Solution Manual of Auditing and Assurance Services A Systematic Approach 11th Edition by William

CHAPTER 2

THE FINANCIAL STATEMENT AUDITING ENVIRONMENT

 

Answers to Review Questions

 

2-1     Auditors can be classified under four types: (1) external auditors, (2) internal auditors, (3) government auditors, and (4) forensic auditors.

 

External auditors: provide reasonable assurance that financial statements are fairly stated for publicly traded and private companies, partnerships, universities, and government entities, but are not employees of the entity being audited

 

           Internal auditors: employed by companies to provide independent, objective assurance and consulting services designed to add value and improve an organization’s operations

 

           Government auditors: employed by federal, state, and local agencies to provide services similar to internal auditors

 

           Forensic auditors: employed by corporations, government agencies, public accounting firms, and consulting and investigative services firms to detect, investigate, and deter fraud and white-collar crime

          

2-2     Examples of compliance audits include (1) internal auditors determining whether corporate rules and policies are being followed by departments within the organization, (2) an examination of tax returns of individuals and companies by the Internal Revenue Service for compliance with the tax laws, and (3) an audit under the Single Audit Act of 1984 to determine whether an entity receiving federal assistance is in compliance with applicable laws and regulations.

 

Examples of operational audits include (1) an audit by the GAO of the Food and Drug Administration to determine the efficiency and effectiveness of procedures for introducing new drugs to the market, (2) internal auditors examining the effectiveness and efficiency of funds being spent on the entity’s computer resources, and (3) a university hiring an external auditor to examine the effectiveness and efficiency of student advisory services.

 

Examples of forensic audits include (1) an examination by an external auditor of cash disbursements for payments to unauthorized vendors, (2) assistance by an auditor to a law enforcement agency in tracing laundered monies by organized criminals, and (3) an independent auditor helping identify hidden assets as part of a divorce settlement.

 

Student answers will likely be less detailed but should capture the general idea of each type of audit.

 

2-3     During the late 1990s and early 2000s, accounting firms aggressively sought opportunities to expand their business in non-audit services such as consulting. This expansion from their core audit practice, combined with allegations of auditors refusing to challenge management’s actions, resulted in conflict between regulators and the accounting profession. Subsequent financial fiascos such as those at Enron, WorldCom, Tyco, and many others caused investors to doubt the fundamental integrity of the financial reporting system. Under pressure to restore the public’s confidence, Congress passed the Sarbanes-Oxley Act and created the PCAOB in 2002.

 

2-4     The accounting profession’s expansion into new areas, combined with changes in the overall business environment, resulted in new regulations and guidelines. The scandals of the late 1990s and early 2000s brought into question the profession’s ability to self-regulate, resulting in new legislation. While these changes have caused pain and turmoil, they highlight the essential importance of auditing in our economic system. Ultimately, the “back to basics” emphasis, along with auditing firms’ renewed focus on thorough and effective financial statement audits, will likely prove healthy for the U.S. financial reporting system and for the profession. Further, somewhat ironically, the SOX-mandated audit of internal control over financial reporting has brought significant new revenues to accounting firms.

 

2-5     Management is responsible to prepare financial statements that fairly present the company’s financial condition and operations in accordance with established accounting standards. Note that the auditor’s opinion explicitly states that the financial statements are the responsibility of management. The auditor is responsible to issue an opinion in regards to the financial statements prepared by management. In order to issue this opinion, the auditor must plan and perform the audit in accordance with established standards to obtain reasonable assurance that the financial statements are free of material misstatement, whether caused by error or fraud. However, it is important to note that an auditor’s unqualified opinion does not mean that errors or fraud do not exist but rather that there is reasonable assurance that they do not exist in material amounts.

 

2-6     The essential components of the high-level model of business offered in the chapter include the following: corporate governance, objectives, strategies, processes, controls, transactions, and financial statements. Corporate governance is carried out by management and the board of directors in order to ensure that business objectives are carried out and that company assets are safeguarded. To achieve its objectives, management must formulate strategies and implement various processes which are in turn carried out through business transactions. The entity’s information and internal control systems must be designed to ensure that these transactions are properly executed, captured, and processed in order to produce accurate financial statements. It is important that the auditor obtain a firm understanding of these components in order to understand relevant risks and to plan the nature, timing, and extent of the audit so that it is efficient and effective.

 

2-7     The information system must maintain a record of all businesses transactions. It should be capable of producing accurate financial reports to summarize the effects of the entity’s transactions. Among other things, internal control is required to ensure that a proper environment is established and that transactions are appropriately conducted and recorded by the information system and company employees. Effective internal control provides safeguards to ensure the (1) reliability of financial reporting, (2) compliance with laws and regulations, and (3) the effectiveness and efficiency of operations. Auditing standards require that the auditor obtain an understanding of the client’s environment, including its internal control, in planning the nature, timing, and extent of testing.

          

2-8     The AICPA issues the following standards:

• Statements on Auditing Standards
• Statements on Standards for Attestation Engagements
• Statements on Standards for Accounting and Review Services
• Statements on Quality Control Standards
• Standards for Performing and Reporting on Peer Reviews
• Statements on Standards for Consulting Services
• Statements on Standards for Tax Services

 

2-9     The PCAOB is a quasi-governmental organization overseen by the SEC. It was formed to provide governmental regulation of the standards used in conducting public company audits because of a perceived failure of the profession to adequately regulate itself.

 

2-10   The SEC has congressional authority from the original Securities Acts of 1933 and 1934 to establish accounting and auditing standards for publicly traded companies; however, in the past the SEC has largely delegated this authority to other bodies, including the FASB and the AICPA’s Auditing Standards Board. The Sarbanes-Oxley Act of 2002 gave the SEC the mandate to actively regulate the public accounting profession by establishing and overseeing the PCAOB and its standard-setting process relating to the audits of public companies. The SEC has authority to implement and oversee standards relating to all aspects of the audits of public companies, including standards relating to auditor independence (such as the requirement for audit firms to rotate audit partners off audit engagements every five years).

 

2-11   The documents most frequently encountered by auditors under the Securities Exchange Act of 1934 are forms 10K, 10Q, and 8K. Forms 10K and 10Q are, respectively, annual and quarterly reports, which include the audited financial statements periodically filed with the SEC by a publicly traded entity. An 8K is filed whenever a “material corporate event” occurs, such as a change of independent auditors.

 

2-12   The four categories of Principles Underlying an Audit Conducted in Accordance with   GAAS are:

Purpose of an Audit and Premise upon which an Audit is Conducted

This section explains the purpose and value of a financial statement audit and lays out the responsibilities of management and those charged with governance.

Responsibilities

This section describes the responsibilities of the auditor regarding their capabilities, professional skepticism, and ethical behavior.

Performance

This section describes the auditor’s responsibilities in performing an effective audit. This includes their reasonable, rather than absolute, assurance that the financial statements are free of material misstatements and the cost versus benefit analysis in determining procedures.

Reporting

This section describes the responsibility of the auditor for expressing an opinion and providing a written report of that opinion.

 

2-13  Auditing standards are important for evaluating whether an auditor has done an adequate audit. Users of financial statements desire consistency between audits of various companies. Standards are a way to hold auditors accountable by ensuring that they fulfill the requirements defining what a good audit entails. If the auditor fails to identify a material misstatement, this does not necessarily mean that the auditor has failed to perform a high-quality audit, since an audit can only provide reasonable, rather than absolute, assurance. If a material misstatement goes undetected, the auditor can defend her or his performance by showing conformance with auditing standards.

2-14   Independence is a fundamental principle for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report objectively and truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner.

 

Answers to Multiple-Choice Questions

 

2-15	b		2-20	a
2-16	a		2-21	a
2-17	d		2-22	c
2-18	d		2-23	c
2-19	c

 

Solutions to Problems

 

2-24

Item Number	Type of Audit	Type of Auditor
a.	Operational	Government
b.	Financial statement	External
c.	Compliance or operational or possibly internal control	Internal or external
d.	Forensic/Financial	Internal, external, or forensic
e.	Operational	Government, external, or internal
f.	Operational	Internal or external
g.	Compliance	Government
h.	Compliance or forensic	Government, external, or forensic

 

 

 

 

 

 

2-25

 

Brief Description of Principles Underlying an Audit

Sally Jones’ Actions Resulting in Failure to Comply with Principles Underlying an Audit

Purpose and Premise of an Audit: An audit is to provide an opinion by an auditor on whether financial statements are presented fairly, in all material respects, according to the applicable framework. Management and those charged with governance are responsible for the preparation and fair presentation of the financial statements and for the design, implementation, and maintenance of internal control over financial reporting. They are also responsible for providing the auditor with all information relevant to the preparation of the financial statements.

Jones expressed an opinion regarding the financial statements, but not on whether the financial statements are presented fairly in accordance with generally accepted accounting principles, or any other financial reporting framework. Therefore, she did not fulfill the primary purpose of the audit.   Jones did not ensure that management fulfilled its responsibilities for the fair presentation of the financial statements, since that requires making the appropriate footnote disclosures in the financial statements.

 

Responsibilities: Auditors are responsible for having appropriate competence and capabilities to perform the audit; complying with relevant ethical requirements; and maintaining professional skepticism and exercising professional judgment, throughout the planning and performance of the audit.

It was inappropriate for Jones to hire the two students to conduct the audit, because they do not have appropriate competence and capabilities.   In order to comply with ethical requirements, Jones must be without bias with respect to the client under audit. Because of the financial interest in whether the bank loan is granted to Boucher, Jones is not independent in either fact or appearance with respect to the assignment undertaken.   Neither Jones nor her two assistants exercised professional skepticism or professional judgment in performing the audit.

Performance: The auditor must obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. To do so, the auditor must plan the work and supervise any assistants; determine an appropriate materiality level; identify and assess risks of material misstatement based on an understanding of the entity and its environment, including its internal control; and obtain sufficient appropriate audit evidence about whether misstatements exist. The auditor is unable to obtain absolute assurance that the financial statements are free from material misstatements.

Jones failed to supervise the assistants. The work performed was not adequately planned.   Jones did not study the client or its environment, including internal control, nor did the assistants. Consequently, she could not have identified risks of material misstatements.   Jones acquired little evidence that would support the fairness of the financial statements. Jones merely checked the mathematical accuracy of the records and summarized the accounts. Several standard audit procedures and techniques were neglected.

 

Reporting: Based on an evaluation of the audit evidence obtained, the auditor expresses an opinion in accordance with the auditor’s findings, or states that an opinion cannot be expressed. The opinion states whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.

Although Jones’ report contains an expression of opinion, her opinion is not based on the results of a proper audit examination. Jones should disclaim an opinion because she failed to conduct an examination in accordance with generally accepted auditing standards.   Jones’ opinion made no reference to the applicable financial reporting framework. Also, since the financial statements did not contain adequate disclosures, they could not have been in accordance with any financial reporting framework.

 

 

Solutions to Discussion Cases

 

2-26    Merry-Go-Round Part I.

 

1. EY is alleged to have violated the Principles of responsibilities and performance.

• The firm is alleged to have violated the Principle of responsibilities in the sense that it appeared that the staff assigned to the engagement did not have sufficient training or experience for the engagement. EY’s relationship with MGR’s landlords and attorneys likely caused them to violate this Principle, which requires compliance with relevant ethical requirements.
• Poor staff assignments, the leader’s vacation, and the use of inexperienced personnel all suggest that the engagement was not adequately planned and that assistants were not properly supervised, which violates the Principle of performance. Also, the inadequate nature of EY’s recommendations suggests that they likely did not gain a sufficient understanding of the entity and its operations.

 

1. There are arguments both for and against having formal standards for CPAs who consult. Advantages include potential increase in public trust, some assurance that a minimal level of service quality would be attained, and perhaps more guidance for consultants (to allow them to perform more effective consulting engagements). The primary disadvantage would result from the fact that CPAs who consult compete with consulting firms comprised of non-CPAs. If standards were not thought out carefully, perhaps the standards would put CPAs at a disadvantage relative to non-CPAs in the sense that CPAs would be subject to standards that constrain their activities or perhaps result in their not being able to compete with non-CPAs in the area of fees. Note that CPAs face certain restrictions in providing consulting services to audit clients. These restrictions are covered in a later chapter.

 

 

 

2-27     Merry-Go-Round Part II.

 

1. In one sense, EY acted unethically. That is, it should have disclosed the nature of these relationships to MGR. In another sense, it is difficult to ascertain whether these relationships caused EY to act unethically. Specifically, was EY’s advice affected by its relationship with the landlord? Is this relationship the reason that EY’s cost-cutting suggestions did not go farther? These questions point out the importance of independence in fact and appearance, even when acting in a consulting capacity. Even if EY acted ethically, this relationship creates the appearance of impropriety.

 

1. As mentioned in Part a, the relationship with Rouse could have caused EY to hesitate to suggest that the stores for which Rouse was the landlord be closed for fear of losing business from Rouse. Its relationship with Swidler could have made EY feel that it could not lose the engagement under any circumstances, thereby possibly explaining its apparently lackadaisical attitude towards the engagement.

 

Solutions to Internet Assignments

 

2-28     A search of the GAO’s homepage will identify recent audits conducted by this agency.

 

2-29    a. According to its website, the AICPA’s mission is to “provide members with the resources, information, and leadership that enable them to provide valuable services in the highest professional manner to benefit the public as well as employers and clients.”

 

1. The SEC’s website states that its mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” It goes on to emphasize that its purpose is to promote and sustain economic growth. The site also mentions that the SEC promotes the disclosure of important market information, maintains fair dealings, protects against fraud, and enforces its authority.

 

1929. During the 1920s, many people began investing heavily in the stock market without fully thinking about the risk that they were taking upon themselves. As a result of poor investment choices and unreliable information, the stock market crashed in 1929. In an attempt to restore confidence in the capital markets, Congress passed the Securities Act of 1933. One year later, the SEC was created by the Securities Exchange Act of 1934.

 

1. The PCAOB’s website provides information on the Board’s organization, policies, and standards. It also indicates that the Board uses an expert advisory group to help the Board develop standards. Though many observers dispute this claim, the Board asserts that its standards are also developed in an open, public process to allow all parties of interest to comment. Section 103 of the Sarbanes-Oxley Act empowers the PCAOB to set auditing standards for audits of public companies.

 

The Dodd-Frank Act amended the Sarbanes-Oxley Act to give the PCAOB the authority to establish auditing and related professional practice standards for audits of the financial statements and selected practices and procedures of broker-dealers. The Board’s Office of the Chief Auditor is responsible for developing these standards.

 

1978. The International Auditing Practices Committee (IAPC) was founded in 1978. During its first meeting, the group agreed to issue its publications as guidelines rather than standards. The IAPC’s initial work focused on three areas: object and scope of audits of financial statements, engagement letters, and general auditing guidelines. During this initial meeting, the IAPC also agreed to respond to a request from the International Accounting Standards Committee (IASC) chairman and Governors of the Central Banks to develop guidance on inter-bank confirmations.

 

In 1988, the IAPC approved the release of The Auditor’s Report on Financial Statements guidelines. It later developed final guidelines on three key subjects: related parties, going concern, and management representations.

 

In 1985, Chairman Justin Fryer called on the IAPC to act in the interests of the public. He also called on the IAPC to resolve differences in auditing standards where differences exist in different countries and to establish a single set of international standards. The IAPC recognized that a fundamental way to protect the public interest was to require the application of a core set of internationally recognized auditing and assurance standards.

 

IFAC was among the first organizations to refer to international auditing guidelines in its own financial statements. In 1991, the IAPC pro­posed to IFAC member bodies that the term “guidelines” be replaced with “stand­ards.” With that, International Standards on Auditing, or ISAs, were born.

 

In 2001, IAPC was renamed as the International Auditing and Assurance Standards Board (IAASB). The IAASB then embarked on its first joint project with a national standard setter, the AICPA, which resulted in the development of the suite of audit risk standards.

 

In 2003, IFAC approved a series of reforms designed to strengthen the IAASB’s standard-setting processes so that it are properly responsible to the public interest. By 2007, the IAASB had become arguably the most transparent auditing standard setter in the world.

 

To encourage greater use of its standards and facilitate transla­tion, in 2004 the IAASB launched a project designed to improve the clarity of its pro­nouncements. It revised its drafting conventions to make the ISAs more readily understood. By the end of 2008, the IAASB had approved all final redrafted auditing standards. The IAASB is currently working on revising its standards for assurance engagements other than audits.

 

1. The IASB is the independent accounting standard-setting body of the IFRS Foundation. The IASB is composed of 16 experts with an appropriate mix of recent practical experience in setting accounting standards, in preparing, auditing, or using financial reports, and in accounting education. The IASB is advised by the IFRS Advisory Council which, along with the IASB, is overseen by the IFRS Foundation trustees. The IFRS Foundation is overseen by a monitoring board of public capital market authorities.

 

The IFRS Foundation is a not-for-profit, private sector body that raises funds to support the operations of the IASB as an independent accounting standard setter. Mandatory levies are issued for listed and non-listed companies in a growing number of countries. The Foundation strives to ensure that its financial support is broad based.

 

The IASB is responsible for the development and publication of IFRSs and for approving Interpretations of IFRSs as developed by the IFRS Interpretations Committee. All meetings of the IASB are held in public and are broadcast through the internet. In fulfilling its standard-setting duties, the IASB follows a thorough, open and transparent process of which the publication of consultative documents, such as discussion papers and exposure drafts for public comment is an important component. The IASB engages closely with stakeholders around the world, including investors, analysts, regulators, business leaders, accounting standard-setters, and the accountancy profession.

 

The SEC has not yet reached a decision as to how, or even whether, the U.S. will adopt IFRS. Currently, the FASB is working to converge many of its standards with those of the IASB. For example, the FASB’s guidance on fair value measurement is largely identical to guidance issued by the IASB. The FASB is currently working on converging its standards regarding revenue recognition, financial instruments, and lease accounting to be more in line with IFRS.