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Chapter 1
The Demand for Audit and Other Assurance Services
Review Questions
1-1 The relationship among audit services, attestation services, and assurance services is reflected in Figure 1-3 on page 13 of the text. An assurance service is an independent professional service to improve the quality of information for decision makers. An attestation service is a form of assurance service in which the CPA firm issues a report about the reliability of an assertion that is the responsibility of another party. Audit services are a form of attestation service in which the auditor expresses a written conclusion about the degree of correspondence between information and established criteria. The most common form of audit service is an audit of historical financial statements, in which the auditor expresses a conclusion as to whether the financial statements are presented in conformity with generally accepted accounting principles. An example of an attestation service is a report on the effectiveness of an entity’s internal control over financial reporting. There are many possible forms of assurance services, including services related to business performance measurement, health care performance, and information system reliability.
1-2 An independent audit is a means of satisfying the need for reliable information on the part of decision makers. Factors of a complex society which contribute to this need are:
- Remoteness of information a. Owners (stockholders) divorced from management b. Directors not involved in day-to-day operations or decisions c. Dispersion of the business among numerous geographic locations and complex corporate structures
- Biases and motives of provider a. Information will be biased in favor of the provider when his or her goals are inconsistent with the decision maker's goals.
- Voluminous data a. Possibly millions of transactions processed daily via sophisticated computerized systems b. Multiple product lines c. Multiple transaction locations
- Complex exchange transactions a. New and changing business relationships lead to innovative accounting and reporting problems b. Potential impact of transactions not quantifiable, leading to increased disclosures
1-3 1. Risk-free interest rate This is approximately the rate the bank could earn by investing in U.S. treasury notes for the same length of time as the business loan.
- Business risk for the customer This risk reflects the possibility that the business will not be able to repay its loan because of economic or business conditions such as a recession, poor management decisions, or unexpected competition in the industry.
- Information risk This risk reflects the possibility that the information upon which the business risk decision was made was inaccurate. A likely cause of the information risk is the possibility of inaccurate financial statements.
Auditing has no effect on either the risk-free interest rate or business risk. However, auditing can significantly reduce information risk.
1-4 The four primary causes of information risk are remoteness of information, biases and motives of the provider, voluminous data, and the existence of complex exchange transactions. The three main ways to reduce information risk are:
- User verifies the information.
- User shares the information risk with management.
- Audited financial statements are provided. The advantages and disadvantages of each are as follows:
ADVANTAGES DISADVANTAGES
USER VERIFIES
INFORMATION
- User obtains information desired.
- User can be more confident of the qualifications and activities of the person getting the information. 1. High cost of obtaining information. 2. Inconvenience to the person providing the information because large number of users would be on premises. USER SHARES INFORMATION RISK WITH MANAGEMENT
- No audit costs incurred. 1. User may not be able to collect on losses.
AUDITED
FINANCIAL
STATEMENTS
ARE PROVIDED
- Multiple users obtain the information.
- Information risk can usually be reduced sufficiently to satisfy users at reasonable cost.
- Minimal inconvenience to management by having only one auditor. 1. May not meet needs of certain users. 2. Cost may be higher than the benefits in some situations, such as for a small company.
OPERATIONAL
AUDITS
COMPLIANCE
AUDITS
AUDITS OF
FINANCIAL
STATEMENTS
PURPOSE To evaluate whether operating procedures are efficient and effective
To determine whether the client is following specific procedures set by higher authority
To determine whether the overall financial statements are presented in accordance with specified criteria (usually GAAP) USERS OF AUDIT REPORT
Management of organization
Authority setting down procedures, internal or external
Different groups for different purposes — many outside entities NATURE Highly nonstandard; often subjective
Not standardized, but specific and usually objective
Highly standardized
PERFORMED
BY:
CPAs Frequently Occasionally
Almost universally
GAO AUDITORS Frequently Frequently Occasionally
IRS AUDITORS Never Universally Never INTERNAL AUDITORS Frequently Frequently Frequently
1-9 Five examples of specific operational audits that could be conducted by an internal auditor in a manufacturing company are:
- Examine employee time cards and personnel records to determine if sufficient information is available to maximize the effective use of personnel.
- Review the processing of sales invoices to determine if it could be done more efficiently.
- Review the acquisitions of goods, including costs, to determine if they are being purchased at the lowest possible cost considering the quality needed.
1-9 (continued)
- Review and evaluate the efficiency of the manufacturing process.
- Review the processing of cash receipts to determine if they are deposited as quickly as possible.
1-10 When auditing historical financial statements, an auditor must have a thorough understanding of the client and its environment. This knowledge should include the client’s regulatory and operating environment, business strategies and processes, and measurement indicators. This strategic understanding is also useful in other assurance or consulting engagements. For example, an auditor who is performing an assurance service on information technology would need to understand the client’s business strategies and processes related to information technology, including such things as purchases and sales via the Internet. Similarly, a practitioner performing a consulting engagement to evaluate the efficiency and effectiveness of a client’s manufacturing process would likely start with an analysis of various measurement indicators, including ratio analysis and benchmarking against key competitors.
1-11 The major differences in the scope of audit responsibilities are:
- CPAs perform audits in accordance with auditing standards of published financial statements prepared in accordance with generally accepted accounting principles.
- GAO auditors perform compliance or operational audits in order to assure the Congress of the expenditure of public funds in accordance with its directives and the law.
- IRS agents perform compliance audits to enforce the federal tax laws as defined by Congress, interpreted by the courts, and regulated by the IRS.
- Internal auditors perform compliance or operational audits in order to assure management or the board of directors that controls and policies are properly and consistently developed, applied and evaluated.
1-12 The four parts of the Uniform CPA Examination are: Auditing and Attestation, Financial Accounting and Reporting, Regulation, and Business Environment and Concepts.
1-13 It is important for CPAs to be knowledgeable about e-commerce technologies because more of their clients are rapidly expanding their use of e-commerce. Examples of commonly used e-commerce technologies include purchases and sales of goods through the Internet, automatic inventory reordering via direct connection to inventory suppliers, and online banking. CPAs who perform audits or provide other assurance services about information generated with these technologies need a basic knowledge and understanding of information technology and e-commerce in order to identify and respond to risks in the financial and other information generated by these technologies.
1-17 (continued)
LENDER
CPA
SERVICE
COST OF CPA
SERVICES
ANNUAL
INTEREST
ANNUAL
LOAN COST
Existing loan None 0 $ 332,500 $ 332, First National Bank Review $ 20,000 $ 297,500 $ 317, City First Bank Audit $ 45,000 $ 262,500 $ 307,
c. Vial-tek should select the loan from First National Bank due to the higher cost of the audit and the reduced interest rate for the loan from First National Bank. The following is the calculation of total costs for each loan:
LENDER
CPA
SERVICE
COST OF CPA
SERVICES
ANNUAL
INTEREST
ANNUAL
LOAN COST
Existing loan None 0 $ 332,500 $ 332, First National Bank Review $ 20,000 $ 280,000 $ 300, City First Bank Audit $ 50,000 $ 262,500 $ 312,
d. Vial-tek may desire to have an audit because of the many other positive benefits that an audit provides. The audit will provide Vial- tek’s management with assurance about annual financial information used for decision-making purposes. The audit may detect errors or fraud, and provide management with information about the effectiveness of controls. In addition, the audit may result in recommendations to management that will improve efficiency or effectiveness.
e. The auditor must have a thorough understanding of the client and its environment, including the client’s e-commerce technologies, industry, regulatory and operating environment, suppliers, customers, creditors, and business strategies and processes. This thorough analysis helps the auditor identify risks associated with the client’s strategies that may affect whether the financial statements are fairly stated. This strategic knowledge of the client’s business often helps the auditor identify ways to help the client improve business operations, thereby providing added value to the audit function.
1-18 a. The services provided by Consumers Union are very similar to assurance services provided by CPA firms. The services provided by Consumers Union and assurance services provided by CPA firms are designed to improve the quality of information for decision makers. CPAs are valued for their independence, and the reports provided by Consumers Union are valued because Consumers Union is independent of the products tested.
1-18 (continued)
b. The concepts of information risk for the buyer of an automobile and for the user of financial statements are essentially the same. They are both concerned with the problem of unreliable information being provided. In the case of the auditor, the user is concerned about unreliable information being provided in the financial statements. The buyer of an automobile is likely to be concerned about the manufacturer or dealer providing unreliable information.
c. The four causes of information risk are essentially the same for a buyer of an automobile and a user of financial statements: (1) Remoteness of information It is difficult for a user to obtain much information about either an automobile manufacturer or the automobile itself without incurring considerable cost. The automobile buyer does have the advantage of possibly knowing other users who are satisfied or dissatisfied with a similar automobile. (2) Biases and motives of provider There is a conflict between the automobile buyer and the manufacturer. The buyer wants to buy a high quality product at minimum cost whereas the seller wants to maximize the selling price and quantity sold. (3) Voluminous data There is a large amount of available information about automobiles that users might like to have in order to evaluate an automobile. Either that information is not available or too costly to obtain. (4) Complex exchange transactions The acquisition of an automobile is expensive and certainly a complex decision because of all the components that go into making a good automobile and choosing between a large number of alternatives.
d. The three ways users of financial statements and buyers of automobiles reduce information risk are also similar: (1) User verifies information him or herself That can be obtained by driving different automobiles, examining the specifications of the automobiles, talking to other users and doing research in various magazines. (2) User shares information risk with management The manufacturer of a product has a responsibility to meet its warranties and to provide a reasonable product. The buyer of an automobile can return the automobile for correction of defects. In some cases a refund may be obtained. (3) Examine the information prepared by Consumer Reports This is similar to an audit in the sense that independent information is provided by an independent party. The information provided by Consumer Reports is comparable to that provided by a CPA firm that audited financial statements.
1-20 a. The following parts of the definition of auditing are related to the narrative: (1) Haraldsson is being asked to issue a report about qualitative and quantitative information for the buses. The buses and their value are therefore the information with which she is concerned. (2) There are four established criteria which must be evaluated and reported by Haraldsson: existence of the buses on the night of August 31, 2008, ownership of each bus by Danville Bus Services, physical condition of each bus and fair market value of each bus. (3) Annaliese Haraldsson will accumulate and evaluate four types of evidence : (e) Count the buses to determine their existence. (f) Use registrations documents held by Olson for comparison to the serial number on each bus to determine ownership. (g) Examine the buses to determine each bus's physical condition. She can examine the bus’s condition herself or hire an expert to do so. (h) Examine the blue book to determine the fair market value of each bus. (4) Annaliese Haraldsson, CPA, appears qualified, as a competent, independent person. She is a CPA, and she spends most of her time auditing used automobile, bus, and truck dealerships, and has experience that is consistent with the nature of the engagement. (5) The report results are to include: (i) which of the 20 buses are parked in Danville's parking lot the night of August 31. (j) whether all of the buses are owned by Danville Bus Services. (k) the condition of each bus, using established guidelines. (l) fair market value of each bus using the current blue book for buses. b. The only parts of the audit that will be difficult for Haraldsson are: (1) Evaluating the condition, using the guidelines of poor, good, and excellent. It is highly subjective to do so. One method is to find the “blue book” value. (Note: Kelley Blue Book is a United States automotive vehicle valuation company that gives used vehicle pricing information. Because of its popularity, the term “blue book” has become synonymous with the car’s market value.) If she uses a different criterion than the "blue book," the fair market value will not be meaningful. Her experience will be essential in using this guideline.
(2) Determining the fair market value, unless it is clearly defined in the blue book for each condition.
1-21 a. The major advantages and disadvantages of a career as an CAO auditor, tax authority agent, CPA, or internal auditor are:
EMPLOYMENT ADVANTAGES DISADVANTAGES CAO AUDITOR 1. Increasing opportunity for experience in operational auditing.
- Exposure to highly sophisticated statistical sampling and computer auditing techniques. 1. Possibility of limited exposure to diversity of enterprises and industries. 2. Bureaucracy of federal government.
TAX AUTHORITY AGENT
- Extensive training in individual, corporate, gift, trust and other taxes is available with concentration in area chosen.
- Hands-on experience with sophisticated selection techniques. 1. Experience limited to taxes. 2. No experience with operational or financial statement auditing. 3. Training is not extensive with any business enterprise. CPA 1. Extensive training in audit of financial statements, compliance auditing and operational auditing.
- Opportunity for experience in auditing, tax consulting, and management consulting practices.
- Experience in a diversity of enterprises and industries with the opportunity to specialize in a specific industry.
- Experience with risk assessment and sampling techniques 1. Exposure to taxes and to the business enterprise may not be as in-depth as the internal revenue agent or the internal auditor. 2. Likely to be less exposed to operational auditing than is likely for internal auditors.
INTERNAL AUDITOR
- Extensive exposure to all segments of the enterprise with which employed.
- Constant exposure to one industry presenting opportunity for expertise in that industry.
- Likely to have exposure to compliance, financial and operational auditing. 1. Little exposure to taxation and the audit thereof. 2. Experience is limited to one enterprise, usually within one or a limited number of industries.
Internet Problem 1-1 (continued)
Answer: According to Section 404 the two required elements of management’s report on internal control are:
a. a statement that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting. b. an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.
- What obligation does a public company’s auditor have with respect to internal control over financial reporting according to Section 404?
Answer: With respect to the internal control assessment prepared by management, the company’s auditing firm that prepares or issues the audit report for the company shall attest to, and report on, the assessment made by the management of the issuer. Section 404 indicates that the attestation should not be a separate engagement, which means that it is to be integrated with the audit of the financial statements.
( Note : Internet problems address current issues using Internet sources. Because Internet sites are subject to change, Internet problems and solutions may change. Current information on Internet problems is available at www.pearsonglobaleditions.com/arens).
Chapter 2
The CPA Profession
Concept Checks
P. 54
- The four major services that CPAs provide are:
a. Audit and assurance services Assurance services are independent professional services that improve the quality of information for decision makers. Assurance services include attestation services, which are any services in which the CPA firm issues a report that expresses a conclusion about the reliability of an assertion that is the responsibility of another party. The four categories of attestation services are audits of historical financial statements, attestation on the effectiveness of internal control over financial reporting, reviews of historical financial statements, and other attestation services. b. Accounting and bookkeeping services Accounting services involve preparing the client’s financial statements from the client’s records. Bookkeeping services include the preparation of the client’s journals and ledgers as well as financial statements. c. Tax services Tax services include preparation of corporate, individual, and estate returns as well as tax-planning assistance. d. M anagement consulting and risk advisory services These services range from suggestions to improve the client’s accounting system to advice on risk management or on computer installations.
- The six organizational structures available to CPA firms are proprietorship, general partnership, general corporation, professional corporation, limited liability company, and limited liability partnership. CPA firms are typically not organized as a general partnership because a general partnership offers less protection from legal liability relative to other structures such as a limited liability partnership.
P. 63
- The Public Company Accounting Oversight Board provides oversight for auditors of public companies, including establishing auditing and quality control standards for public company audits, and performing inspections of the quality controls at audit firms performing those audits.
2-2 The Public Company Accounting Oversight Board (PCAOB) provides oversight for auditors of public companies, including establishing auditing and quality control standards for public company audits, and performing inspections of the quality controls at audit firms performing those audits.
2-3 The purpose of the Securities and Exchange Commission is to assist in providing investors with reliable information upon which to make investment decisions. Since most reasonably large CPA firms have clients that must fi le reports with the SEC each year (all companies filing registration statements under the securities acts of 1933 and 1934 must file audited financial statements and other reports with the SEC at least once each year), the profession is highly involved with the SEC requirements. The SEC has considerable influence in setting generally accepted accounting principles and disclosure requirements for financial statements because of its authority for specifying reporting requirements considered necessary for fai r disclosure to investors. In addition, the SEC has power to establish rules for any CPA associated with audited financial statements submitted to the Commission.
2-4 The document provides a framework for attest engagements, including detailed standards for specific types of attestation engagements for auditors to follow.
2-5 The local auditing and assurance standards body has the responsibility of establishing auditing standards for public companies and private companies. In Malaysia, this is a job for the Malaysian Auditing and Assurance Standards Board (AASB).
2-6 International Standards on Auditing (ISAs) are issued by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) and are designed to improve the uniformity of auditing practices and related services throughout the world. The IAASB issues pronouncements on a variety of audit and attest functions and promotes their acceptance worldwide. As a result of efforts by the Auditing Standards Board to converge U.S. GAAS with international standards, AICPA auditing standards and International Standards on Auditing are similar in most respects.
2-7 Auditing standards represent pronouncements by any of the organizations responsible for setting auditing standards. In the U.S. these standards are set by the PCAOB for public companies and broker dealers, and by the Auditing Standards Board of the AICPA for other entities. Examples of auditing standards include any of the SASs (e.g., SAS No. 125), covering topics such as audit planning or assessing the risk of material misstatement. Generally accepted accounting principles are specific rules for accounting for transactions occurring in a business enterprise. Examples may be any of the opinions of the FASB , such as accounting for leases, pensions, or fair value assets.
2-8 Auditors develop their competency and capabilities for performing an audit through formal education in auditing and accounting, adequate practical experience, and continuing professional education. Auditors can demonstrate their proficiency by becoming licensed to practice as CPAs, which requires successful completion of the Uniform CPA Examination. The specific requirements for licensure vary from state to state.
2-9 For the most part, auditing standards, including SASs, are general rather than specific. Many practitioners along with critics of the profession believe the standards should provide more clearly defined guidelines as an aid in determining the extent of evidence to be accumulated. This would eliminate some of the difficult audit decisions and provide a source of defense if the CPA is charged with conducting an inadequate audit. On the other hand, highly specific requirements could turn auditing into mechanical evidence gathering, void of professional judgment. From the point of view of both the profession and the users of auditing services, there is probably a greater harm from defining authoritative guidelines too specifically than too broadly.
2-10 Quality controls are the procedures used by a CPA firm that help it meet its professional responsibilities to clients. Quality controls are therefore established for the entire CPA firm as opposed to individual engagements.
2-11 The element of quality control is personnel management. The purpose of the requirement is to help assure CPA firms that all new personnel are qualified to perform their work competently. A CPA firm must have competent employees conducting the audits if quality audits are to occur.
2-12 A peer review is a review, by CPAs, of a CPA firm’s compliance with its quality control system. A mandatory peer review means that such a review is required periodically. AICPA member firms are required to have a peer review every three years. Registered firms with the PCAOB are subject to quality inspections. These are different than peer reviews because they are performed by independent inspection teams rather than another CPA firm. Peer reviews can be beneficial to the profession and to individual firms. By helping firms meet quality control standards, the profession gains if reviews result in practitioners doing higher quality audits. A firm having a peer review can also gain if it improves the firm’s practices and thereby enhances its reputation and effectiveness, and reduces the likelihood of lawsuits. Of course , peer reviews are costly. There is always a trade-off between cost and benefits.
2-14 a. Acceptance and continuation of clients and engagements b. Leadership responsibilities c. Monitoring d. Engagement performance e. Engagement performance f. Engagement performance g. Engagement performance h. Relevant ethical requirement i. Human resources j. Human resources
2-15 a. The International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) is responsible for issuing International Standards on Auditing (ISAs). The ISAs do not override a specific country’s regulations governing the audit of financial statements. b. The AICPA Auditing Standards Board (ASB) is responsible for issuing standards in the U.S. to be used by auditors when auditing the financial statements of all entities other than U.S. publicly traded companies. The Public Company Accounting Oversight Board (PCAOB) is responsible for issuing standards to be used by auditors when auditing a U.S. public company or other entities registered with the SEC (e.g., broker-dealers). c. The ASB has revised most of its standards to converge them with the international standards. As a result, U.S. standards are mostly consistent with international standards, except for certain requirements that reflect unique characteristics of the U.S. environment. d. When developing a new SAS, the ASB uses the ISAs as the base standard and then modifies that base standard only when appropriate for the U.S. environment. e. The PCAOB develops and issues its standards. While the PCAOB considers existing international standards, it does not start with the ISA standard as the base. f. When conducting an audit of a client that is listed on both a foreign stock exchange and a U.S. stock exchange, the auditor would have to satisfy both the relevant international auditing standards as well as the PCAOB auditing standards. This does not mean the auditor conducts two separate audits, but rather their procedures must satisfy both sets of standards, which will be similar in many ways but may also require the auditor to perform additional procedures required by one, but not the other, set of standards.
2-16 a. Egyptian auditing standards. b. Genovian auditing standards. c. Hong Kong auditing standards. d. PCAOB auditing standards (reporting in Japan will be under international auditing standards). e. U.S. generally accepted auditing standards. f. UK auditing standards. g. International auditing standards. h. International auditing standards.
2-
BRIEF DESCRIPTION OF PRINCIPLE
HOLMES’ ACTIONS RESULTING IN FAILURE TO COMPLY WITH PRINCIPLE
RESPONSIBILITIES PRINCIPLES
The auditor must possess the competency and capabilities to perform the audit.
It was inappropriate for Holmes to hire the two students to conduct the audit. The audit must be conducted by persons with proper education and experience in the field of auditing. Although junior assistants may not have completed their formal education, they may help in the conduct of the audit as long as there is proper supervision and review.
The auditor must comply with ethical requirements, which include maintaining independence in mental attitude in all matters relating to the audit.
To satisfy this principle, Holmes must be without bias with respect to the client under audit. Holmes has an obligation for fairness to the owners, management, and creditors who may rely on the report. Because of the financial interest in whether the bank loan is granted to Ray, Holmes is independent in neither fact nor appearance with respect to the assignment undertaken.
The auditor must maintain professional skepticism and exercise professional judgment in the performance of the audit and the preparation of the report.
This principle requires Holmes to perform the audit with due care, which imposes on Holmes and everyone in Holmes’ organization a responsibility to observe the principles of performance and reporting. Maintaining professional skepticism and exercising professional judgment require critical review at every level of supervision of the work done and the judgments exercised by those assisting in the audit. Holmes did not review the work or the judgments of the assistants and clearly failed to adhere to this standard.
