of Auditing

Auditing in general is defined (American Accounting Association) as a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between these assertions and established criteria, and communicating the results to interested users.

Applied to a statutory audit of financial statements in the Philippines:

• Assertions represent the implicit or explicit representations made by management regarding the recognition, measurement, presentation, and disclosure of transactions and accounts in the financial statements.
• Established Criteria refer to the applicable financial reporting framework, which in the Philippines primarily consists of Philippine Financial Reporting Standards (PFRS), PFRS for Small and Medium-sized Enterprises (PFRS for SMEs), or PFRS for Small Entities.
• Users include existing and potential investors, creditors, financial institutions, employees, regulatory authorities, and the general public.

Primary Objective under PSA 200

Under Philippine Standard on Auditing 200 (PSA 200), Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Philippine Standards on Auditing, the overarching objectives of the auditor are:

1. To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and
2. To report on the financial statements, and communicate as required by the PSAs, in accordance with the auditor's findings.

Levels of Assurance: Reasonable vs. Absolute Assurance

The auditor provides a high, but not absolute, level of assurance, termed reasonable assurance. Reasonable assurance represents an accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole.

An audit is not a guarantee that financial statements are free from all misstatements. The auditor does not provide absolute assurance because an audit is subject to pervasive inherent limitations.

Inherent Limitations of an Audit

PSA 200 identifies three broad categories of inherent limitations that prevent the auditor from providing absolute assurance:

                               Inherent Limitations of an Audit
                                               │
         ┌─────────────────────────────────────┼─────────────────────────────────────┐
         ▼                                     ▼                                     ▼
Nature of Financial Reporting            Nature of Audit Procedures               Timeliness & Cost-Benefit
• Subjective management judgments       • Practical & legal constraints         • Selective testing / sampling
• Accounting estimates & uncertainty    • Intentional concealment & collusion   • Persuasive rather than
• Alternative acceptable accounting     • Non-possession of search/subpoena       conclusive evidence
  treatments                              powers                                • Reasonable time & expense

1. Nature of Financial Reporting

The preparation of financial statements involves significant management judgment, subjective decisions, and accounting estimates that involve uncertainty (e.g., expected credit loss allowances, fair value measurements of illiquid assets, provision for environmental liabilities, and asset impairment testing). Consequently, many financial statement items cannot be measured with mathematical exactness.

2. Nature of Audit Procedures

Auditors face practical and legal constraints when gathering audit evidence:

• Management and third parties may intentionally or unintentionally fail to provide complete information requested by the auditor.
• Fraud Concealment: Fraud, especially fraud involving management override of controls, forgery, intentional misrepresentation, or collusion between employees and external parties, is deliberately designed to be hidden. Standard audit procedures may be ineffective for discovering sophisticated concealment.
• Lack of Legal Powers: Auditors are not government prosecutors or judicial officers. They do not possess legal powers of search, seizure, or subpoena to compel testimony or confiscate records.

3. Timeliness of Financial Reporting and Balance Between Benefit and Cost

Users expect financial information to be made available within a reasonable period following the reporting date. To provide timely reports at a reasonable economic cost:

• Auditors must rely on selective testing (sampling) rather than examining 100% of the entity's transactions and account balances.
• The matter of difficulty, time, or cost involved is not in itself a valid basis for the auditor to omit an audit procedure for which there is no alternative, but the audit is planned so that audit effort is directed toward areas where risk of material misstatement is highest.
• Audit evidence is predominantly persuasive rather than conclusive in nature.

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2. Economic Demand for Auditing & Information Risk

The Agency Problem and Stewardship Theory

Modern corporate enterprise is characterized by the separation of ownership and management. Shareholders (principals) delegate day-to-day operational control and custody of economic resources to professional managers (agents). This structural separation produces an inherent agency problem:

• Asymmetry of Information: Management possesses direct, comprehensive, real-time access to the company's financial and operational data, whereas shareholders and creditors receive only periodic summary reports prepared by that same management.
• Conflict of Interest: Management may have personal incentives (e.g., performance bonuses, stock option values, promotion aspirations, job preservation) to present an overly favorable portrait of financial performance and financial condition, potentially disguising operational failures or capital losses.

The independent audit serves as a vital corporate governance monitoring mechanism. By retaining an independent third party to verify management's representations, principals mitigate agency costs and reduce information asymmetry.

Information Risk: Definition and Drivers

Information risk is the risk that financial information upon which a business, investment, or credit decision is made is inaccurate, incomplete, or materially misleading. In capital markets, an entity's cost of capital reflects three distinct components:

$\text{Cost of Capital} = \text{Risk-Free Interest Rate} + \text{Business Risk} + \text{Information Risk}$

While an auditor cannot alter the risk-free rate and cannot eliminate the client's underlying business risk (e.g., technological obsolescence, economic recessions, competitor actions), an independent audit directly reduces information risk. Lower information risk enables the reporting entity to obtain debt and equity capital at lower financing costs.

Four fundamental economic drivers create information risk:

Mechanisms for Reducing Information Risk

Users of financial statements have three potential approaches to manage information risk:

1. User Directly Verifies the Information: The user examines the records directly. This is economically inefficient, impractical for large enterprises, and legally restricted for minority shareholders.
2. User Shares Information Risk with Management: The user contracts with management to absorb losses resulting from inaccurate information. However, if the business collapses into insolvency, management cannot make the user whole.
3. Independent Audited Financial Statements are Provided: Management hires an independent CPA firm to audit the statements, or users mandate that an independent audit report accompany the financial statements. This is the universal, cost-effective solution supporting modern capital markets.

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3. Types of Audits and Auditors

Other key distinctions: assurance engagements increase users' confidence in a subject matter against criteria, while related services (agreed-upon procedures and compilations) do not express assurance. An external auditor may rely on the work of internal auditors only after evaluating their objectivity, competence, and systematic approach under PSA 610.