CHAPTER 1 AN INTRODUCTION TO ASSURANCE AND FINANCIAL STATEMENT AUDITING Answers to Review Questions 1-1 The study of auditing is more conceptual in nature compared to other accounting courses. Rather than focusing on learning the rules, techniques, and computations required to prepare financial statements, auditing emphasizes learning a framework of analytical and logical skills to evaluate the relevance and reliability of the systems and processes responsible for financial information, as well as the information itself.
To be successful, students must learn the framework and then learn to use logic and common sense in applying auditing concepts to various circumstances and situations. Understanding auditing can improve the decision making ability of consultants, business managers, and accountants by providing a framework for evaluating the usefulness and reliability of information—an important task in many different contexts. -2There is a demand for auditing in a free-market economy because the agency relationship between an absentee owner and a manager produces a natural conflict of interest due to the information asymmetry that exists between the owner and manager. As a result, the agent agrees to be monitored as part of his/her employment contract. Auditing appears to be a cost-effective form of monitoring. The empirical evidence suggests auditing was demanded prior to government regulation. In 1926, before it was required by law, independent auditors audited 82 percent of the companies on the New York Stock Exchange.
Additionally, many private companies and municipalities not subject to government regulations such as the Securities Act of 1933 and Securities Exchange Act of 1934 also purchase various forms of auditing and assurance services. 1-3The agency relationship between an owner and manager produces a natural conflict of interest because of differences in the two parties’ goals and because of the information asymmetry that exists between them. That is, the manager may well have different goals than the owner, and generally has more nformation about the “true” financial position and results of operations of the entity than the absentee owner does. If both parties seek to maximize their own self-interest, it is likely that the manager will not act in the best interest of the owner and may manipulate the information provided to the owner accordingly. 1-4Independence is a bedrock principle for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report objectively and truthfully on the financial statements, and the auditor’s work loses its value.
From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner. 1-5Auditing (broadly defined) is a systematic process of (1) objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and (2) communicating the results to interested users.
Attest services occur when a practitioner issues a report on subject matter, or an assertion about subject matter, that is the responsibility of another party. Assurance services are independent professional services that improve the quality of information, or its context, for decision makers. 1-6The phrase systematic process implies that there should be a well-planned, logical approach for conducting an audit that involves objectively obtaining and evaluating evidence. -7Materiality is defined as “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement” (AU 312). Audit risk is defined as the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated (AU 312).
The concept of materiality is reflected in the wording of the auditor’s standard audit report through the phrase “the financial statements present fairly in all material respects. ” This is the manner in which the auditor communicates the notion of materiality to the users of the auditor’s report. The auditor’s standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements. The term “reasonable assurance” implies that there is some risk that a material misstatement could be present in the financial statements and the auditor will fail to detect it. -8On most audits, it is not feasible or cost-effective to audit all transactions. For example, in a small business, the auditor might be able to examine all transactions that occurred during the period. However, it is unlikely that the owner of the business could afford to pay for such an extensive audit. For a large organization, the sheer volume of transactions prevents the auditor from examining every transaction. Thus, there is a trade-off between the exactness or precision of the audit and its cost. 1-9The major phases of the audit are: Client acceptance/continuance and establishing an understanding with the client • Preliminary engagement activities • Plan the audit • Consider and audit internal control • Audit business processes and related accounts • Complete the audit • Evaluate results and issue audit report 1-10The auditor’s understanding of the entity and its environment includes knowledge about: (1) the client’s industry, regulatory, and other external factors, (2) the nature of the entity, (3) its objectives and strategies, (4) its measurement and performance review process, and (5) the entity’s system of internal control. -11 The four paragraphs of the auditor’s standard unqualified report for a public company client are: (1) the introductory paragraph, (2) the scope paragraph, (3) the opinion paragraph, and (4) an explanatory paragraph referring to the audit of internal control, as illustrated in this chapter. 1-12Auditors frequently face situations where no standard audit procedure exists, such as the example from the text of verifying the inventory of cattle. Such circumstances require that the auditor exercise creativity and innovation when planning and administering audit procedures where little or no guidance or precedent exists.
Every client is different, and applying auditing concepts in different situations requires logic and common sense, and frequently creativity and innovation. Answers to Multiple-Choice Questions |1-13 |B | |1-19 |A | |1-14 |B | |1-20 |D | |1-15 |C | |1-21 |D | |1-16 |C | |1-22 |D | |1-17 |C | |1-23 |B | |1-18 |C | | | |
Solutions to Problems 1-24The memo should cite the following facts: • There is a historical relationship between accounting and auditing. • When parties to the agency relationship (contract) do not possess the same amount of information (information asymmetry) there is a natural conflict of interest between the parties. For example, when an owner and manager are negotiating an employment contract, the owner may assume that the manager likely will use organizational funds for personal uses. Auditing plays an important role in such relationships.
The owner and manager will consummate an employment contract only if the manager agrees to be monitored. Auditing can be used to monitor the contract agreed to by the two parties. (P. S. As an attorney, Lee should be well versed on contract law. ) • Auditing is also used to monitor other types of contracts for which no laws or regulations require an audit, for example, contracts between management and debt holders. • There is historical evidence of forms of auditing in the early Greek states and in the United Kingdom during the industrial revolution.
More relevant evidence is the fact that 82 percent of the NYSE companies were audited prior to the securities acts. • Additional evidence for the demand for auditing is also provided by the fact that many private companies and municipalities not subject to the securities acts contract for audits. 1-25There are two major factors that may make an audit necessary for Greenbloom Garden Centers. First, the company may require long-term financing for its expansion into other cities in Florida. Entities such as banks or insurance companies are likely to be the sources of the company’s debt financing.
These entities normally require audited financial statements before lending significant funds and generally require audited financial statements during the time period the debt is outstanding. There is information asymmetry between the lender of funds and the owner of the business, and this asymmetry results in information risk to the lender. Even if the business could get funding without an audit, a clean audit report by a reputable auditor might very well reduce the lender’s information risk and make the terms of the loan more favorable to the owner.
Second, as the company grows, the family will lose control over the day-to-day operations of the stores. An audit can provide an additional monitoring activity for the family in controlling the expanded operations of the company. 1-26a. Evidence that assists the auditor in evaluating financial statement assertions consists of the underlying accounting data and any additional information available to the auditor, whether originating from the client or externally. b. Management makes assertions about components of the financial statements.
For example, an entity’s financial statements may contain a line item that accounts receivable amount to $1,750,000. In this instance, management is asserting, among other things, that the receivables exist, the entity owns the receivables, and the receivables are properly valued. Audit evidence helps the auditor determine whether management’s assertions are being met. If the auditor is comfortable that he or she can provide reasonable assurance that all assertions are met for all accounts, he or she can issue a clean audit report.
In short, the assertions are a conceptual tool to help the auditor ensure that she or he has “covered all the bases. ” c. In searching for and evaluating evidence, the auditor should be concerned with the relevance and reliability of evidence. If the auditor mistakenly relies on evidence that does not relate to the assertion being tested, an incorrect conclusion may be reached about the management assertion. Reliability refers to the ability of evidence to signal the true state of the assertion, i. e. whether it is actually being met or not. 1-27a.
The major phases of the audit and their descriptions are: 1. Client acceptance/continuance and establish an understanding with the client. The auditor decides to accept a new client or to retain an existing client. The auditor establishes an understanding with the client regarding the services to be performed, engagement timing, fees, etc. 2. Preliminary engagement activities. This phase involves determining the audit engagement team requirements and ensuring the independence of the audit team and audit firm, among other things. 3. Plan the audit.
During this phase of the audit, the auditor uses the knowledge of the client to plan the audit and perform preliminary analytical procedures. The 4. purpose of this phase is to plan an effective and efficient audit. 4. Consider and audit internal control. The auditor understands and evaluates the client’s internal controls in order to assess the risk that they will not prevent or detect a material misstatement. In the case of a public company, the auditor will conduct an audit of internal control over financial reporting. 5. Audit business processes and related accounts.
The auditor conducts substantive tests, including analytical procedures and the details of the account balances, searching for material misstatements. 6. Complete the audit. The auditor searches for contingent liabilities and subsequent events, and performs a final review of the evidence gathered. 7. Evaluate results and issue the audit report. Based on the collection and evaluation of evidence, the auditor issues a report on whether the financial statements are fairly presented. b. While audit procedures may be designed to test a specific assertion, they often simultaneously provide evidence on another account or assertion.
An example would be when an auditor obtains evidence about a client’s transactions affecting the inventory account and whether shipments of inventory to customers were included in the proper period. Such evidence may also be relevant to the client’s assertions regarding whether accounts receivable balances were correct at the end of the period. c. Auditors develop an understanding of an entity’s internal control in order to establish the scope of the audit. However, during the course of this work, the auditor may become aware of weaknesses in the entity’s accounting systems.
The auditor is required to communicate this information to management. The auditor may also make suggestions on how to correct the weaknesses. The auditor’s work on internal control may also have a preventive effect on the behavior of the entity’s employees. If the employees know that their work will be audited, they are less likely to commit errors or fraud. Because of the Sarbanes-Oxley Act, internal control is a topic that is front-and-center in the accounting profession. 28. A search of the homepage of most public companies will include links to their latest financial information or 10-K filings.
The SEC’s homepage will also include this information along with any other recent filings. Examining the independent auditor’s report and financial statements will allow the student have a better idea as to how the chapter’s information is applied in real companies. 29. Scope paragraph: “These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. ” The use of the term reasonable assurance indicates that there is no guarantee that the financial statements are correct, only “reasonable assurance. Also the statement that the financials are “free of material misstatement” indicates that the financials may have some error that is not material. “An audit also includes assessing the accounting principles used and significant estimates made…” The explanation that management uses estimates indicates that some of the figures in the financial statements are not exact. “We believe that our audits provide a reasonable basis for our opinion. ” This statement indicates that the audit is not “proof” that the financial statements are exact, only that there is reasonable evidence about their accuracy.
Opinion paragraph: “…the consolidated financial statements referred to above present fairly, in all material respects,…” This sentence indicates that the financial statements are a “fair”, not exact, representation. Also, the idea of materiality is revisited here, indicating that there may still be relatively small errors in the financial statements. Solutions to Discussion Cases 1-30Independent audits are a critical component of corporate governance and can enhance the effectiveness of the examination and supervision process.
Such audits can improve the reliability of financial reports and help identify internal control weaknesses. Thus, such audits can benefit bank examiners in enhancing the safety and soundness of financial institutions. Solutions to Internet Assignments 1-31There are numerous Internet sites that contain accounting information. Following are some suggested sites: • The AICPA’s home page (www. aicpa. org) contains extensive information on the organization’s activities. For example, it contains the entire report of the Special Committee on Assurance Services. • The American Accounting Association’s home page (www. aahq. org) contains numerous links, including professional organizations, accounting journals, and education sites. • The Association of Certified Fraud Examiners (www. cfenet. com) home page contains extensive information on the Association’s certification as Certified Fraud Examiners (CFE). • The Institute of Internal Auditors (www. theiia. org) home page contains detailed information on internal auditing. • The International Federation of Accountants (www. ifac. org) Web site provides detailed information on international accounting and auditing standards. The Government Accountability Office (formerly the General Accounting Office, www. gao. gov) Web site provides detailed information on the GAO’s activities and allows users to obtain copies of GAO reports. • The SEC’s Edgar Web site (www. sec. gov) contains all filings by public companies with the SEC. It also contains information on other activities by the SEC. • The PCAOB’s Web site (www. pcaob. org) offers detailed information about the PCAOB and the standards it has proposed and established. • The major public accounting firms and many smaller firms also maintain Web sites.