Type:
Solution Manual
Resource:
Auditing A Practical Approach
Edition:
4th Edition
Author(s):
Robyn Moroney
Moroney, Campbell, Hamilton, Warren
Auditing: A Practical Approach, Fourth Canadian Edition
Chapter 1 Introduction and Overview of Audit and Assurance SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 1.1 In the financial reporting context, “assurance” relates to the audit or review of an entity’s financial statements. An audit provides reasonable assurance about the fair presentation of the financial statements, while a review provides limited assurance. The audit contains a positive expression of opinion (e.g., ”in our opinion the accompanying financial statements present fairly, in all material respects….”, while the review contains a negative expression of their conclusion (e.g., “nothing has come to our attention that causes us to believe that the financial statements do not present fairly….”. The practitioner is an auditor working in public practice providing assurance on financial statements of publicly listed companies, or other entities. Intended users are the people for whom the provider prepares their report (e.g., the shareholders). The responsible or accountable party is the person or organization (e.g., a company) responsible for the preparation of the subject matter (e.g., the financial statements). An “assurer” must have the knowledge and expertise to assess the fairness of the information being presented by the preparers. Auditors of financial statements need to be trained accountants with detailed knowledge about the complex technical accounting and disclosure issues required to assess the choices made by the financial statement preparers. When undertaking an audit, the auditor should use professional scepticism, professional judgement, and due care. Auditors should be independent of the client. Independent auditors have no incentives to aid the entity in presenting their results in the best possible light. They are concerned with ensuring that the information contained in the financial statements is reliable and free from any significant (material) misstatements (error or fraud). A user needs to believe that the auditor is acting independently. This means that not only should auditors be independent (i.e., not have any undue personal or financial incentive to protect the client), auditors should avoid doing anything that would cause a reasonable person to doubt their independence.
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Auditing: A Practical Approach, Fourth Canadian Edition
REVIEW QUESTION 1.2 The users of the financial statements issued by a large listed public company include shareholders, customers, suppliers, employees, lenders, competitors, and government agencies. They need information that will help them evaluate the following: • Future financial performance of the company (including profitability, liquidity, and solvency • Whether the company has overseas operations and the nature of their activities in those countries (e.g., to evaluate exposure to foreign exchange risk and the risk to the company due to a change in local economic conditions) • Possible lack of compliance with various laws and regulations, whether the company (and its industry) need government support. • Investors are concerned with the value of their investment, employees with their job security, customers with whether the company is likely to remain in business long enough to honour warranties, suppliers with whether they will be paid, lenders with the risk to their loans, competitors with the health of their rivals, and government agencies will be interested in taxes, tariffs, industry support, and economic growth. Users of a sporting team’s financial statements are likely to be interested in the following: • Condition and performance of the team (its solvency) • Whether it is investing in physical facilities, player payments, etc. • Whether the sporting team supports local businesses and community groups. Although sports teams are often companies limited by guarantee and have members, the members are usually unable to trade their interest in the team. Therefore, users of a sporting team’s financial statements are not concerned about profitability for its own sake, but whether it helps the team pay its players and expand its facilities. Creditors and lenders will be interested in the likelihood that they will be repaid. Government will be interested with sporting and community concerns, and whether any applicable taxes are being paid. REVIEW QUESTION 1.3 Audits are intended to provide the users of the audit report with a positive expression of opinion regarding the financial statements. An audit is performed using a risk-based approach in order to perform procedures to obtain sufficient and appropriate audit evidence to reduce the audit risk to an acceptably low level. However, an auditor cannot review 100% of the transactions of an organization, and for that reason, while they can provide an opinion, they cannot provide absolute assurance. Other limitations include the use of professional judgement, human error, or even fraudulent activities from responsible parties or in some cases perhaps even the auditor.
REVIEW QUESTION 1.4 A performance audit (value for money audit, operational audit, or efficiency audit) is an assessment of the economy, efficiency, and effectiveness of an organization’s operations. It can be conducted internally (by internal audit) or externally (by an audit firm) and across the entire organization or for part of an organization.
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Auditing: A Practical Approach, Fourth Canadian Edition
Management may request a performance audit (operational audit) of its own company (or part thereof) in order to assess the economy, efficiency, and effectiveness of the organization. Ideally, the audit would identify issues that need to be addressed in order to increase the performance of the division or company. For example, the audit could examine a logistics department. It would assess the cost of running the department, the number of deliveries per input (such as labour hours or vehicle hours), and indicators of delivery on time to the correct address. A performance audit could be conducted on a government department or agency as part of the process of accountability to the public. Stakeholders of government entities are usually seen to be more interested in economy, efficiency, and effectiveness than in profit, or surplus. Performance auditing can expose poor practices, or even corruption, in an organization. Performance auditing can provide information on the implementation of government policies. Regular performance auditing of government entities can help build trust between the government and its citizens. REVIEW QUESTION 1.5 Internal auditors are employees of the company, and therefore cannot be completely independent of the company. However, it is possible to increase the independence of the internal audit department through means such as funding, terms of reference, and lines of reporting. A well-funded internal audit department can investigate more issues and spend more time on each investigation, potentially increasing the chance of discovering fraud and other problems. An internal audit department with a small budget is likely to have fewer and less qualified staff (because they will be lower paid), and will have to make compromises on the issues to be investigated. An internal audit department with wide terms of reference has the freedom to pursue the issues that the audit staff believe are most important or create the most risk for the organization. A department with narrow terms of reference could be limited to investigating only certain matters, or must seek the approval of higher levels of management before commencing any investigation. If the internal audit department reports to the CFO, it is possible that the CFO will prevent some issues from reaching other members of the management team, or the board of directors. Often, the problems will be within the CFO’s department, creating a conflict of interest for the CFO when deciding whether to report the issue more widely. An internal audit department that reports directly to the audit committee is outside the normal lines of management and reporting, thus being more independent. The audit committee is part of the board of directors. Therefore, reporting to the audit committee increases the chance that the highest level of the organization is aware of the problems and will approve the investigation. The audit committee also deals with the external auditor. If the internal auditor reports directly to the audit committee, it can communicate the issues to the external auditor and ask them to consider them, where relevant, as part of the financial statement audit.
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Not all companies have an audit committee. Where the audit committee does not exist, the internal auditor could report directly to the full board of directors.
REVIEW QUESTION 1.6 Reasonable assurance is provided when an auditor provides a positive opinion, after obtaining sufficient and appropriate audit evidence, that the subject matter is fairly presented. Audits can be performed on a variety of subject matters; however, the most common is financial information in the form of financial statements. Reasonable assurance provides a high level of assurance on the reliability of the subject matter; however, because of its inherent limitations, it cannot provide absolute assurance. Those limitations include the use of professional judgement used in order to bring the audit risk to an acceptably low level as well as the fact that an auditor cannot review 100% of the subject matter. The assurance is generally provided in the form of an opinion in an audit report. (See 1.5 Different Audit Opinions for further details).
REVIEW QUESTION 1.7 As defined in CAS 706 para. 7, an emphasis of matter paragraph means “A paragraph included in the auditor’s report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements.”
An emphasis of matter paragraph draws the attention of the reader to an issue that the auditor believes has been adequately and accurately explained in a note to the financial statements. The purpose of the paragraph is to ensure that the reader pays appropriate attention to the issue when reading the financial statements. The audit report remains unmodified and the user of the financial statements can still rely on the information contained in the financial statements. The usual circumstance that would warrant an emphasis of matter paragraph in the auditor’s report is the existence of a significant uncertainty, the resolution of which may materially affect the financial statements. From CAS 706: A4. Examples of circumstances where the auditor may consider it necessary to include an emphasis of matter paragraph are: • An uncertainty relating to the future outcome of exceptional litigation or regulatory action. • A significant subsequent event that occurs between the date of the financial statements and the date of the auditor’s report. • Early application (where permitted) of a new accounting standard (for example, a new Canadian generally accepted accounting principle) that has a material effect on the financial statements. • A major catastrophe that has had, or continues to have, a significant effect on the entity’s financial position.
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CAS 706 stresses that the inclusion of an emphasis of matter paragraph in the auditor’s report does not affect the auditor’s opinion. An emphasis of matter can be included in an unmodified auditor’s report or a qualified auditor’s report (see appendices 3 and 4 in CAS 706).
REVIEW QUESTION 1.8 As there are many users relying on the opinion in an audit report, an auditor has responsibilities when providing such an opinion. The auditor’s responsibilities include professional scepticism, professional judgement, and due care. Professional scepticism is demonstrated when an auditor keeps a questioning mind. For example, an auditor should not only rely on management assertions as there could be bias present; therefore, the auditor should obtain other corroborative evidence in order to conclude that management representations are reasonable. An auditor has the responsibility to exercise professional judgement. They should use their expertise, knowledge, and training. Past experiences as well as instinct should not be ignored. If they feel they lack the professional judgement required, an auditor should take appropriate action such as finding the appropriate expertise or not accepting the engagement. Due care is exercised by an auditor by being diligent, applying technical and statute-backed standards, and by thoroughly documenting the work performed. REVIEW QUESTION 1.9 The audit expectation gap occurs when there is a difference between the expectations of assurance providers and financial statement users. The gap occurs when user beliefs do not align with what an auditor has actually done. In particular, the gap is caused by unrealistic user expectations, such as: • The auditor is providing complete assurance • The auditor is guaranteeing the future viability of the entity • An unmodified (clean) audit opinion is an indicator of complete accuracy • The auditor will definitely find any fraud • The auditor has checked all transactions. The reality is that: • An auditor provides reasonable assurance • The audit does not guarantee the future viability of the entity • An unmodified opinion indicates that the auditor believes that there are no material (significant) misstatements (errors or fraud) in the financial statements • The auditor will assess the risk of fraud and conduct tests to try to uncover any fraud, but there is no guarantee that they will find fraud, should it have occurred • The auditor tests a sample of transactions.
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The audit expectation gap can be reduced by: • Auditors performing their duties appropriately, complying with auditing standards, and meeting the minimum standards of performance that should be expected of all auditors • Peer reviews of audits to ensure that auditing standards have been applied correctly • Auditing standards being reviewed and updated on a regular basis to enhance the work being done by auditors • Education of the public • Enhanced reporting to explain what processes have been followed in arriving at an audit opinion (reasonable assurance) or a review opinion (limited assurance) (significant improvements have been introduced by standard setters improving assurance reporting) • Assurance providers reporting accurately the level of assurance being provided (reasonable, limited, or none). The audit expectation gap is represented in figure 1.7. REVIEW QUESTION 1.10 The two main bodies that regulate auditors are the Canadian Securities Administrators (CSA) and the Canadian Public Accountability Board (CPAB). CPAB registers auditors for public companies, processes annual statements from registered auditors, enforces independence requirements, and provides a whistleblowing facility for the reporting of contraventions of the appropriate Corporations Acts. CPAB conducts an audit inspection program to report on audit quality and make recommendations for continued improvement. CPAB visits a selection of firms annually to gain an understanding of their policies and procedures in relation to their independence, audit quality, methodologies, and training programs. CPAB also responds to allegations that an auditor has breached the applicable Corporations Act or the standards set out by the Auditing and Assurance Standards Board (AASB). The CPAB, and AASB will be involved when it is believed an auditor has not carried out their duties properly, is not a fit and proper person, is subject to disqualification, or should not remain registered for some other reason. In response, they may cancel or suspend the individual’s registration, give the individual a warning, or ask them to make an undertaking to improve their conduct. The inspection process concentrates on an audit firm’s compliance with auditing standards, and their independence and quality control systems. The process includes • Reviewing and undertaking limited testing of the firm’s independence and quality control systems • Interviewing the leaders of the audit firm, human resources personnel, and selected partners and staff • Examining the firm’s audit methodology for compliance with auditing standards • Reviewing the conduct of aspects of selected audit and review engagements
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The program finishes with an exit meeting and CPAB sends the audit firm a confidential report of their findings. CPAB publishes a public report summarizing all their findings. CPAB – Practice Inspections • In accordance with CPAB's mission, they have developed a program of quality inspections which covers all firms that audit reporting issuers who issue securities to the public in Canada and are subject to the rules of provincial or territorial securities commissions. • Registered firms that audit reporting issuers are subject to inspection by CPAB. Their current practice inspection program selects firms for inspection on a cycle ranging from one to three years according to certain criteria. Annually, CPAB monitors the ongoing effectiveness of its practice inspection program and publishes a report highlighting inspection findings from the current year as well as trends relating to audit quality. • As part of their inspection process, CPAB has the right to take a disciplinary action against firms or individuals that CPAB has determined did not perform audits in accordance with professional standards. (see http://www.cpab-ccrc.ca/ for further information)
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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS PROFESSIONAL APPLICATION 1.1 – Assurance engagement An assurance engagement is defined as “an engagement in which a practitioner aims to obtain sufficient appropriate evidence in order to express a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the measurement or evaluation of an underlying subject matter against criteria.” In the case of Bravo Bags, Brad Pope, CPA was engaged to issue a written conclusion. In order to express that conclusion, he must obtain sufficient and appropriate evidence in order to determine whether the actual results indicated by Bravo Bags meets the lease agreement criteria. The results of the conclusion will enhance the landlord’s confidence that Bravo Bags has met the requirements of the lease. Therefore, the requirements of an assurance engagement are met as there is a practitioner (Brad Pope, CPA), who will issue a conclusion on the subject matter (the lease agreement) to a user (the landlord). PROFESSIONAL APPLICATION 1.2 – Demand for assurance The three theories discussed in the chapter are agency theory, the information hypothesis, and the insurance hypothesis. Agency theory suggests there are incentives to hire an auditor to assess the fair presentation of the information contained in the financial statements. An auditor reports to the owners on the fair presentation of the financial statements prepared by the manager. High-quality managers are willing to have an audit of their results because it allows them to distinguish themselves from poor-quality managers. Shareholders are willing to pay the audit fee (i.e., the audit fee is paid by the company, reducing the profit available to distribute to the shareholders) to monitor the managers (who are their agents). High-quality auditors are more highly valued for this monitoring function than poor-quality auditors. Arthur Andersen lowered their quality through their involvement with Enron, leading some companies to prefer another auditor. It has been suggested that companies taking early action to dismiss Arthur Andersen proactively protected their share price by demonstrating their financial reporting credibility. Ultimately, all of Arthur Andersen’s clients had to find another auditor. The information hypothesis suggests that financial statement users value higher quality information. Higher quality auditors are associated with higher quality financial statements. Therefore, when Arthur Andersen’s quality was called into question by their association with Enron, their client companies that valued higher quality auditors switched to another auditor. The insurance hypothesis suggests that investors insure against their losses from company failure by purchasing an audit. When Arthur Andersen’s credibility was damaged by the Enron affair, there was doubt about their ability to survive and provide the insurance for such losses. The insurance factor is impounded into share prices, so when the insurance cover is lost the share price should fall. This means that companies that were more sensitive to the loss of the insurance cover were more likely to dismiss Arthur Andersen earlier.
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PROFESSIONAL APPLICATION 1.3 – Assurance providers a) The solution will depend on the accounting firms chosen and the date of the analysis. However, the answers should show for the Big-4: greater geographic coverage, larger numbers of staff and broader range of skills offered, greater claims to specialization and industry coverage, more publications available (particularly from the international offices), and more consistent and sophisticated marketing. b)
Financial statement audits are mandatory for most companies, so overall demand is largely fixed or determined by economic conditions affecting the number of companies. However, for organizations that are not required by legislation to have an audit, there are two opposing pressures in times of economic recession. First, cost-cutting would result in fewer audits. Second, organizations with less credible financial statements will face most difficulty in borrowing during a credit squeeze. This suggests that demand for auditing will increase in difficult times because an audit will increase the credibility of the statements and thus increase access to external finance. Also, shifting from a national auditor to a Big-4 auditor would increase both costs and financial reporting credibility for a company. Therefore, it can be argued that firms with a greater need to reduce costs will shift from Big-4 auditors to national auditors, but firms with a greater need for credibility (and financial advice) will shift from national auditors to Big-4 auditors.
PROFESSIONAL APPLICATION 1.4 – Types of assurance engagements A review provides limited assurance. The practitioner does adequate work to report whether or not anything came to their attention which would lead them to conclude that the information being assured is not fairly presented. To comment on the appropriateness of a review for financial statements, the differences between an audit and a review should be identified. • Assurance: An audit provides reasonable assurance that provides high but not absolute assurance on the reliability of the subject matter. This is compared to a review, which provides limited assurance, where the evidence gathered is at least sufficient for the practitioner to conclude. • Opinion/Conclusion: An audit forms a positive expression of an opinion regarding whether the information being assured is presented fairly. A review provides a conclusion that the practitioner has done adequate work to report whether or not anything came to their attention that would lead them to believe the information is not prepared in accordance with the applicable framework. • Procedures: An audit will include a significant amount of procedures and detailed testing, the extent of which will be determined by risks identified, internal controls, accounting policies used, results of procedures, and professional judgement. Review procedures are a subset of those performed for an audit. The practitioner is not required to conduct detailed testing; however, they are required to do at least enough work so that the report enhances users’ confidence about the information.
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As stated in figure 1.4, the practitioner performs procedures, primarily consisting of making inquiries of management and others within the entity, as appropriate, and applying analytical procedures, and evaluates the evidence obtained. The procedures performed in a review are substantially less in extent than, and vary in nature from, those performed in an audit conducted in accordance with Canadian generally accepted auditing standards. • Reports: annual reports – both audits and review engagements are appropriate for annual reporting as long as they achieve the desired level of assurance for the stakeholders. • Other factors: Securimax Limited should consider when changing from an audit to a review engagement: • Cost: A review engagement is less costly than an audit as fewer procedures are performed. • Other considerations include: • What are the bank’s assurance requirements? It is common for financial institutions to require assurance as part of loan agreements to obtain comfort on the financial information they receive. If the bank requests high assurance, an audit will be required. If the bank does not require high assurance but only some assurance, then a review may be more desirable due to the lower costs associated. • Are there any international requirements? If international requirements require an audit, then Securimax may require an audit in order to win large government contracts. • Are there plans for an initial public offering (IPO)? The Canadian Securities Administrators governs IPOs and requires two years of audited financial statements. If this is a requirement, Securimax will require an audit. • Securimax obtains large government contracts; are there any requirements from their clients to obtain an audit? • If an audit is required in the future, there can be increased costs to go from a review engagement to an audit engagement. There could also be the possibility of a qualified opinion. For example, during the first year of an audit opening inventory balances cannot be audited because no inventory count can be performed as at that date, because it has already passed. If in the future Securimax stakeholders require an unmodified audit report, this will not be possible in the first year and could have a negative impact on the company for that year. • Conclusion: Review engagement reporting is more limited than an audit and thus a lower level of assurance is appropriate as long as it is understood and agreed to by the stakeholders. PROFESSIONAL APPLICATION 1.5 – Audit expectation gap The expectation gap is the difference between the expectations of financial statement users and the auditor’s performance. Special users for Securimax could include:
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• • • •
•
Auditing: A Practical Approach, Fourth Canadian Edition
government agencies, including Department of Foreign Affairs and Trade, who would be interested in the purchases by foreign governments and individuals of this type of security vehicle. competing companies and/or governments who would be interested in sensitive information about the construction of the vehicles and the identity of the purchasers. Waterloo local government and the Ontario Provincial Government, who would be interested in the financial viability of the business and its impact on local employment and economic activity. suppliers of technological equipment – it is possible that the Terrain Master uses specialized components. These suppliers would be interested in the financial viability of the business and the likelihood of its timely payment for goods purchased on credit. Such equipment could be made to specialized order with limited alternative customers. The suppliers would have large investments to support the manufacture of these specialized components. other potential customers.
The usual relationships would exist with lenders, shareholders, and employees. Discussion: Consider how well would Securimax’s financial statements provide the information that these users would require, given the highly sensitive and confidential nature of the manufacturing process. Management is responsible for preparing the reports, but the users may look to the auditors to make sure that the required information is provided. Also consider how well would the audit process be able to meet the users’ needs for this information. Users may expect that because the financial statements are audited, information such as suppliers, competing companies, the location of purchasers, or the volume of purchases would be disclosed. This would create an expectation gap if under the applicable framework, these disclosures are not a requirement. Given the highly sensitive nature of Securimax’s business, they would likely not voluntarily disclose such sensitive information unless required to do so under a framework. In addition, the users may perceive that because an audit has been performed, it provides complete assurance and guarantees the future viability of the company when in reality only reasonable assurance is provided and there is no such guarantee. PROFESSIONAL APPLICATION 1.6 – Performance and compliance audits TLCL must comply with the Ministry of Health’s ”Guidelines for Procurement of Medical Equipment” when purchasing the new machine. We are not provided with this document, but it is likely to contain rules about approved suppliers, the tendering/purchasing process (including the type of supplier/equipment documentation required), and so on. The auditor will gather evidence about TLCL’s purchase of the machine and assess whether the guidelines were followed. If the guidelines are specified with a great deal of detail, the audit will focus on ensuring that these guidelines were followed as specified. If the guidelines are expressed loosely (e.g., ”The firm should obtain a number of quotes”), the auditor will need to use more judgement to assess compliance than if the guidelines are expressed precisely (e.g., ”The firm will obtain at least three quotes”). The auditor will have to decide if the Solutions Manual Chapter 1: Introduction and overview of audit assurance 1-12 Copyright © 2021 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.
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number of quotes obtained in those circumstances is sufficient to satisfy the loosely expressed guidelines. Are two quotes sufficient? If at least three quotes are required, the auditor will likely decide that two quotes are not sufficient, unless there are extenuating circumstances (e.g., there are only two possible suppliers worldwide). PROFESSIONAL APPLICATION 1.7 – Types of engagements and reports a)
The three most common types of engagements a CPA may perform that provide some type of report attached to the financial statements are a compilation engagement, a review engagement, and an audit. A compilation engagement provides no assurance and no opinion. The practitioner compiles and formats financial statements based on the information provided by the client ensuring mathematical accuracy but does not perform any procedures to assure that the information is not materially misstated. This is the least costly option. It will be unlikely that the bank will be satisfied with this report as no assurance is provided and independence is not required. A review engagement provides limited assurance and a conclusion, but no opinion. The practitioner will gather sufficient evidence upon which to conclude on the reliability of the information being assured with enquiry, analysis, and observation. More evidence is gathered than a compilation engagement and therefore this is a pricier option. It may be possible that the bank will be satisfied with this report because it provides some assurance on the financial statements. However, because the assurance provided is limited, and BOL’s profitability is declining, it is possible that this may not meet the banks requirements. An audit provides reasonable assurance and is the highest level of assurance. It means that the auditor has conducted audit procedures and gathered sufficient and appropriate evidence to provide an opinion on the fair presentation of the financial statements. Because audit procedures are performed, a more significant amount of work is required by the auditor, and therefore this is the most expensive option. It is more than likely than not that in this situation BOL’s bank would request an audit report attached to the financial statements as it will give a higher level of assurance that the financial statements are not materially misstated.
b)
When a compilation engagement is performed, the financial statements are accompanied by a Compilation Engagement Report. Included in the report will be a statement that, on the basis of information provided by management, the practitioner has compiled the financial information, an indication of where the information can be found for the basis of accounting applied, and a description of both management’s and the practitioner’s responsibilities. There will also be an explanation that the practitioner did not perform an audit engagement or a review engagement, and that the practitioner does not express an audit opinion or a review conclusion, and it will
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explicitly state that no assurance is being provided. Users are then cautioned that the statements may not be appropriate for their purposes. When a review engagement is performed, the financial statements are accompanied by an Independent Practitioner’s Review Engagement Report. The report will outline management’s responsibility for the financial statements as well as the practitioner’s responsibility. The practitioner’s responsibility section highlights that a review provides limited assurance and that the procedures performed are substantially less in extent than those performed in an audit and that no opinion will be expressed on the financial statements. If no material issues were noted, the report will include a statement written in the negative that will conclude that that nothing has come to the practitioner’s attention that would lead them to believe that the financial statements were not presented fairly, in all material respects, in accordance with the financial reporting framework. When an audit engagement is performed, the financial statements are accompanied by an Independent Auditor’s Report. The auditor will state, in an unmodified opinion, that they believe that the statements present fairly the financial position and financial performance of the client in accordance with the applicable financial framework. The report will also state the basis for the opinion in accordance with auditing, independence and ethical standards, key audit matters, other information (if applicable), management’s responsibilities for the financial information, and the auditor’s expanded responsibilities as outlined in figure 1.3. c)
The type of report that would be most appropriate in this case will largely be determined by the bank’s requirements. If the bank requires an audit opinion, then Jack will require an audit report in order to obtain the financing required to continue with his diversification into the consumer retail market. This option is the most expensive option available. Because the bank appears to have some reservations in lending BOL any money, it is highly unlikely that a compilation report will satisfy their requirements to approve the loan, as it provides no assurance. If the bank agrees that a review engagement report would meet their requirements, this would be the recommended option for BOL. A review engagement report is less costly than an audit report but can still provide the bank with some level of assurance, even if it is limited. However as mentioned in part a), it is more likely that the bank will require an audit given BOL’s declining profitability.
d)
An assurance engagement is defined as an engagement performed by a practitioner to enhance the reliability of the subject matter for which a responsible party is accountable to the intended user. A practitioner is engaged to gather evidence, assess the subject matter against criteria, and issue a written conclusion. In this case, if the bank requires an audit of the financial statements of DOL, it meets the definition of an assurance engagement. The accountable party (DOL) is responsible for the subject matter for the intended user, the bank. Once the auditor has obtained sufficient and appropriate evidence to base an opinion that the financial statements are presented fairly against the criteria, the applicable accounting framework, they
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will provide a written report in the form of an Independent Auditor’s Report. The audit opinion will enhance the degree of confidence the bank has in DOL’s financial statements. An audit of a company’s financial statements is one of the most common types of assurance engagements. PROFESSIONAL APPLICATION 1.8 – Types of assurance engagements a) A review engagement is required because the bank requires a certain level of assurance, but it has already been agreed that an external audit will not be re-quired. A review provides limited assurance. The practitioner does adequate work to report whether or not anything came to their attention that would lead them to conclude that the information being assured is not fairly presented in accordance with the applicable framework. b)
The title of the report or communication that Cicak & Jones will prepare is an INDEPENDENT PRACTITIONER’S REVIEW ENGAGEMENT REPORT.
c)
The types of procedures that Cicak & Jones will be required to conduct in this review engagement would be inquiry, analysis, and observation to address high-risk areas where it was determined material misstatements could arise and to address all material items in the financial statements. Some of the procedures performed will be to compare year over year balances, considering the relationships between financial statement data, and to calculate various financial statement ratios. Once unusual or significant fluctuations are identified, the practitioner then discusses with the client whether these fluctuations and changes are plausible.
PROFESSIONAL APPLICATION 1.9 – Audit opinions a) Unmodified with emphasis of matter. The litigation is adequately disclosed but the issue is significant (exceptional litigation) and there is a need to draw the attention of the users to it in the audit report. b) A disclaimer of opinion. The client’s records are inadequate, creating a scope limitation that is so extreme that the auditor is unable to obtain sufficient and appropriate evidence to base an opinion. c) Either an adverse opinion or a qualified opinion, depending on how pervasive the GAAP departure is deemed to be. If the material GAAP departure is not pervasive to the overall financial statements, for example if it is localized to opening inventory amounts, and it can be identified and quantified, then a qualified opinion can be expressed identifying the specific GAAP departure. If the material GAAP departure is pervasive to the overall financial statements, for example if management does not want to present consolidated financial statements as per GAAP requirements, then an adverse opinion should be expressed.
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d) Either a disclaimer of opinion or a qualified opinion. Not allowing the auditor to contact the client’s legal counsel creates a scope limitation where the practitioner will not be able to mitigate the risk that the accounts associated with litigation exist, are complete and accurate, and are appropriately valued (liabilities, contingent liabilities, expenses, assets, contingent assets, and revenues). If the scope limitation is deemed so extreme that the auditor is unable to obtain sufficient appropriate evidence to base an opinion, a disclaimer of opinion should be expressed. If the effects can be identified, quantified, and explained, then a qualified opinion can be considered by the practitioner. This will be a matter of professional judgement and materiality should be considered. e) A disclaimer of opinion. Because the accounting records have been destroyed, this creates a scope limitation for the practitioner as there is essentially no financial records to audit; therefore, the auditor is unable to obtain sufficient and appropriate evidence to base an opinion. f) A qualified opinion. The GAAP departure can be identified, quantified, and explained in the audit report as it is localized to inventory and is not pervasive to the overall financial statements. Therefore “except for” inventory, the financial statements can be relied upon by the reader. g) Either an adverse opinion or a qualified opinion. The GAAP departure due to the inventory misstatement is pervasive to the overall financial statements and therefore it is more than likely that an adverse opinion should be expressed. However, it is possible if the misstatements can be identified, quantified, and explained to specifically the Inventory accounts and/or cost of goods sold, then a qualified opinion can be considered by the practitioner. This will be a matter of professional judgement. PROFESSIONAL APPLICATION 1.10 – Types of audit opinions Situation 1 a) Unmodified, qualified, or disclaimer of opinion. b) The client has, in effect, imposed a scope limitation on Aschari and Di Tomaso. The type of report issued depends upon the materiality of accounts receivable and the likelihood that a potential error would be material. If the accounts receivable balance was immaterial, then an unmodified report could still be issued. If the likelihood that a potential error would be material, but not pervasive, then an opinion qualified as to scope would be appropriate. If the likelihood that a potential error would be material and pervasive, then a disclaimer of opinion would be warranted. Situation 2 a) Unmodified, qualified, or adverse opinion.
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b) By not recording the probable need to pay $3 million as a result of the lawsuit as a liability in the financial statements, the statements are likely materially misstated. If the amount is considered not to be material, then an unmodified report can still be considered. If the financial statements are considered to be materially misstated, but the effect is not pervasive, a qualified opinion would be appropriate. If the statements are considered to be materially misstated and the effect is pervasive, an adverse opinion would be appropriate. PROFESSIONAL APPLICATION 1.11 – Different audit opinions Khaled should review the completed financial statements and the working papers to satisfy himself that: • The financial statements are not materially misstated; • The financial statements present fairly the financial position of the company; and • The information provided is in accordance with Canadian GAAP. PROFESSIONAL APPLICATION 1.12 – The audit expectation gap a) The auditor is responsible to provide an opinion on the fair presentation of the historical financial statements in accordance with Canadian GAAP, unless they are engaged to provide assurance on other information. Therefore, auditors do not review press releases and other information that may be distributed to the users and other stakeholders. Auditors do have a responsibility to ensure offering documents provided by the company are consistent with the financial statements, but they do not provide assurance over that information. b)
The audit expectation gap occurs when there is a difference between the expectations of assurance providers and financial statement users. In this case, the users seem to believe the auditor should have provided more information with respect to the future success of the company. This demonstrates the “expectation gap,” where users tend to blame the auditor when companies fail. Users tend to believe that the auditor should have done more (i.e., provided assurance over the success of research expenditures). A financial statement audit will include procedures on the risks associated with the research costs recorded (e.g., Are all the expenditures recorded and complete? Is the information provided mathematically accurate? Were the expenditures appropriately valued? Are the expenditures appropriately classified as an expenditure or should they be recorded as an asset?). A financial statement audit will however not provide an opinion as to whether they will lead to a future benefit. Auditors tend to avoid special engagements that would provide an opinion over such subjective information, as it is too difficult to verify.
c)
Auditors can reduce the audit expectation gap by: Performing their duties appropriately, complying with auditing standards, and meeting the minimum standards of performance that should be expected of all auditors
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• • • •
•
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Using peer reviews of audits to ensure that auditing standards have been applied correctly Having auditing standards reviewed and updated on a regular basis to enhance the work being done by auditors Educating the public, Enhancing reporting to explain what processes have been followed in arriving at an audit opinion (reasonable assurance) or a review opinion (moderate or limited assurance) (significant improvements have been introduced by standard setters improving assurance reporting), Assurance providers reporting accurately the level of assurance being provided (reasonable, limited, or none),
PROFESSIONAL APPLICATION 1.13 – Audit reports a) The audit report highlights to readers that the management of the company and the auditors have separate and distinct responsibilities. Management is responsible for the oversight of the financial reporting process (maintaining accounting systems and internal controls), assessing the ability to continue as a going concern, and preparing and ensuring the fair presentation of the financial statements in accordance with GAAP that are free from material misstatement. The auditors are responsible for conducting an audit of the financial statements by evaluating their contents against the criteria of the accounting standards and relevant legislation. The auditor’s responsibilities do not include preparing the financial statements and the auditor must use judgement when choosing procedures and evaluating audit evidence. It also highlights that there is no guarantee that an audit performed in accordance with standards will detect all material misstatements. b)
Figure 1.3 has a paragraph that is headed “Opinion.” It states that in the independent auditor’s opinion the financial statements present fairly, in all material respects, the financial position and financial performance of the company in accordance with the applicable framework. This means that the opinion is unmodified.
c)
In a review engagement report, the practitioner expresses a conclusion, not an opinion. It is not an opinion because they did not conduct an audit. The statement is negative – ”nothing has come to our attention ...”.
d)
Other differences include: The opinion in the audit report appears in the second paragraph. The conclusion in the review engagement appears in the last paragraph. The audit report may include a Key Audit Matters section. There is nothing similar included in the review engagement report. The audit report contains expanded auditor responsibilities. A description of the work done by the auditor indicates that the procedures used in the review engagement are less comprehensive than those of the audit. This is the
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main difference why the audit report contains an opinion and the review report expresses a conclusion rather than an opinion. PROFESSIONAL APPLICATION 1.14 – Being an auditor a) There is a gap between Kim’s expectations and the level of auditor performance. An audit provides reasonable assurance, not absolute assurance. The audit enhances the reliability and credibility of the information included in the financial statements but is not a guarantee that the financial statements are free from error or fraud, or that the company will not fail. Partly, this is because of the nature of financial reporting. It requires judgements about accounting estimates and the choice and application of various accounting methods. There is usually not one right answer for a company’s profit. The auditor cannot guarantee the profit reported by the company is right, but only provide assurance about the appropriateness of the accounting method selection and application and the accounting estimates. Another reason the assurance is not absolute is the nature of the audit process. Auditors cannot review every transaction and account balance, so they use sampling (which could mean that representative items are not selected for testing), some transactions and balances are difficult to gather reliable evidence about, clients can conceal evidence, and auditors have a limited time frame in which to complete the audit. b)
Professional scepticism is required of an auditor. It is an attitude that requires the auditor to remain independent of the client and its staff. The auditor has a questioning mind and thoroughly investigates all evidence presented by their client. This does not mean that they regard the client as a liar, but that they need to do more than simply accept the client’s word. Usually, there will be corroborating evidence that supports the client’s statements (e.g., copies of contracts and minutes of meetings). Evidence gathered from independent third parties is generally regarded as more reliable than that gathered from the client. Managers will not always try to deceive auditors, but auditors must keep a questioning mind and take the responsibility of gathering evidence to verify managers’ statements. The auditor needs to be aware that some managers will try to deceive auditors sometimes.
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Case Study — Cloud 9 a)
The objective of an audit is to obtain reasonable assurance by gathering sufficient evidence upon which to form a positive expression of an opinion regarding whether the information being assured is presented fairly. This means that the auditor has done adequate work to report with reasonable certainty that the information being assured is, or is not, reliable. This does not reflect absolute assurance, as an auditor can never be 100% certain that there are no errors or omissions. For example, an auditor is in the position to say whether in their opinion the financial statements are in accordance with relevant laws and accounting standards and they present fairly the financial position of the reporting entity. Auditors can only make such a positive statement if they are reasonably sure that the evidence gathered is sufficient. The audit of a company’s financial statements is one example of a reasonable assurance engagement. CAS 700 Forming an Opinion and Reporting on Financial Statements provides guidance on the form and elements of the audit report. The audit opinion will depend upon the auditor’s findings while conducting the audit. Reasonable assurance is the highest level of assurance provided; again, note that it is high but not absolute assurance. The objective of a review engagement is to obtain limited assurance by gathering sufficient evidence upon which to conclude on the reliability of the information being assured. This means that the practitioner has done adequate work to report whether or not anything came to their attention that would lead them to believe that the information being assured is not worthy of belief. The practitioner is not in a position to say that in their opinion the financial statements are in accordance with relevant laws and accounting standards, and does present fairly the financial position and performance of the reporting entity. The practitioner is only able to say that nothing makes them believe otherwise. To make a negative statement, practitioners do not need to be as sure about the evidence as they must be to make a positive statement. The review of a company’s financial statements is called a review engagement. A review engagement may be requested when the client requires some assurance over the financial statements but does not require an audit level of assurance. CPA Canada Handbook section CSRE 2400 provides guidance on review engagements of historical financial information and the form and elements of the review report. The review report highlights the responsibilities of the practitioner to comply with Canadian generally accepted standards for review engagements and that the financial statements comply with Canadian GAAP or another appropriate financial reporting framework. An explanation of the procedures used in conducting the review is provided. The report states explicitly that an audit was not performed and therefore an audit opinion is not being expressed. Finally, the review report includes the conclusion of the practitioner that they were not aware of any matter that made them believe that the financial statements are not presented fairly, in all material respects, in accordance with GAAP.
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In conducting a review, a practitioner will obtain an understanding of the entity under review; identify potential material misstatements where effort should be concentrated; and conduct analytical procedures, inquiries of entity personnel, and other tasks if needed to aid in the formulation of their conclusion. No opinion is expressed. The work done when conducting a review is less extensive than the work done when conducting an audit. Specifically, a practitioner will make inquiries of key personnel and perform analytical procedures. That is why a practitioner can provide only limited assurance after completing a review. It is also why this engagement is less time-consuming and therefore less costly. For a compilation engagement, the practitioner compiles and formats a set of financial statements based on the information provided by the client, ensuring mathematical accuracy, but does not perform any procedures to ensure that the information is not materially misstated, and therefore no expression of assurance is provided. However, the practitioner must ensure that they are not associated with information that may be false or misleading. To ensure that users are aware that no assurance is being provided, the practitioner attaches what is called a Compilation Engagement Report to the financial statements. The Compilation Engagement Report explicitly states that no assurance is being provided. For a compilation engagement, Canadian GAAP is not required as the financial reporting framework (it is the required framework for audits and review engagements), however the financial statements must include disclosure with respect to the basis of accounting used to prepare the financial statements (for example, cash or accrual basis). b)
An audit provides reasonable assurance and is the highest level of assurance. It means that the auditor has conducted audit procedures and gathered sufficient and appropriate evidence to provide an opinion on the fair presentation of the financial statements. The auditor states, in an unmodified opinion, that they believe that the statements present a fair presentation of the financial position and performance of the client. A review engagement provides limited assurance, which is a lower level of assurance. The practitioner performs limited procedures and gathers less evidence. The practitioner provides a conclusion. They state that they have found no evidence which causes them to believe that the financial statements do not present fairly the financial position and performance of the client. Reasonable assurance is provided in an audit and limited assurance is provided in a review engagement. c) Chip would ask that Ron have the financial statements for McLellan’s Shoes audited rather than reviewed because the audit provides a higher level of assurance that the financial statements give a fair presentation of the financial position and performance of the business. The risk that the audit opinion is inappropriate is lower than the risk that a review conclusion is inappropriate. Chip would feel more confident about the information being provided if it is audited rather than reviewed. d) Ron would be purchasing a service from an audit firm. Therefore, Ron would consider the benefits being offered by each firm and the price being charged. Auditors
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generally charge based on the amount of work being done (which would be affected by the size of the business and its complexity) and the difficulty in performing the work. For example, if the auditor was unable to use their normal audit software because it was incompatible with the business’s systems, they might be forced to use more expensive techniques to conduct the audit. The audit firm would evaluate the type of business and the type of accounting records being kept before quoting their price. Ron should consider how well he is likely to be able to work with the auditors, how easy they are to contact and whether he believes they understand his requirements, and how much time they would require at his business. Many clients would like the audit to be conducted as quickly as possible so that it does not interfere too much with their normal operations. Ron might also consider whether he is likely to be given useful advice by the auditors, although as he is trying to sell his business he is unlikely to seek advice on how to improve his systems. Some clients try to “purchase” the right opinion. Auditors’ professional ethics prevent them from being involved in “opinion shopping,” which is the practice of clients going to a number of audit firms seeking the opinion that would be most favourable.
Research Question 1.1 – Chong and Pflugrath a)
The question asks for the student’s view. The student should propose a standard audit report format with justification for each section. The factors to be considered include report length, location of the audit opinion, and plain or technical language. If the student regards the current audit report as the most appropriate, justification should still be provided and the student should discuss how the report conveys realistic expectations of the auditor’s role and the level of assurance provided. The student should provide evidence of different possible audit report formats as part of their discussion.
b)
The arguments supporting auditors’ current practices and the users’ alternative expectations should be researched and discussed. Are there any arguments to support the auditors’ position that could not be regarded as merely defending existing practices? Are there any arguments to support critics who suggest that auditors should be doing more? Recent changes to the law suggest that regulators are willing to reconsider the auditor’s role (e.g., banning certain nonaudit services, requiring an independence declaration, and requiring audit partner rotation). If auditors proactively adopt these types of changes, is it possible that more draconian regulatory changes could be avoided?
Research Question 1.2 – Access the CPA Canada Handbook a)
CAS 230 Audit Documentation.
b)
Each CAS has a different number of sections, depending on the volume required to express the standard. However, it is important to note the general structure
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that is present in each CAS as they all have the following sections (if that particular section is relevant to that CAS): • Introduction • Scope • Effective date • Objective • Definitions • Requirements • Application and other explanatory material • Appendices c)
The name of CSAE 3000 is "Attestation Engagements Other than Audits or Reviews of Historical Financial Information.”
d)
The Canadian Standard on Review Engagements (CSRE 2400) should be used as guidance in preparing a review engagement. It was issued on March 31, 2016 for periods ending on or after December 14, 2017.
e)
At the time of writing, the Compilation Engagement Report was called a “Notice to Reader” and the wording can be found in the CPA Canada Handbook, Section 9200 "Compilation Engagements," para. 26. In October 2019 the AASB approved a new standard, Canadian Standards on Related Services - CSRS 4200 “Compilation Engagements” effective for compiled financial information for periods ending on or after December 14, 2021, with early application permitted. The compilation Engagement Report Requirements are located in the CPA Canada Handbook, Section 4200 “Compilation Engagements" para. 37 with an illustration of a report in Appendix 2.
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Solutions Manual to accompany
Auditing: A Practical Approach Fourth Canadian Edition by
Robyn Moroney Fiona Campbell Jane Hamilton Valerie Warren
CHAPTER 2 Ethics, Legal Liability, and Client Acceptance
John Wiley & Sons Canada, Ltd. 2021
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Chapter 2 Ethics, Legal Liability, and Client Acceptance SOLUTIONS TO REVIEW QUESTIONS REVIEW QUESTION 2.1 Compliance with the fundamental principles of the code of professional conduct can contribute to the ability of the auditor to discharge their duty to act in the public interest. Upholding the fundamental ethical principles that apply to all members of the profession means to exhibit professional behaviour, act with integrity and due care, maintain professional competence, respect confidentiality, and act with objectivity. When a public accountant upholds these principles, it increases the reliability and the faithful representation of the information under audit. This level of professionalism is expected from the public and increases their confidence in the profession and the quality of the work being performed. The requirement to act in the public interest means that auditors should consider how their actions impact the client and their employer. They must also consider the impact of their actions on others such as the client’s employees, investors, credit providers, and those without direct financial interests in the client such as the broader business and financial community and members of the public. All these people could be reliant on the quality of the auditor’s work, even though they are not party to the contract between the client and the audit firm. The reliability of the financial statements and the audit report is potentially damaged if the auditor does not exhibit professional behaviour (protecting their reputation and the profession’s reputation), act with integrity (honesty) and due care, maintain professional competence (executing the work with the required level of knowledge and skill), respect confidentiality (refrain from discussing the client’s affairs with others inappropriately), and act with objectivity (being independent). Unprofessional behaviour brings discredit to the profession. A dishonest auditor could knowingly help publish a materially false, misleading, or reckless financial statement. Auditors who do not uphold due care principles could fail to act diligently in accordance with the applicable technical standards. Auditors who do not uphold professional competence principles could provide incompetent professional service. Disclosures of the client’s confidential information without proper or specific authority from the client or without a legal duty to disclose could disadvantage the client in the conduct of its affairs. Auditors who compromise their objectivity could be biased or unduly influenced to publish an inappropriate audit opinion.
REVIEW QUESTION 2.2 The four biases that may impair professional scepticism are: Availability bias
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This bias involves considering information that is easy to remember as being more likely, more relevant, and more important. This can occur when an auditor does not consider possible alternatives as they are focusing on the most recent information that they have received. For example, suppose the client’s repairs and maintenance expense is more than double that of the previous year. Management’s explanation was that a windstorm caused significant damage. The auditor then focuses on searching for evidence to corroborate this information rather than looking for alternatives, such as the development of a new piece of equipment that should have been capitalized. Confirmation bias This bias occurs when the auditor favours evidence that confirms their beliefs or expectations, possibly downplaying or ignoring other relevant evidence. For example, accounts payable is down and the auditor believes this to be reasonable as sales are down and no further evidence is gathered. The auditor ignores the fact that management increased credit limits for its customers in order to boost sales and recorded the additional sales as deferred revenue, creating a classification issue. Overconfidence bias This bias occurs when the auditor overestimates their ability. For example, an auditor completes an inventory count twice as fast as the auditor the previous year and believes that it is because they were more efficient. After the file is reviewed it is determined that the sample selection was too small, and more evidence needs to be gathered. Anchoring bias This bias occurs when an auditor starts from an initial numerical value and then insufficiently adjusts that initial value in forming a final judgement. For example, management estimates the allowance for doubtful accounts to be $100,000. The auditor believes it to be too low and suggests the estimate should be $120,000. In fact, one of their major clients has declared bankruptcy and the estimate should be $200,000.
REVIEW QUESTION 2.3 Both aspects of independence are important. If an auditor has independence in fact, the auditor will act independently. Acting independently means that the auditors are free of the clients’ influence and will perform their duties as required by the auditing standards and codes of ethics, even if the clients do not agree. Acting independently is essential for a high-quality audit. However, despite how independently the auditor may act, the audit report will not be credible if the outside parties do not believe that the auditor acted independently. That is, outside parties may not believe the audit report has any credibility because they believe that the clients have influenced the auditor. Therefore, the auditor must be seen to be independent by outside parties. That is, the auditor must be independent in appearance for the audit report to be believed.
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