Auditing and assurance services 12th edition Arens Solution Manuals by TBtutors

Type:

Solution Manual

Resource:

Auditing and assurance services

Edition:

12th Edition

Author(s):

Alvin A. Arens Randal J. Elder Mark S. Beasley

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: 1.

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

1-1

1-3

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: 1. 2. 3.

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

1. User obtains information desired. 2. 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

1. No audit costs incurred.

1. User may not be able to collect on losses.

AUDITED FINANCIAL STATEMENTS ARE PROVIDED

1. Multiple users obtain the information. 2. Information risk can usually be reduced sufficiently to satisfy users at reasonable cost. 3. 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.

1-2

1-5 To do an audit, there must be information in a verifiable form and some standards (criteria) by which the auditor can evaluate the information. Examples of established criteria include generally accepted accounting principles and the Internal Revenue Code. Determining the degree of correspondence between information and established criteria is determining whether a given set of information is in accordance with the established criteria. The information for Jones Company's tax return is the federal tax returns filed by the company. The established criteria are found in the Internal Revenue Code and all interpretations. For the audit of Jones Company's financial statements the information is the financial statements being audited and the established criteria are generally accepted accounting principles. 1-6 The primary evidence the internal revenue agent will use in the audit of the Jones Company's tax return include all available documentation and other information available in Jones' office or from other sources. For example, when the internal revenue agent audits taxable income, a major source of information will be bank statements, the cash receipts journal and deposit slips. The internal revenue agent is likely to emphasize unrecorded receipts and revenues. For expenses, major sources of evidence are likely to be cancelled checks, vendors' invoices and other supporting documentation. 1-7 This apparent paradox arises from the distinction between the function of auditing and the function of accounting. The accounting function is the recording, classifying and summarizing of economic events to provide relevant information to decision makers. The rules of accounting are the criteria used by the auditor for evaluating the presentation of economic events for financial statements and he or she must therefore have an understanding of generally accepted accounting principles (GAAP), as well as auditing standards. The accountant need not, and frequently does not, understand what auditors do, unless he or she is involved in doing audits, or has been trained as an auditor.

1-3

1-8 AUDITS OF FINANCIAL STATEMENTS

OPERATIONAL AUDITS

COMPLIANCE AUDITS

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: Frequently

Occasionally

Almost universally

Frequently

Occasionally

IRS AUDITORS

Never

Universally

Never

INTERNAL AUDITORS

Frequently

CPAs GAO AUDITORS

1-9 Five examples of specific operational audits that could be conducted by an internal auditor in a manufacturing company are: 1.

2. 3.

4. 5.

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. 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.

1-4

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: 1.

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 ecommerce. 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.



Multiple Choice Questions From CPA Examinations

1-14 a.

(3)

(2)

(3)

1-15 a.

(2)

(3)

(4)

(3)

1-5



Discussion Questions And Problems

1-16 a.

1-17 a.

The relationship among audit services, attestation services and assurance services is reflected in Figure 1-3 on page 13 of the text. Audit services are a form of attestation service, and attestation services are a form of assurance service. In a diagram, audit services are located within the attestation service area, and attestation services are located within the assurance service area. 1. (1) Audit of historical financial statements 2. (2) An attestation service other than an audit service; or (3) An assurance service that is not an attestation service (WebTrust developed from the AICPA Special Committee on Assurance Services, but the service meets the criteria for an attestation service.) 3. (2) An attestation service other than an audit service 4. (2) An attestation service other than an audit service 5. (2) An attestation service other than an audit service 6. (2) An attestation service that is not an audit service (Review services are a form of attestation, but are performed according to Statements on Standards for Accounting and Review Services.) 7. (2) An attestation service other than an audit service 8. (2) An attestation service other than an audit service 9. (3) An assurance service that is not an attestation service The interest rate for the loan that requires a review report is lower than the loan that did not require a review because of lower information risk. A review report provides moderate assurance to financial statement users, which lowers information risk. An audit report provides further assurance and lower information risk. As a result of reduced information risk, the interest rate is lowest for the loan with the audit report. Given these circumstances, Vial-tek should select the loan from City First Bank that requires an annual audit. In this situation, the additional cost of the audit is less than the reduction in interest due to lower information risk. The following is the calculation of total costs for each loan:

CPA SERVICE

COST OF CPA SERVICES

ANNUAL INTEREST

ANNUAL LOAN COST

Existing loan

None

$ 142,500

First National Bank

Review

$ 12,000

$ 127,500

$ 139,500

City First Bank

Audit

$ 20,000

$ 112,500

$ 132,500

LENDER

1-6

1-17 (continued) 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:

CPA SERVICE

COST OF CPA SERVICES

ANNUAL INTEREST

ANNUAL LOAN COST

Existing loan

None

$ 142,500

First National Bank

Review

$ 12,000

$ 120,000

$ 132,000

City First Bank

Audit

$ 25,000

$ 112,500

$ 137,500

LENDER

1-18 a.

Vial-tek may desire to have an audit because of the many other positive benefits that an audit provides. The audit will provide Vialtek’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. 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. 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. 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. The four causes of information risk are essentially the same for a buyer of an automobile and a user of financial statements: 1-7

1-18 (continued) (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. 1-19 a. The following parts of the definition of auditing are related to the narrative: (1) Virms is being asked to issue a report about qualitative and quantitative information for trucks. The trucks are therefore the information with which the auditor is concerned. (2) There are four established criteria which must be evaluated and reported by Virms: existence of the trucks on the night of June 30, 2007, ownership of each truck by Regional Delivery Service, physical condition of each truck and fair market value of each truck. 1-8

1-19 (continued) (3)

Susan Virms will accumulate and evaluate four types of evidence: (a) Count the trucks to determine their existence. (b) Use registrations documents held by Oatley for comparison to the serial number on each truck to determine ownership. (c) Examine the trucks to determine each truck's physical condition. (d) Examine the blue book to determine the fair market value of each truck. (4) Susan Virms, CPA, appears qualified, as a competent, independent person. She is a CPA, and she spends most of her time auditing used automobile and truck dealerships and has extensive specialized knowledge about used trucks that is consistent with the nature of the engagement. (5) The report results are to include: (a) which of the 35 trucks are parked in Regional's parking lot the night of June 30. (b) whether all of the trucks are owned by Regional Delivery Service. (c) the condition of each truck, using established guidelines. (d) fair market value of each truck using the current blue book for trucks. The only parts of the audit that will be difficult for Virms are: (1) Evaluating the condition, using the guidelines of poor, good, and excellent. It is highly subjective to do so. 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.

1-9

1-20 a. The major advantages and disadvantages of a career as an IRS agent, CPA, GAO auditor, or an internal auditor are: EMPLOYMENT INTERNAL REVENUE AGENT

CPA

GAO AUDITOR

INTERNAL AUDITOR

(b)

ADVANTAGES

DISADVANTAGES

1. Extensive training in individual, corporate, gift, trust and other taxes is available with concentration in area chosen. 2. Hands-on experience with sophisticated selection techniques. 1. Extensive training in audit of financial statements, compliance auditing and operational auditing. 2. Opportunity for experience in auditing, tax consulting, and management consulting practices. 3. Experience in a diversity of enterprises and industries with the opportunity to specialize in a specific industry. 1. Increasing opportunity for experience in operational auditing. 2. Exposure to highly sophisticated statistical sampling and computer auditing techniques. 1. Extensive exposure to all segments of the enterprise with which employed. 2. Constant exposure to one industry presenting opportunity for expertise in that industry. 3. Likely to have exposure to compliance, financial and operational auditing.

1. Experience limited to taxes. 2. No experience with operational or financial statement auditing. 3. Training is not extensive with any business enterprise. 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.

1. Little exposure to diversity of enterprises and industries. 2. Bureaucracy of federal government.

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.

Other auditing careers that are available are:  Auditors within many of the branches of the federal government (e.g., Atomic Energy Commission)  Auditors for many state and local government units (e.g., state insurance or bank auditors)

1-10

1-21 The most likely type of auditor and the type of audit for each of the examples are:

EXAMPLE 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

1-22 a.

1-23 a.

TYPE OF AUDITOR IRS GAO Internal auditor or CPA CPA or Internal auditor GAO CPA GAO IRS CPA Internal auditor or CPA Internal auditor or CPA GAO

TYPE OF AUDIT Compliance Operational Operational Financial statements Operational Financial statements Financial statements Compliance Financial statements Compliance Financial statements Compliance

The conglomerate should either engage the management advisory services division of a CPA firm or its own internal auditors to conduct the operational audit. The auditors will encounter problems in establishing criteria for evaluating the actual quantitative events and in setting the scope to include all operations in which significant inefficiencies might exist. In writing the report, the auditors must choose proper wording to state that no financial audit was performed, that the procedures were limited in scope and that the results reported do not necessarily include all the inefficiencies that might exist. The CPA firm for the Internet company described in this problem could address these customer concerns by performing a WebTrust attestation engagement. The WebTrust assurance service was created by the profession to respond to the growing need for assurance resulting from the growth of business transacted over the Internet. The appropriate WebTrust principle for each of the customer concerns noted in the problem is as follows: 1. Accuracy of product descriptions and adherence to stated return policies: (3) Processing Integrity. 2. Credit card and other personal information: (1) Online Privacy and (2) Security. 3. Selling information to other companies: (1) Online Privacy and (2) Security. 4. System failure: (4) Availability.

1-11



1-1

Internet Problem Solution: Sarbanes—Oxley Act Internal Control Reporting Requirements The Sarbanes-Oxley Act (SOX), also known as the Public Company Accounting Reform and Investor Protection Act, was signed into law on July 30, 2002. Considered by many to be the most sweeping corporate reform legislation since the 1933 and 1934 securities legislation, SOX ushered in a variety of new requirements including reporting on internal control over financial reporting. The newly created Public Company Accounting Oversight Board (PCAOB) was charged with establishing standards applicable to audits of internal control over financial reporting. Visit the PCAOB’s website (below) to review the full text of SOX to answer the following questions: [http://www.pcaobus.org/About_the_PCAOB/Sarbanes_Oxley_Act_of_2002.pdf]

According to Section 404 of SOX a public company’s annual report must include an internal control report. What are the two required elements of management’s report on internal control? 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.

(Note: Internet problems address current issues using Internet sources. Because Internet sites are subject to change, Internet problems and solutions are subject to change. Current information on Internet problems is available at www.prenhall.com/arens).

1-12

Chapter 2 The CPA Profession 

2-1

Review Questions The four major services that CPAs provide are: 1.

3. 4.

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. 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. Tax services Tax services include preparation of corporate, individual, and estate returns as well as tax planning assistance. Management consulting services These services range from suggestions to improve the client's accounting system to computer installations.

2-2 The major characteristics of CPA firms that permit them to fulfill their social function competently and independently are: 1.

Organizational form A CPA firm exists as a separate entity to avoid an employer-employee relationship with its clients. The CPA firm employs a professional staff of sufficient size to prevent one client from constituting a significant portion of total income and thereby endangering the firm's independence. Conduct A CPA firm employs a professional staff of sufficient size to provide a broad range of expertise, continuing education, and promotion of a professional independent attitude and competence. Peer review This practice evaluates the performance of CPA firms in an attempt to keep competence high.

2-3 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.

2-1

2-4 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 file reports with the SEC each year (all companies filing registration statements under the securities acts of l933 and l934 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 fair disclosure to investors. In addition, the SEC has power to establish rules for any CPA associated with audited financial statements submitted to the Commission. 2-5 The AICPA is the organization that sets professional requirements for CPAs. The AICPA also conducts research and publishes materials on many different subjects related to accounting, auditing, management advisory services, and taxes. The organization also prepares and grades the CPA examinations, provides continuing education to its members, and develops specialty designations to help market and assure the quality of services in specialized practice areas. 2-6 Statement on Standards for Attestation Engagements was first issued in 1986 and its purposes were to provide a framework for attest engagements and to develop standards for those engagements. In 2001, the Auditing Standards Board issued SSAE 10 in response to the need for more detailed standards for specific types of attestation services. SSAE 10 supersedes the previously issued standards and its main purpose is to improve the usefulness of the attestation standards and provide greater flexibility to practitioners in providing assurance services. 2-7 The PCAOB now has responsibility for establishing auditing standards for public companies, while the Auditing Standards Board (ASB) of the AICPA establishes auditing standards for private companies. The ASB previously had responsibility for establishing auditing standards for both public and private companies. Existing auditing standards were adopted by the PCAOB as interim auditing standards for public company audits. 2-8 Generally accepted auditing standards are ten general guidelines to aid auditors in fulfilling their professional responsibilities. These guidelines include three general standards concerned with competence, independence, and due professional care; three standards of field work including planning and supervision, understanding the entity and its environment, including its internal control, and the gathering of sufficient appropriate evidence; and four standards of reporting, which require a statement as to presentation in accordance with generally accepted accounting principles, inconsistency observed in the current period in relation to the preceding period, adequate disclosure, and the expression of an opinion as to the fairness of the presentation of the financial statements.

2-2

2-8

(continued)

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. 2-9 Auditors can obtain adequate technical training and proficiency 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. 2-10 For the most part, generally accepted auditing standards 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. 2-11 International Standards on Auditing (ISAs) are issued by the International Auditing Practices Committee (IAPC) of the International Federation of Accountants (IFAC). ISAs are designed to improve the uniformity of auditing practices and related services throughout the world by issuing pronouncements on a variety of audit and attest functions and promoting their acceptance worldwide. A CPA who conducts an audit in accordance with GAAS may not comply with ISAs because there may be additional ISA requirements that extend beyond GAAS requirements. 2-12 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. 2-13 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. 2-14 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.

2-3

2-14 (continued) 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. A CPA firm also gives up some independence of activities when it is reviewed by another CPA firm. 2-15 The two divisions of practice that a CPA firm may belong to are the Center for Public Company Audit Firms (CPCAF) and the Private Companies Practice Section (PCPS). A firm may belong to one section, both sections, or neither. Many of the self-regulatory activities of the CPCAF have been taken over by the PCAOB. Proponents of this division believe that this will improve the quality of practice by CPA firms and that it will improve self-regulation. Critics state that it establishes two classes of CPAs and implies a lower performance quality for firms that are not members of the Center for Public Company Audit Firms.



Multiple Choice Questions From CPA Examinations

2-16 a.

(1)

(2)

(3)

2-17 a.

(2)

(1)

(2)

(3)



Discussion Questions And Problems

2-18 a. The comments summarize the beliefs of many practitioners about the Sarbanes–Oxley Act and the PCAOB. The arguments against the Act can be summarized as four arguments: 1.

2. 3. 4.

Costs of complying with the Act are excessively high, especially the requirement to report on internal control over financial reporting, and will discourage companies from becoming public companies. Relative cost for local audit firms is excessively high. Additional oversight is not needed because sufficient quality controls have already been implemented by most audit firms. Three other things already provide assurance of adequate quality: a competitive economic environment, legal liability, and auditing standards.

To support these comments, it can be argued that the profession has generally functioned well with relatively little controversy and criticism. 2-4

2-18 (continued) The arguments against these comments are primarily as follows: 1.

2. 3. 4.

Reporting on the effectiveness of internal control over financial reporting will provide benefits in improved controls, resulting in higher quality financial reporting and reduced losses from fraud. The increased confidence in financial reporting will increase access to capital and lower the cost of capital by reducing information risk. Changes in the scope of CPA practices and other threats to audit quality required government regulation. Regulation of public company audits will not affect most audit firms that do not have public company audit clients.

There is no correct answer to this question. Different people reach different conclusions, depending on the weights put on the various arguments. Time is needed to effectively assess both the costs and benefits of the Act.

2-19 a. b. c. d. e. f. g. h. i.

Engagement performance Personnel management Engagement performance Engagement performance Independence, integrity, and objectivity Monitoring Acceptance and continuation of clients and engagements Personnel management Personnel management

2-20 a.

Rossi and Montgomery's primary ethical consideration is their professional competence to perform all of the audit work for filing with the SEC. In addition, if Rossi and Montgomery have performed bookkeeping services or certain consulting services for Mobile Home, they will not be independent under PCAOB and SEC independence requirements. The firm must also be a registered firm with the PCAOB. The filing with the SEC, in addition to normal audited financial statements, will require completion and registration with the SEC of Form S-1 which includes an audited summary of operations for the last five fiscal years as well as many additional schedules and descriptions of the business. Each quarter subsequent to the filing, Form 10-Q must be filed; and within 90 days of the end of each fiscal year Form 10-K must be filed with the SEC. In addition, Form 8-K must be filed whenever significant events have occurred which are of interest to public investors. These forms must be filed in conformity with Regulation S-X, which requires considerable disclosures in addition to those normally required in audited financial statements.

2-5

2-21 BRIEF DESCRIPTION OF GAAS

HOLMES' ACTIONS RESULTING IN FAILURE TO COMPLY WITH GAAS

GENERAL STANDARDS 1. The audit must be performed by a person or persons having adequate technical training and proficiency as an auditor.

1. 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 a junior assistant has not completed his formal education, he may help in the conduct of the audit as long as there is proper supervision and review.

2. The auditor must maintain independence in mental attitude in all matters relating to the audit.

2. To satisfy the second general standard, 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.

3. The auditor must exercise due professional care in the performance of the audit and the preparation of the report.

3. This standard requires Holmes to perform the audit with due care, which imposes on Holmes and everyone in Holmes' organization a responsibility to observe the standards of field work and reporting. Exercise of due care requires 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.

2-6

2-21 (continued) BRIEF DESCRIPTION OF GAAS

HOLMES' ACTIONS RESULTING IN FAILURE TO COMPLY WITH GAAS

STANDARDS OF FIELD WORK 1. The auditor must adequately plan the work and must properly supervise any assistants.

1. This standard recognizes that early appointment of the auditor has advantages for the auditor and the client. Holmes accepted the engagement without considering the availability of competent staff. In addition, Holmes failed to supervise the assistants. The work performed was not adequately planned.

2. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures.

2. Holmes did not obtain an understanding of the entity or its internal control, nor did the assistants obtain such an understanding. There appears to have been no audit at all. The work performed was more an accounting service than it was an auditing service.

3. The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit.

3. Holmes acquired no evidence that would support the financial statements. Holmes merely checked the mathematical accuracy of the records and summarized the accounts. Standard audit procedures and techniques were not performed.

STANDARDS OF REPORTING 1. The auditor must state in the auditor’s report whether the financial statements are presented in accordance with generally accepted accounting principles (GAAP).

1. Holmes' report made no reference to generally accepted accounting principles. Because Holmes did not conduct a proper audit, the report should state that no opinion can be expressed as to the fair presentation of the financial statements in accordance with generally accepted accounting principles.

2-7

2-21 (continued) BRIEF DESCRIPTION OF GAAS

HOLMES' ACTIONS RESULTING IN FAILURE TO COMPLY WITH GAAS

2. The auditor must identify in the auditor’s report those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.

2. Holmes' improper audit would not enable him to determine whether generally accepted accounting principles were consistently applied. Holmes' report should make no reference to the consistent application of accounting principles.

3. When the auditor determines that informative disclosures are not reasonably adequate, the auditor must so state in the auditor’s report.

3. Management is primarily responsible for adequate disclosures in the financial statements, but when the statements do not contain adequate disclosures the auditor should make such disclosures in the auditor's report. In this case both the statements and the auditor's report lack adequate disclosures.

4. The auditor must either express an opinion regarding the financial statements, taken as a whole, or state that an opinion cannot be expressed, in the auditor’s report. When the auditor cannot express an overall opinion, the auditor should state the reasons therefor in the auditor’s report. In all cases where an auditor's name is associated with financial statements, the auditor should clearly indicate the character of the auditor's work, if any, and the degree of responsibility the auditor is taking, in the auditor’s report.

4. Although the Holmes report contains an expression of opinion, such opinion is not based on the results of a proper audit. Holmes should disclaim an opinion because he failed to conduct an audit in accordance with generally accepted auditing standards.

2-8

2-22 a.

CPAs can provide the following information and Web links on their firm Web sites:       



Office locations or affiliations Lines of service the firm provides (audit, tax, management consulting, etc.) Industry specialization information for the firm Online software tools and databases Latest tax law developments applicable to clients Calculators for retirement account decisions Online privacy management software

CPA firms invest their resources to develop sophisticated Web sites largely because of a desire to maintain a client-service approach. Increased competition motivates CPA firms to improve the traditional paths of providing information to their clients. A CPA firm can reach clients more quickly and efficiently with vital information via the firm’s Web site than through more traditional forms of communication, such as a monthly or quarterly newsletter. Also, as more clients become sophisticated in the area of technology, they expect their CPA firms to do the same by providing a useful Web site that has links to other helpful tools and resources.

The Internet is a useful tool for a CPA firm’s accounting and auditing practice in many ways. A firm’s Web site can be used to market the firm’s accounting and auditing practice. The Internet also connects the firm’s global professional staff, making it easier for staff from all over the world to provide client service on a timely basis without having to be physically present at the client’s location. CPAs also use online resources and databases to remain current on emerging business and standards-setting issues. Examples include Standard and Poor’s Net Advantage Database and Goldman Sachs Research Database. These two databases provide extensive industry-specific information and coverage of companies that CPAs use on a subscription basis to stay current on industry developments and to obtain industry data useful for auditing and consulting.

Internet Problem Solution: PCAOB Standing Advisory Group

2-1 The Sarbanes-Oxley Act created The Public Company Accounting Oversight Board (PCAOB) to establish auditing standards, quality control standards, and ethics standards for auditors of public companies. The PCAOB has convened a group to advise the Board on the establishment of auditing and related professional practice standards. Visit the PCAOB’s website [http://www.pcaobus.org/Standards/Standards_Setting.aspx] to learn more and answer the following questions. 1.

Who serves on the PCAOB’s standing advisory group (SAG)? How often does the group meet? 2-9

2-1 (continued) Answer: The SAG is composed of approximately 30 highly qualified persons representing the auditing profession, public companies, investors and others. The Board also has granted six organizations observer status with speaking rights at all SAG meetings. Those six organizations are the Financial Accounting Standards Board, the Government Accountability Office, the International Auditing and Assurance Standards Board, the Securities and Exchange Commission, the Department of Labor, and the Auditing Standards Board of the American Institute of Certified Public Accountants. The SAG meets in person approximately three times per year and by telephone, as necessary. 2.

Review the most recent agenda for the SAG and briefly describe some of the key issues discussed during that meeting. Answer: While student answers will vary depending upon the availability of various SAG meetings, the most recent meeting at the time of preparation of this material was October 5, 2006. During that meeting the SAG dealt with three overall matters. First, there was a discussion of the Board’s standards-setting priority for the coming year. Second, the SAG was asked to consider ways in which to measure the success of the PCAOB in achieving its mission outlined in SOX. Finally, the SAG held a panel discussion about issues facing smaller companies and smaller audit firms.

2-10

Chapter 3 Audit Reports 

Review Questions

3-1 Auditor's reports are important to users of financial statements because they inform users of the auditor's opinion as to whether or not the statements are fairly stated or whether no conclusion can be made with regard to the fairness of their presentation. Users especially look for any deviation from the wording of the standard unqualified report and the reasons and implications of such deviations. Having standard wording improves communications for the benefit of users of the auditor’s report. When there are departures from the standard wording, users are more likely to recognize and consider situations requiring a modification or qualification to the auditor’s report or opinion. 3-2

The unqualified audit report consists of: 1. 2. 3.

5. 6. 7.

Report title Auditing standards require that the report be titled and that the title includes the word independent. Audit report address The report is usually addressed to the company, its stockholders, or the board of directors. Introductory paragraph The first paragraph of the report does three things: first, it makes the simple statement that the CPA firm has done an audit. Second, it lists the financial statements that were audited, including the balance sheet dates and the accounting periods for the income statement and statement of cash flows. Third, it states that the statements are the responsibility of management and that the auditor's responsibility is to express an opinion on the statements based on an audit. Scope paragraph. The scope paragraph is a factual statement about what the auditor did in the audit. The remainder briefly describes important aspects of an audit. Opinion paragraph. The final paragraph in the standard report states the auditor's conclusions based on the results of the audit. Name of CPA firm. The name identifies the CPA firm or practitioner who performed the audit. Audit report date. The appropriate date for the report is the end of fieldwork, when the auditor has gathered sufficient appropriate evidence to support the opinion.

The same seven parts are found in a qualified report as in an unqualified report. There are also often one or more additional paragraphs explaining reasons for the qualifications. 3-3 The purposes of the scope paragraph in the auditor's report are to inform the financial statement users that the audit was conducted in accordance with generally accepted auditing standards, in general terms what those standards mean, and whether the audit provides a reasonable basis for an opinion. 3-1

3-3

(continued) The information in the scope paragraph includes: 1. 2. 3. 4.

The auditor followed generally accepted auditing standards. The audit is designed to obtain reasonable assurance about whether the statements are free of material misstatement. Discussion of the audit evidence accumulated. Statement that the auditor believes the evidence accumulated was appropriate for the circumstances to express the opinion presented.

3-4 The purpose of the opinion paragraph is to state the auditor's conclusions based upon the results of the audit evidence. The most important information in the opinion paragraph includes: 1. 2. 3.

The words "in our opinion" which indicate that the conclusions are based on professional judgment. A restatement of the financial statements that have been audited and the dates thereof or a reference to the introductory paragraph. A statement about whether the financial statements were presented fairly and in accordance with generally accepted accounting principles.

3-5 The auditor's report should be dated February 17, 2008, the date on which the auditor completed the most important auditing procedures in the field. 3-6 An unqualified circumstances: 1.

2. 3.

report

may

issued

under the

following

five

All statements—balance sheet, income statement, statement of retained earnings, and statement of cash flows—are included in the financial statements. The three general standards have been followed in all respects on the engagement. Sufficient evidence has been accumulated and the auditor has conducted the engagement in a manner that enables him or her to conclude that the three standards of field work have been met. The financial statements are presented in accordance with generally accepted accounting principles. This also means that adequate disclosures have been included in the footnotes and other parts of the financial statements. There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of the report.

3-2

3-7 The introductory, scope and opinion paragraphs are modified to include reference to management’s report on internal control over financial reporting, and the scope of the auditor’s work and opinion on internal control over financial reporting. The introductory and opinion paragraphs also refer to the framework used to evaluate internal control. Two additional paragraphs are added between the scope and opinion paragraphs that define internal control and describe the inherent limitations of internal control. 3-8 When adherence to generally accepted accounting principles would result in misleading financial statements there should be a complete explanation in a separate paragraph. The separate paragraph should fully explain the departure and the reason why generally accepted accounting principles would have resulted in misleading statements. The opinion should be unqualified, but it should refer to the separate paragraph during the portion of the opinion in which generally accepted accounting principles are mentioned. 3-9 An unqualified report with an explanatory paragraph or modified wording is the same as a standard unqualified report except that the auditor believes it is necessary to provide additional information about the audit or the financial statements. For a qualified report, either there is a scope limitation (condition 1) or a failure to follow generally accepted accounting principles (condition 2). Under either condition, the auditor concludes that the overall financial statements are fairly presented. Two examples of an unqualified report with an explanatory paragraph or modified wording are: 1. 2.

The entity changed from one generally accepted accounting principle to another generally accepted accounting principle. A shared report involving the use of other auditors.

3-10 When another CPA has performed part of the audit, the primary auditor issues one of the following types of reports based on the circumstances. 1.

No reference is made to the other auditor. This will occur if the other auditor audited an immaterial portion of the statement, the other auditor is known or closely supervised, or if the principal auditor has thoroughly reviewed the other auditor's work. Issue a shared opinion in which reference is made to the other auditor. This type of report is issued when it is impractical to review the work of the other auditor or when a portion of the financial statements audited by the other CPA is material in relation to the total. The report may be qualified if the principal auditor is not willing to assume any responsibility for the work of the other auditor. A disclaimer may be issued if the segment audited by the other CPA is highly material.

3-3

3-11 Even though the prior year statements have been restated to enhance comparability, a separate explanatory paragraph is required to explain the change in generally accepted accounting principles in the first year in which the change took place. 3-12 Changes that affect the consistency of the financial statements may involve any of the following: a. b. c.

Change in accounting principle Change in reporting entity Corrections of errors involving accounting principles.

An example of a change that affects consistency would be a change in the method of computing depreciation from straight line to an accelerated method. A separate explanatory paragraph is required if the amounts are material. Comparability refers to items such as changes in estimates, presentation, and events rather than changes in accounting principles. For example, a change in the estimated life of a depreciable asset will affect the comparability of the statements. In that case, no explanatory paragraph for lack of consistency is needed, but the information may require disclosure in the statements. 3-13 The three conditions requiring a departure from an unqualified opinion are: 1.

The scope of the audit has been restricted. One example is when the client will not permit the auditor to confirm material receivables. Another example is when the engagement is not agreed upon until after the client's year-end when it may be impossible to physically observe inventories. The financial statements have not been prepared in accordance with generally accepted accounting principles. An example is when the client insists upon using replacement costs for fixed assets. The auditor is not independent. An example is when the auditor owns stock in the client's business.

3-14 A qualified opinion states that there has been either a limitation on the scope of the audit or a departure from GAAP in the financial statements, but that the auditor believes that the overall financial statements are fairly presented. This type of opinion may not be used if the auditor believes the exceptions being reported upon are extremely material, in which case a disclaimer or adverse opinion would be used. An adverse opinion states that the auditor believes the overall financial statements are so materially misstated or misleading that they do not present fairly in accordance with GAAP the financial position, results of operations, or cash flows. A disclaimer of opinion states that the auditor has been unable to satisfy him or herself as to whether or not the overall financial statements are fairly presented because of a significant limitation of the scope of the audit, or a nonindependent relationship under the Code of Professional Conduct between the auditor and the client. 3-4

3-14

(continued)

Examples of situations that are appropriate for each type of opinion are as follows: OPINION TYPE Disclaimer

EXAMPLE SITUATION Material physical inventories not observed and the inventory cannot be verified through other procedures. Lack of independence by the auditor.

Adverse

A highly material departure from GAAP.

Qualified

Inability to confirm the existence of an asset which is material but not extremely material in value.

3-15 The common definition of materiality as it applies to accounting and, therefore, to audit reporting is: A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect a decision of a reasonable user of the statements. Conditions that affect the auditor's determination of materiality include:   

Potential users of the financial statements Dollar amounts of the following items: net income before taxes, total assets, current assets, current liabilities, and owners' equity Nature of the potential misstatements—certain misstatements, such as fraud, are likely to be more important to users of the financial statements than other misstatements.

3-16 Materiality for lack of independence in audit reporting is easiest to define. If the auditor lacks independence as defined by the Code of Professional Conduct, it is always considered highly material and therefore a disclaimer of opinion is always necessary. That is, either the CPA is independent or not independent. For failure to follow GAAP, there are three levels of materiality: immaterial, material, and highly material. 3-17 The auditor's opinion may be qualified by scope limitations caused by client restrictions or by limitations resulting from conditions beyond the client's control. The former occurs when the client will not, for example, permit the auditor to confirm material receivables or physically observe inventories. The latter may occur when the engagement is not agreed upon until after the client's year-end when it may not be possible to physically observe inventories or confirm receivables.

3-5

3-17 (continued) A disclaimer of opinion is issued if the scope limitation is so material that the auditor cannot determine if the overall financial statements are fairly presented. If the scope limitation is caused by the client's restriction the auditor should be aware that the reason for the restriction might be to deceive the auditor. For this reason, a disclaimer is more likely for client restrictions than for conditions beyond anyone's control. When there is a scope restriction that results in the failure to verify material, but not pervasive accounts, a qualified opinion may be issued. This is more likely when the scope limitation is for conditions beyond the client's control than for restrictions by the client. 3-18 A report with a scope and an opinion qualification is issued when the auditor can neither perform procedures that he or she considers necessary nor satisfy him or herself by using alternative procedures, usually due to the existence of conditions beyond the client's or the auditor's control, but the amount involved in the financial statements is not highly material. An important part of a scope and opinion qualification is that it results from not accumulating sufficient audit evidence, either because of the client's request or because of circumstances beyond anyone's control. A report qualified as to opinion only results when the auditor has accumulated sufficient appropriate evidence but has concluded that the financial statements are not correctly stated. The only circumstance in which an opinion only qualification is appropriate is for material, but not highly material, departures from GAAP. 3-19 The three alternative opinions that may be appropriate when the client's financial statements are not in accordance with GAAP are an unqualified opinion, qualified as to opinion only and adverse opinion. Determining which is appropriate depends entirely upon materiality. An unqualified opinion is appropriate if the GAAP departure is immaterial (standard unqualified) or if the auditor agrees with the client's departure from GAAP (unqualified with explanatory paragraph). A qualified opinion is appropriate when the deviation from GAAP is material but not highly material; the adverse opinion is appropriate when the deviation is highly material. 3-20 The AICPA has such strict requirements on audit opinions when the auditor is not independent because it is important that stockholders and other third parties be absolutely assured that the auditor is unbiased throughout the entire engagement. If users develop the attitude that auditors are not independent of management, the value of the audit function will be greatly reduced, if not eliminated. 3-21 When the auditor discovers more than one condition that requires a departure from or a modification of a standard unqualified report, the report should be modified for each condition. An exception is when one condition neutralizes the other condition. An example would be when the auditor is not independent and there is also a scope limitation. In this situation the lack of independence overshadows the scope limitation. Accordingly, the scope limitation should not be mentioned. 3-6