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Chapter 01 - Auditing and Assurance Services
Solution Manual For Auditing & Assurance Services
9th Edition by Timothy Louwers, Penelope Bagley
Chapter 01 - Auditing and Assurance Services
CHAPTER 01
Auditing and Assurance Services
LEARNING OBJECTIVES
Review
Checkpoints
Multiple
Choice
Exercises, Problems,
and Simulations
1. Define information risk and explain how the
financial statement auditing process helps to
reduce this risk, thereby reducing the cost of
capital for a company.
1, 2, 3 29, 31, 38 65*
2. Define and contrast assurance, attestation,
and financial statement auditing services.
4, 5, 6, 7, 8 23, 25, 28, 44,
50
60, 65*
3. Describe and define the assertions that
management makes about the recognition,
measurement, presentation, and disclosure of
the financial statements and explain why
auditors use them as a focal point of the audit.
9, 10, 11 36, 39, 40, 41, 45,
46, 47, 48, 49, 52,
53, 54, 55, 57, 58,
59
62, 63, 67, 68, 69
4. Define professional skepticism and explain its
key characteristics.
12 24, 37 61
5. Describe the organization of public accounting
firms and identify the various services that
they offer.
13, 14 30, 42, 56 72
6. Describe the audits and auditors in
governmental, internal, and operational
auditing.
15, 16, 17, 18 26, 27, 32, 34, 35 64, 66
7. List and explain the requirements for
becoming a certified public accountant (CPA)
and other certifications available to an
accounting professional.
19, 20, 21, 22 33, 43, 51 70, 71
(*) Item relates to multiple learning objectives
Chapter 01 - Auditing and Assurance Services
SOLUTIONS FOR REVIEW CHECKPOINTS
1.1 Business risk is the risk that an entity will fail to meet its business objectives. When assessing
business risk, a professional must consider all possible threats to an entity‘s goals and objectives. Some
illustrative examples include the risk that: 1) its existing customers will start buying products or services
from its primary competitors; 2) its product lines will become obsolete; 3) its taxes will increase; 4) key
government contracts will be lost; 5) key employees will leave the entity; and many other examples exist.
1.2 To help minimize business risk and take advantage of other opportunities presented in today‘s competitive
business environment, decision makers such as chief executive officers (CEOs) demand timely, relevant,
and reliable information. There are at least four environmental conditions that increase demand for reliable
information. First, complexity which implies that events and transactions in today‘s global business
environment can be complicated. Most investors do not have the level of expertise needed to properly
account for complex transactions. Second is remoteness which implies that decision makers are often
separated from current and potential business relationships due to distance and time. For example, investors
may not be able to visit distant locations to check up on their investments. Third is time-sensitivity which
implies that in today‘s economic environment, investors and other users of financial statements need to
make decisions more rapidly than ever before. As a result, the ability to promptly obtain high-quality
information is essential. Fourth is a consequence which implies that decisions may very well involve
significant investments. As a result, the consequences can be severe if information cannot be obtained
1.3 Of all the different risks discussed in the chapter up to this point, information risk is the one that is most
likely to create the demand for independent and objective assurance services is information risk or the
probability that the information circulated by an entity will be false or misleading. Because the primary
source of information for investors and creditors is the company itself, an incentive exists for that
company‘s management to make their business or service appear to be better than it actually may be, to put
their best foot forward. As a result, preparers and issuers of financial information (directors, managers,
accountants, and other people employed in a business) might benefit by giving false, misleading, or overly
optimistic information. This potential conflict of interest between information providers and users which
provides the underlying basis for the demand for reliable information.
1.4 The four major elements of the broad definition of assurance services are
Independence. CPAs want to preserve their reputation and competitive advantage by always preserving
integrity and objectivity when performing assurance services.
Professional services. Virtually all work performed by CPAs is defined as ―professional services‖ as long
as it involves some element of judgment based on education and experience.
Improving the quality of information or its context. The emphasis is on ―information,‖ CPAs‘ traditional
area of expertise. CPAs can enhance quality by assuring users about the reliability and relevance of
information, and these two features are closely related to the familiar credibility-lending products of
attestation and audit services. ―Context‖ is relevance in a different light. For assurance services, improving
the context of information refers to improving its usefulness when targeted to particular decision makers in
the surroundings of particular decision problems.
For decision makers. As the ―consumers‖ of assurance services, decision makers are the beneficiaries of the
assurance services. Decision makers may or may not be the ―client‖ that pays the fee and may or may not be
one of the parties to an assertion or other information, but they personify the consumer focus of new and
different professional work.
1.5 An assurance services engagement is any assignment that improves the quality of information, or its
context, for decision makers. Because information (e.g., financial statements) are prepared by managers of
an entity who have authority and responsibility for financial success or failure, an outsider may be skeptical
that the information truly is objective, free from bias, fully informative, and free from material error,
intentional or inadvertent. The services of an independent auditor helps resolve those doubts because the
Chapter 01 - Auditing and Assurance Services
auditor‘s success depends upon his or her independent, objective, and competent assessment of the
information (e.g., the conformity of the financial statements with the appropriate reporting framework).
The independent auditor‘s role is to lend credibility to the information; hence, the outsider will likely seek
his or her independent opinion about the financial statements.
1.6 An attestation engagement is ―an engagement in which a practitioner is engaged to issue or does issue a
written communication that expresses a conclusion about the reliability of a written assertion that is the
responsibility of another party‖ (SSAE 10, AT 101.01). To attest means to lend credibility or to vouch for
the truth or accuracy of the statements that one party makes to another. The attest function is a term often
applied to the activities of independent CPAs when acting as auditors of financial statements.
1.7 An assurance service engagement is one that improves the quality of information, or its context, for
decision makers. Thus, an attestation service engagement is one type of an assurance service. Another
way of thinking about the issue is to remember that the financial statement audit engagement is one type of
an attestation service. Please see exhibit 1.3 in the text which depicts the relationship among assurance,
attestation, and auditing engagements.
1.8 According to the American Accounting Association, ―Auditing is a systematic process of objectively
obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the
degree of correspondence between the assertions and established criteria and communicating the results to
interested users.‖ In effect, auditors add reliability to the information that is provided to interested users.
Of course, this definition is focused on an external reporting context. Students may also discuss how
governmental and internal auditors operate as well.
In response to ―What do auditors do?‖ students can respond by stating that auditors (1) obtain and evaluate
evidence about assertions made by management about economic actions and events, (2) ascertain the
degree of correspondence between the assertions and the appropriate reporting framework, and (3) issue an
audit report (opinion). Students can also respond more generally by stating that auditors essentially lend
credibility to the financial statements presented by management.
1.9 Financial accounting refers to the process of recording, classifying, summarizing, and reporting about a
company‘s assets, liabilities, capital, revenues, and expenses in the financial statements in accordance with
the applicable financial reporting framework (e.g., GAAP). In so doing, the management team is making
several assertions about the financial statements. The financial accounting process is the responsibility of
the management team.
Financial statement auditing refers to the process whereby professional auditors gather evidence related to
the assertions that management makes in the financial statements, evaluates the evidence and concludes on
the fairness of the financial statements in a report.
They differ because accountants produce the financial statements in accordance with the applicable
financial reporting framework. After this is complete, financial statement auditors then perform procedures
to ascertain whether the financial statements have been prepared in accordance with the applicable financial
reporting framework.
1.10 The two major classifications of ASB assertions with several assertions in each classification are:
Assertions About Classes of Transactions and Events, and Related Disclosures
Occurrence assertion: The objective is to establish with evidence that transactions giving rise to assets,
liabilities, sales, and expenses occurred. Key questions include ―Did the recorded sales transactions really
occur?‖
Completeness assertion: The objective is to establish with evidence that all transactions of the period that
should be are included in the financial statements (including footnotes). Completeness also refers to proper
inclusion in financial statements of all revenue, expense, and related disclosures. Key questions related to
Chapter 01 - Auditing and Assurance Services
completeness include ―Are the revenue and expense account balances complete?‖ and ―Were all the
transactions that should be included reflected properly in the footnote disclosures?‖
Cutoff assertion: The objective is to establish with evidence that all transactions that properly belong in the
preceding or following accounting periods are excluded. And, that only those transactions that should be
included in the financial statements are included. A key question related to the cutoff assertion includes
―Were all the transactions recorded in the right period?‖
Accuracy assertion: The objective is to establish with evidence that transactions have been recorded at the
correct amount. Key questions include ―Were the expenses recorded at the proper dollar amount?‖
Classification assertion: The objective is to establish with evidence that transactions were posted to the
correct accounts. Key questions include ―Was this expense recorded in the appropriate account?‖
Presentation assertion: The objective is to establish with evidence that the information has been properly
presented and described, and that the disclosures are clearly expressed. Key questions include ―Was the
information in the disclosure properly presented and disclosed?‖
Assertions about Account Balances and Related Disclosures
Existence assertion: The objective is to establish with evidence that the balance represents assets,
liabilities, sales, and expenses that are real and in existence at the balance sheet date. Key questions
include ―Does this number truly represent assets that existed at the balance sheet date?‖
Completeness assertion: The objective is to establish with evidence that all balances of the period are in the
financial statements. Key questions related to completeness include ―Are the asset and liability accounts in
the financial statements complete?‖
Rights and obligations assertion: The objectives related to rights and obligations are to establish with
evidence that assets are owned (or rights such as capitalized leases are shown) and liabilities are owed. Key
questions related to this assertion include ―Does the company really own the assets? And ―Are related legal
responsibilities identified?‖
Accuracy, Valuation and Allocation assertions: The objective is to establish with evidence that balances
have been valued correctly. Key questions include ―Are the account balances accurate?‖ ―Are the accounts
valued correctly?‖ and ―Are expenses allocated to the period(s) benefited?‖
Presentation assertion: The objective is to establish with evidence that the balance sheet amounts, and
related footnote disclosures are complete, properly presented and are understandable to the financial
statement users. Key questions relate to ―Is the account properly presented in the correct financial
statement category‖ And, ―are the footnote disclosures complete and presented to promote an
understanding of the nature of the account?‖
1.11 In general, management‘s financial statement assertions are important to auditors because they are used
when assessing risks by determining the different types of misstatements that could occur for each assertion
related to each significant account and disclosure. Next, auditors use the assertions to develop audit
procedures that are appropriate to mitigate the risk of material misstatement for each assertion. In essence,
the key questions that must be answered about each of the relevant assertions become the focal points for
audit procedures. Audit procedures are the means to answer the key questions posed by management‘s
financial statement assertions. In fact, the procedures are completed to provide the evidence necessary to
persuade the auditor that there is no material misstatement related to each of the relevant assertions
identified for an engagement.
The ASB assertions differ from the PCAOB assertions in that they provide greater detail and clarity for
auditors to conceptualize the type of misstatements that may exist in the financial statements. Thus, the
PCAOB assertions are more general than the ASB assertions. Importantly, the PCAOB recognizes that
Chapter 01 - Auditing and Assurance Services
their assertions are more general and do allow auditors to use the more granular and specific ASB
assertions when completing the audit. As a result, largely each of the firms auditing public companies with
international operations feature the ASB assertions to guide their auditing processes. Importantly, a student
of auditing will note that the ASB assertions are in direct alignment with the PCAOB assertions. This is
illustrated in the text in Exhibit 1.4
1.12 By having a belief that a potential conflict of interest always exists between the auditor and the
management team, auditors will be skeptical when completing the audit. Indeed, even though the vast
majority of audits do not contain fraud, auditors have no choice but to consider the possibility of fraud on
every audit. Stated simply, errors and financial reporting frauds have happened in the past, and users of
financial statements and audit reports expect auditors to detect material misstatements if they exist.
Indeed, auditing firms have long recognized the importance of exercising professional skepticism when
making professional judgments. As a student of auditing, you can expect to encounter difficult economic
transactions as an auditor. When a difficult transaction is encountered, auditors must take the time to fully
understand the economic substance of that transaction and then critically evaluate, with skepticism, the
evidence provided by the client to justify its accounting treatment. There are no shortcuts allowed. Rather,
auditors must always hold a belief that a potential conflict of interest exist between the auditor and
management, and they must be unbiased and objective when making their professional judgments.
1.13 Generally speaking, assurance services involve the lending of credibility to information, whether financial
or nonfinancial. CPAs have assured vote counts (e.g., Baseball Hall of Fame), dollar amounts of prizes that
sweepstakes have claimed to award, accuracy of advertisements, investment performance statistics, and
characteristics claimed for computer software programs. Some specific examples of assurance service
engagements performed on nonfinancial information include
 eXtensible Business Reporting Language (XBRL) reporting.
 Enterprise risk management assessment.
 Information risk assessment and assurance.
 Third-party reimbursement maximization.
 Rental property operations review.
 Customer satisfaction surveys.
 Evaluation of investment management policies.
 Fraud and illegal acts prevention and deterrence.
 Internal audit outsourcing.
1.14 There are three major areas of public accounting services
 Financial Statement Audit and other types of Assurance services.
 Tax services.
 Consulting and Advisory services.
1.15 Operational auditing is the study of business operations for the purpose of making recommendations about
the economic and efficient use of resources, effective achievement of business objectives, and compliance
with company policies. The AICPA views operational auditing as a type of consulting or advisory service
offered by public accounting firms.
Chapter 01 - Auditing and Assurance Services
1.16 The GAGAS issued by the GAO is very clear on this point. Specifically, the elements of expanded-scope
auditing include (1) financial and compliance audits, (2) economy and efficiency audits, and (3) program
results audits.
1.17 Compliance auditing involves a study of an organization‘s policies, procedures, and, ultimately, its
performance in following applicable laws, rules, and regulations. An example would be a school district‘s
policies and procedures related to a meal program for its students. In these types of situations, there would
be a demand for a compliance audit which would be designed to ensure that the school district complies
with the stated policies and procedures of the program.
1.18 Other kinds of auditors include Internal Revenue Service auditors who are required to audit the taxable
income and deductions taken by taxpayers in tax returns and determine their correspondence with the
standards found in the Internal Revenue Code. They also might have to audit for fraud and tax evasion.
Other examples include state and federal bank examiners who are responsible for auditing banks, savings
and loan associations, and other financial institutions for evidence of solvency and compliance with
banking and other related laws and regulations.
1.19 The purpose of the continuing education requirement is to ensure that CPAs in practice maintain their
expertise at a sufficiently high level in light of evolving business conditions and new regulations. For
CPAs in public practice, 120 hours of continuing education is required every three years with no less than
20 hours in any one year. For CPAs not in public practice, the general requirement is 120 or fewer (90 in
some states) every three years.
1.20 Not everything can be learned in the classroom, and some on-the-job experience is helpful before a person
is able to be held out to the public as a licensed professional. Also, the experience requirement tends to
―weed out‖ those individuals who are just looking to become certified without ever being involved in actual
accounting work.
1.21 State boards administer the state accountancy laws and are responsible for ensuring that candidates have
passed the CPA examination and satisfied the state requirements for education and experience before being
awarded a CPA certificate. At the same time, new CPAs must pay a fee to obtain a state license to practice.
Thereafter, state boards of accountancy regulate the behavior of CPAs under their jurisdiction (enforcing
state rules of conduct) and supervise the continuing education requirements. As a result, the state boards
play an important role in the CPA certification and licensure process.
1.22 After becoming a CPA licensed in one state, a person can obtain a CPA certificate and license in another
state. The process is known as reciprocity. CPAs can file the proper application with another state board of
accountancy, meet the state‘s requirements, and obtain another CPA certificate. Many CPAs hold
certificates and licenses in several states. From a global perspective, individuals must be licensed in each
country. Similar to CPAs in the United States, chartered accountants (CAs) practice in Australia, Canada,
Great Britain, and India.
Chapter 01 - Auditing and Assurance Services
SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS
1.23 a. Incorrect This is an attestation to the prize promoter‘s claims. Because attestation and
audit engagements are subsets of assurance engagements, this is an example of
an assurance engagement. However, each response is an example of an
assurance engagement; thus, the answer is (e).
b. Incorrect This is an audit engagement to give an opinion on financial statements. Because
attestation and audit engagements are subsets of assurance engagements, this is
an example of an assurance engagement. However, each response is an example
of an assurance engagement; thus, the answer is (e).
c. Incorrect This is an assurance engagement on a newspaper‘s circulation data. Because
attestation and audit engagements are subsets of assurance engagements, all are
assurance engagements. Thus, the answer is (e).
d. Incorrect This is an assurance engagement on the performance of golf balls. Because
attestation and audit engagements are subsets of assurance engagements, all are
assurance engagements. Thus, the answer is (e).
e. Correct Because attestation and audit engagements are subsets of assurance
engagements, all of the responses are examples of assurance engagements.
1.24 a. Correct The management team is generally trying to put its ―best foot forward‖ when
reporting their financial statement information. The auditor must make sure that
the management team does not violate the accounting rules when doing so. IN
essence, this statement characterizes why professional skepticism is required to
be exercised by auditors.
b. Incorrect ―Exclusively in the capacity of an auditor‖ is not an idea that relates to an
attitude of professional skepticism.
c. Incorrect Professional obligations are not related to an attitude of professional skepticism.
d. Incorrect While it is true that financial statement and financial data are verifiable, this
does not related to the reasons why an auditor needs to begin an audit with an
attitude of professional skepticism.
1.25 a. Incorrect While work on a forecast would potentially be covered by the attestation
standards, the auditors must provide assurance about some type of management
assertion in an attestation engagement.
b. Correct This is the basic definition of an attestation service, as articulated in the book
and the professional standards.
c. Incorrect Since there is no assurance about any management assertion when preparing a
tax return with information that has not been reviewed or audited, this type of
tax work is not considered an attestation service.
d. Incorrect Since there is no assurance about any management assertion when giving expert
testimony about particular facts in an income tax case, this type of work is not
considered an attestation service.
1.26 a. Incorrect The objective of environmental auditing is to help achieve and maintain
compliance with environmental laws and regulations and to help identify and
correct unregulated environmental hazards. This answer is therefore incorrect.
b. Incorrect The objective of financial auditing is to obtain assurance on the conformity of
financial statements with generally accepted accounting principles. This answer
is therefore incorrect.
c. Incorrect The objective of compliance auditing is the entity‘s compliance with laws and
regulations. This answer is therefore incorrect.
d. Correct Operational auditing refers to the study of business operations for the purpose of
making recommendations about the economic and efficient use of resources,
effective achievement of business objectives, and compliance with company
policies.
Chapter 01 - Auditing and Assurance Services
1.27 a. Incorrect This is not the primary objective of an operational audit. However, while
completing an operational audit, a professionally skeptical auditor should still be
concerned about compliance with financial accounting standards.
b. Correct This statement exactly characterizes the goal of an operational audit. In
addition, the statement is part of the basic definition of operational auditing.
c. Incorrect An operational audit does not focus on the financial statements of an entity.
d. Incorrect While analytical tools and skills may be used during an operational audit, they
are also a very important aspect of financial auditing.
1.28 a. Correct According to the AICPA definition found in AU 200 (paragraph 11) and in your
book, ―the purpose of an audit is to enhance the degree of confidence that
intended users can place in the financial statements. This is achieved by the
expression of an opinion by the auditor on whether the financial statements are
prepared, in all material respects, in accordance with an applicable financial
reporting framework. As a result, this is the correct response.
b. Incorrect The AICPA definition is not limited to the FASB for the appropriate reporting
framework that is used as the benchmark when completing an audit. The
definition is general enough to include other financial reporting frameworks as
well, such as IFRS.
c. Incorrect The AICPA definition does not focus on the SEC as an appropriate reporting
framework to be used as a benchmark when completing an audit. The definition
is focused on the ―applicable‖ financial reporting framework, such as GAAP or
IFRS. The reference to the SEC is wrong.
d. Incorrect This phrase is not referenced in the AICPA definition found in the auditing
standards. This phrase is found in the AAA definition of the audit found in this
book.
1.29 a. Incorrect While complexity is an important condition that increases the demand for
reliable information, the potential conflict of interest between management and
the bank is far and away the biggest factor driving the demand for audited
financial statements.
b. Incorrect While remoteness is an important condition that increases the demand for
reliable information, the potential conflict of interest between management and
the bank is far and away the biggest factor driving the demand for audited
financial statements.
c. Incorrect While the consequences of making a bad decision are an important condition
that increases the demand for reliable information, the potential conflict of
interest between management and the bank is far and away the biggest factor
driving the demand for audited financial statements.
d. Correct The potential conflict of interest between management and the bank is far and
away the biggest factor driving the demand for audited financial statements.
Consider for example a company that was desperate for cash in order to survive.
Would it be possible that the management team would present unreliable
financial statements to the bank in order to get a desperation loan? Because of
this possibility, a financial statement audit is needed to add credibility to the
financial statements.
1.30 a. Incorrect According to Section 201 of the Sarbanes-Oxley Act, bookkeeping services are
prohibited.
b. Incorrect According to Section 201 of the Sarbanes-Oxley Act, internal audit services are
prohibited.
c. Incorrect According to Section 201 of the Sarbanes-Oxley Act, valuation services are
prohibited.
d. Correct Sarbanes-Oxley prohibits the provision of all of the services listed in answers a,
b, and c; therefore, d (all of the above) is the best response.
Chapter 01 - Auditing and Assurance Services
1.31 a. Incorrect Financial statement auditors do not reduce business risk.
b. Correct After completing a financial statement audit, information risk has been reduced
for investors.
c. Incorrect Complexity creates demand for accounting services but is not an objective of the
financial statement audit.
d. Incorrect Auditors do not directly control the timeliness of financial statements.
Management must first provide the information to be audited.
1.32 a. Incorrect A financial statement opinion is the objective of a financial statement audit, not
a compliance audit.
b. Incorrect A basis for a report on internal control is the objective of an internal control
audit under Section 404 of the Sarbanes-Oxley Act, not a compliance audit.
c. Incorrect A study of effective and efficient resources is the objective of an operational
audit, not a compliance audit.
d. Correct A compliance audit refers to procedures that are designed to ascertain that the
company‘s personnel are following laws, rules, regulations, and policies.
1.33 a. Incorrect While successful completion of the Uniform CPA is necessary to be licensed as
a CPA, a candidate also requires the proper experience and proper education.
Thus, letter (d.) is correct.
b. Incorrect While proper experience is necessary to be licensed as a CPA, a candidate also
requires the successful completion of the Uniform CPA and proper education.
Thus, letter (d.) is correct.
c. Incorrect While proper education is necessary to be licensed as a CPA, a candidate also
requires the successful completion of the Uniform CPA and proper experience.
Thus, letter (d.) is correct.
d. Correct A candidate requires the successful completion of the Uniform CPA, proper
experience and proper education to be licensed as a CPA.
1.34 a. Incorrect The GIAA is not responsible for monitoring the use of public funds by public
officials. This is the responsibility of the GAO.
b. Incorrect The CIA is not responsible for monitoring the use of public funds by public
officials. This is the responsibility of the GAO.
c. Incorrect The SEC is not responsible for monitoring the use of public funds by public
officials. This is the responsibility of the GAO.
d. Correct The mission of the U.S. Government Accountability Office is to ensure that
public officials are using public funds efficiently, effectively, and economically.
1.35 a. Incorrect A financial audit is typically not included as part of a performance audit.
b. (&d) Correct The two categories of performance audits are economy and efficiency audits and
program audits.
c. Incorrect A compliance audit is typically not included as part of a performance audit.
d. (&b) Correct The two categories of performance audits are economy and efficiency audits and
program audits.
1.36 a. Incorrect A review of credit ratings of customers would not provide evidence about the
completeness of accounts receivable. Because GAAP requires the accounts
receivable balance to be valued at the amount expected to be collected from
customers, the review of credit ratings relates to valuation.
b. Incorrect A review of credit ratings of customers would not provide evidence about the
existence of accounts receivable. Because GAAP requires the accounts
receivable balance to be valued at the amount expected to be collected from
customers, the review of credit ratings relates to valuation.
c. Correct A review of credit ratings of customers‘ gives indirect evidence of the
collectability of accounts receivable. Because GAAP requires the accounts
Chapter 01 - Auditing and Assurance Services
receivable balance to be valued at the amount expected to be collected from
customers, the review of credit ratings relates to valuation.
d. Incorrect A review of credit ratings of customers would not provide evidence about the
rights of accounts receivable. Because GAAP requires the accounts receivable
balance to be valued at the amount expected to be collected from customers, the
review of credit ratings relates to valuation.
e. Incorrect A review of credit ratings of customers would not provide evidence about the
occurrence of accounts receivable. Because GAAP requires the accounts
receivable balance to be valued at the amount expected to be collected from
customers, the review of credit ratings relates to valuation.
1.37 a. Incorrect Rhonda‘s representations are not sufficient evidence to support assertions made
in the financial statements.
b. Incorrect Despite Rhonda‘s representations, Jones must gather additional evidence to
corroborate Rhonda‘s assertions.
c. Incorrect Rhonda‘s representations are a form of evidence (albeit weak) that should
neither be disregarded nor blindly regarded without professional skepticism.
d. Correct Rhonda‘s assertions are nice. However, to be considered as sufficient to
conclude that all expenses have been recorded, they will need corroboration with
documentary evidence. Thus, this is the correct response.
1.38 a. Incorrect Although there is a high level of risk associated with client acceptance, this
phrase was created by the authors.
b. Correct By definition, information risk is the probability that the information circulated
by a company will be false or misleading.
c. Incorrect Moral hazard is the risk that the existence of a contract will change the behavior
of one or both parties to the contract.
d. Incorrect Business risk is the probability an entity will fail to meet its strategic objectives.
1.39 a. Correct This is clearly a test of the completeness as the assertion always includes any
issues of transaction cutoff, which means that the recording of all revenue,
expense, and other transactions must be included in the proper period in
accordance with GAAP.
b. Incorrect This is not an existence test. This is clearly a test of the completeness as the
assertion always includes any issues of transaction cutoff, which means that the
recording of all revenue, expense, and other transactions must be included in the
proper period in accordance with GAAP.
c. Incorrect This is not a test of valuation. This is clearly a test of the completeness as the
assertion always includes any issues of transaction cutoff, which means that the
recording of all revenue, expense, and other transactions must be included in the
proper period in accordance with GAAP.
d. Incorrect This is not a test of rights and obligations. This is clearly a test of the
completeness as the assertion always includes any issues of transaction cutoff,
which means that the recording of all revenue, expense, and other transactions
must be included in the proper period in accordance with GAAP.
e. Incorrect This is not an occurrence test. This is clearly a test of the completeness as the
assertion always includes any issues of transaction cutoff, which means that the
recording of all revenue, expense, and other transactions must be included in the
proper period in accordance with GAAP.
1.40 a. Incorrect This is not a completeness test. This is clearly a test related to rights and
obligations as the question that must be answered with evidence is to establish
that amounts reported as assets of the company represent true assets that it really
does own and that the amounts reported as liabilities truly represent its
obligations. Goods on consignment, by definition, are not owned by the
Chapter 01 - Auditing and Assurance Services
b. Incorrect
company. Thus, there is a risk that the company is recording assets that they do
not own on their balance sheet.
This is not an existence test. This is clearly a test related to rights and
c. Incorrect
obligations as the question that must be answered with evidence is to establish
that amounts reported as assets of the company represent true assets that it really
does own and that the amounts reported as liabilities truly represent its
obligations. Goods on consignment, by definition, are not owned by the
company. Thus, there is a risk that the company is recording assets that they do
not own on their balance sheet.
This is not a test of valuation. This is clearly a test related to rights and
d. Correct
obligations as the question that must be answered with evidence is to establish
that amounts reported as assets of the company represent true assets that it really
does own and that the amounts reported as liabilities truly represent its
obligations. Goods on consignment, by definition, are not owned by the
company. Thus, there is a risk that the company is recording assets that they do
not own on their balance sheet.
This is clearly a test related to rights and obligations as the question that must be
e. Incorrect
answered with evidence is to establish that amounts reported as assets of the
company represent true assets that it really does own and that the amounts
reported as liabilities truly represent its obligations. Goods on consignment, by
definition, are not owned by the company. Thus, there is a risk that the
company is recording assets that they do not own on their balance sheet.
This is not an occurrence test. This is clearly a test related to rights and
obligations as the question that must be answered with evidence is to establish
that amounts reported as assets of the company represent true assets that it really
does own and that the amounts reported as liabilities truly represent its
obligations. Goods on consignment, by definition, are not owned by the
company. Thus, there is a risk that the company is recording assets that they do
not own on their balance sheet.
1.41 a.
b.
Incorrect
Correct
This is not a test of completeness. This is a test of existence which is completed
by auditors to answer the question as to whether the transactions recorded as an
asset really represent assets that exist and did add value to the company‘s
equipment as compared to routine repair and maintenance expenses under
GAAP. Management‘s existence assertion states that the reported assets
actually exist. If an addition to the equipment account cannot be located or
identified as adding value to the equipment balance, it is possible that the
amount should have been classified as repair and maintenance expenses under
GAAP.
This is a test of existence. This test is completed by auditors to answer the
c. Incorrect
question as to whether the transactions recorded as an asset really represent
assets that exist and did add value to the company‘s equipment as compared to
routine repair and maintenance expenses under GAAP. Management‘s
existence assertion states that the reported assets actually exist. If an addition to
the equipment account cannot be located or identified as adding value to the
equipment balance, it is possible that the amount should have been classified as
repair and maintenance expenses under GAAP.
This is not a test of valuation. This is a test of existence which is completed by
auditors to answer the question as to whether the transactions recorded as an
asset really represent assets that exist and did add value to the company‘s
equipment as compared to routine repair and maintenance expenses under
GAAP. Management‘s existence assertion states that the reported assets
actually exist. If an addition to the equipment account cannot be located or
identified as adding value to the equipment balance, it is possible that the
amount should have been classified as repair and maintenance expenses under
GAAP.
Chapter 01 - Auditing and Assurance Services
d. Incorrect This is not a test of rights and obligations. This is a test of existence which is
completed by auditors to answer the question as to whether the transactions
recorded as an asset really represent assets that exist and did add value to the
company‘s equipment as compared to routine repair and maintenance expenses
under GAAP. Management‘s existence assertion states that the reported assets
actually exist. If an addition to the equipment account cannot be located or
identified as adding value to the equipment balance, it is possible that the
amount should have been classified as repair and maintenance expenses under
GAAP.
e. Incorrect This is not a test of occurrence. This is a test of existence which is completed by
auditors to answer the question as to whether the transactions recorded as an
asset really represent assets that exist and did add value to the company‘s
equipment as compared to routine repair and maintenance expenses under
GAAP. Management‘s existence assertion states that the reported assets
actually exist. If an addition to the equipment account cannot be located or
identified as adding value to the equipment balance, it is possible that the
amount should have been classified as repair and maintenance expenses under
GAAP.
1.42 a. Incorrect Under Sarbanes-Oxley, public accounting firms are prevented from acting in a
managerial decision-making role for an audit client.
b. Incorrect Under Sarbanes-Oxley, public accounting firms are prevented from auditing the
firm‘s own work on an audit client.
c. Incorrect Under Sarbanes-Oxley, public accounting firms may only provide tax consulting
services to an audit client with the audit committee‘s approval.
d. Correct Sarbanes-Oxley prevents public accounting firms from serving an audit client in
any of the preceding listed roles. As a result, each of the responses a, b, and c is
incorrect and letter d is the correct response.
1.43 a. Incorrect Substantial equivalency does not refer to the financial statement auditing
process. The term relates to the practice of public accountancy in states other
than a CPA‘s state of licensure.
b. Incorrect Substantial equivalency does not refer to consulting services. The term relates
to the practice of public accountancy in states other than a CPA‘s state of
licensure.
c. Incorrect Substantial equivalency does not refer to other professional organizations. The
term relates to the practice of public accountancy in states other than a CPA‘s
state of licensure.
d. Correct Substantial equivalency relates to the practice of public accountancy in states
other than a CPA‘s state of licensure. Under the concept of substantial
equivalency, as long as the licensing (home) state requires (1) 150 hours of
education, (2) successful completion of the CPA exam, and (3) one year of
experience, a CPA can practice (either in person or electronically) in another
substantial equivalency state without having to obtain a license in that state.
1.44 a. Correct Auditing is a subset of attestation engagements that focuses on the certification
of financial statements. The subject matter is the set of financial statements
from management and the criteria is GAAP in the United States.
b. Incorrect That is not true. Auditing is one example of an attest engagement. The level of
assurance provided is not lower for an attestation engagement.
c. Incorrect That is not true. The auditor is not allowed to provide management support for
its audit clients. Rather, consulting engagements can focus on providing clients
with advice and decision support.
d. Incorrect The definition provided is the one for assurance engagements, which is quite
broad and includes all engagements that are designed to improve the quality of
information, or its context, for decision makers.
Chapter 01 - Auditing and Assurance Services
1.45 a. Correct Management is more likely to overstate assets and understate liabilities. As a
result, when auditing an asset balance, the most relevant assertions are likely to
be either existence or valuation. In this situation, because of the nature of cash
and the fact that is no foreign currency translation calculation, the existence
assertion is clearly the most important assertion.
b. Incorrect Although rights and obligations is an important assertion, it is not the most
relevant assertion for the cash balance. Since management is more likely to
overstate assets, when auditing an asset balance, the most relevant assertions are
likely to be either existence or valuation. In this situation, because of the nature
of cash and the fact that is no foreign currency translation calculation, the
existence assertion is clearly the most important assertion.
c. Incorrect Although valuation is an important assertion, it is not the most relevant assertion
for the cash balance. In this situation, because of the nature of cash and the fact
that is no foreign currency translation calculation, the existence assertion is
clearly the most important assertion. If however, there was a foreign currency
translation adjustment, valuation of cash would also be relevant.
d. Incorrect Although occurrence is an important assertion, it is not the most relevant
assertion for any balance sheet account. Rather, the occurrence assertion is more
closely related to income statement accounts because the question that needs to
be answered with evidence is whether the transaction really did occur in
accordance with GAAP. In this situation, because of the nature of cash and the
fact that is no foreign currency translation calculation, the existence assertion is
clearly the most important assertion.
1.46 a. Incorrect This evidence would provide evidence about management‘s assertion about
rights and obligations and perhaps existence. However, this evidence would not
help to value the investment in accordance with GAAP.
b. Incorrect While this evidence would potentially be helpful to value an investment in
another company, it is not the best answer. If a quote was available from an
independent source, this would be a better form of evidence for valuation.
c. Incorrect This evidence would provide evidence about management‘s assertion about
existence and perhaps rights and obligations. However, this evidence would not
help to value the investment in accordance with GAAP.
d. Correct Always remember that management is more likely to overstate assets. As a
result, when auditing an asset balance like investments, a relevant assertion is
likely to be valuation. In this situation, to answer the question of what the
investment should be valued at in the balance sheet, an auditor would first seek
to obtain a market quotation from an independent source like the Wall Street
Journal.
1.47 a. Incorrect This test is not related to presentation and disclosure. A cutoff test is clearly a
test of the completeness assertion as the test is designed to insure that all
transactions that should have been included in accordance with GAAP have
been recorded.
b. Correct A cutoff test is clearly a test of the completeness assertion as the test is designed
to insure that all transactions that should have been included in accordance with
GAAP have been recorded.
c. Incorrect This test is not related to rights and obligations. A cutoff test is clearly a test of
the completeness assertion as the test is designed to insure that all transactions
that should have been included in accordance with GAAP have been recorded.
d. Incorrect This test is not related to existence. A cutoff test is clearly a test of the
completeness assertion as the test is designed to insure that all transactions that
should have been included in accordance with GAAP have been recorded.
Chapter 01 - Auditing and Assurance Services
1.48 a. Incorrect This test is designed to test the completeness assertion for the inventory account.
It does not provide any evidence related to the rights and obligations assertion.
b. Correct This is clearly a test related to rights and obligations as the question that must be
answered with evidence is to establish that the inventory reported as assets really
is owned by the company. Goods on consignment, by definition, are not owned
by the company. Thus, there is a risk that the company is recording assets that
they do not own on their balance sheet.
c. Incorrect This test is designed to test the completeness assertion for sales revenue. It does
not provide evidence related to the rights and obligations assertion for inventory.
d. Incorrect This test is designed to test the presentation and disclosure assertion for
inventory purchase commitments. It does not provide evidence related to the
rights and obligations assertion for inventory.
1.49 a. Incorrect Management is far more likely to understate liabilities than to overstate them.
As a result, when auditing the accrued liabilities account, existence or
occurrence is not as likely to be violated. Rather, the most relevant assertion is
likely to be completeness.
b. Correct Management is more likely to understate liabilities. As a result, when auditing
the accrued liabilities account, the most relevant assertion is likely to be
completeness.
c. Incorrect Management is far more likely to understate liabilities. As a result, when
auditing the accrued liabilities account, the most relevant assertion is likely to be
completeness. Presentation and disclosure may be relevant. However, it is not
as likely to contain a material misstatement as completeness.
d. Incorrect Management is far more likely to understate liabilities than to overstate them.
As a result, when auditing the accrued liabilities account, the most relevant
assertion is likely to be completeness. Valuation may be relevant. However, it is
not as likely to contain a material misstatement as completeness.
1.50 a. Incorrect This is not correct as an auditing engagement refers to an examination of the
financial statements to determine whether the information has been presented in
accordance with GAAP. Also, a consulting engagement is one where the
professional provides advice and decision support.
b. Incorrect This is not correct as a consulting engagement is one where the professional
provides advice and decision support. Also, an assurance engagement can
include many more types of information than just the financial statements.
c. Incorrect This is not correct as an auditing engagement refers to an examination of the
financial statements to determine whether the information has been presented in
accordance with GAAP. Also, a consulting engagement is one where the
professional provides advice and decision support.
d. Correct This is correct as an auditing engagement refers to an examination of the
financial statements to determine whether the information has been presented in
accordance with GAAP and an attestation engagement can include a financial
statement audit. In addition, An assurance engagement can apply to all types of
information and a consulting engagement is one where the professional provides
advice and decision support.
1.51 a. Incorrect Credibility is a reason to become certified. Because all three responses are
reasons, (d) is correct.
b. Incorrect Advancement and promotion are reasons to become certified. Because all three
responses are reasons, (d) is correct.
c. Incorrect Monetary reward is a reason to become certified. Because all three responses are
reasons, (d) is correct.
d. Correct Credibility, advancement, and monetary rewards are all reasons to become
certified.
Chapter 01 - Auditing and Assurance Services
1.52 a. Incorrect Although existence or occurrence is an important assertion, it is not the most
relevant assertion for retained earnings. Restrictions on retained earnings from
loans, agreements or state law would need to be disclosed in the footnotes to the
financial statements. As a result, presentation and disclosure is clearly the most
important assertion.
b. Incorrect Although completeness is an important assertion, it is not the most relevant
assertion for retained earnings. Restrictions on retained earnings from loans,
agreements or state law would need to be disclosed in the footnotes to the
financial statements. As a result, presentation and disclosure is clearly the most
important assertion.
c. Incorrect Although valuation is an important assertion, it is not the most relevant assertion
for retained earnings. Restrictions on retained earnings from loans, agreements
or state law would need to be disclosed in the footnotes to the financial
statements. As a result, presentation and disclosure is clearly the most important
assertion.
d. Correct Restrictions on retained earnings from loans, agreements or state law would
need to be disclosed in the footnotes to the financial statements. As a result,
presentation and disclosure is clearly the most important assertion.
1.53 a. Correct Management is more likely to overstate assets and understate liabilities. As a
result, when auditing an asset balance, the most relevant assertions are likely to
be either existence or valuation. In this situation, because of the nature of
accounts receivable and the fact that valuation is not an option, the existence
assertion is clearly the most important assertion.
b. Incorrect Although completeness is an important assertion, it is not the most relevant
assertion for the accounts receivable balance. Since management is more likely
to overstate assets and understate liabilities. As a result, when auditing an asset
balance, the most relevant assertions are likely to be either existence or
valuation. In this situation, because of the nature of accounts receivable and the
fact that valuation is not an option, the existence assertion is clearly the most
important assertion.
c. Incorrect Although presentation and disclosure is an important assertion, it is not the most
relevant assertion for the accounts receivable balance. Since management is
more likely to overstate assets and understate liabilities. As a result, when
auditing an asset balance, the most relevant assertions are likely to be either
existence or valuation. In this situation, because of the nature of accounts
receivable and the fact that valuation is not an option, the existence assertion is
clearly the most important assertion.
d. Incorrect Although rights and obligations is an important assertion, it is not the most
relevant assertion for the accounts receivable balance. Since management is
more likely to overstate assets and understate liabilities. As a result, when
auditing an asset balance, the most relevant assertions are likely to be either
existence or valuation. In this situation, because of the nature of accounts
receivable and the fact that valuation is not an option, the existence assertion is
clearly the most important assertion.
1.54 a. Incorrect Although rights and obligations is an important assertion, it is not the assertion
being tested in this situation. Most importantly, the auditor did not select items
for testing from any financial statement records. Rather, the auditor selected
items to be tested from the warehouse, without considering the financial
statement records. As a result, this is a test that is designed specifically to test
whether all items that should be recorded on the financial statements actually are
included on the financial statements. Thus, the assertion being tested is the
completeness assertion. The absolute key to understanding this question is to
focus on how the items were selected for testing.
Chapter 01 - Auditing and Assurance Services
b. Correct Most importantly, the auditor did not select items for testing from any financial
statement records. Rather, the auditor selected items to be tested from the
warehouse, without considering the financial statement records. As a result, this
is a test that is designed specifically to test whether all items that should be
recorded on the financial statements actually are included on the financial
statements. Thus, the assertion being tested is the completeness assertion. The
absolute key to understanding this question is to focus on how the items were
selected for testing.
c. Incorrect Although existence is an important assertion, it is not the assertion being tested
in this situation. Most importantly, the auditor did not select items for testing
from any financial statement records. Rather, the auditor selected items to be
tested from the warehouse, without considering the financial statement records.
As a result, this is a test that is designed specifically to test whether all items that
should be recorded on the financial statements actually are included on the
financial statements. Thus, the assertion being tested is the completeness
assertion. The absolute key to understanding this question is to focus on how
the items were selected for testing.
d. Incorrect Although valuation is an important assertion, it is not the assertion being tested
in this situation. Most importantly, the auditor did not select items for testing
from any financial statement records. Rather, the auditor selected items to be
tested from the warehouse, without considering the financial statement records.
As a result, this is a test that is designed specifically to test whether all items that
should be recorded on the financial statements actually are included on the
financial statements. Thus, the assertion being tested is the completeness
assertion. The absolute key to understanding this question is to focus on how
the items were selected for testing.
1.55 a. Incorrect Although rights and obligations is an important assertion, it is not the most
relevant assertion when testing the pension footnote. The question specifically
relates to testing the information contained in the pension footnote. When
testing the footnote disclosures, the presentation and disclosure is likely to be
the most important assertion being tested.
b. Incorrect Although existence is an important assertion, it is not the most relevant assertion
when testing the pension footnote. The question specifically relates to testing the
information contained in the pension footnote. When testing the footnote
disclosures, the presentation and disclosure is likely to be the most important
assertion being tested.
c. Correct The question specifically relates to testing the information contained in the
pension footnote. When testing the footnote disclosures, the presentation and
disclosure is likely to be the most important assertion being tested.
d. Incorrect Although valuation is an important assertion, it is not the most relevant assertion
when testing the pension footnote. The question specifically relates to testing the
information contained in the pension footnote. When testing the footnote
disclosures, the presentation and disclosure is likely to be the most important
assertion being tested.
1.56 a. Incorrect Since there is no assurance about any management assertion provided when
completing an engagement to implement an ERP system, this is not considered
an attestation service. This is a consulting service.
b. Incorrect Since there is no assurance about any management assertion provided when
completing an engagement to develop a more efficient payroll process, this is
not considered an attestation service. This is a consulting service.
c. Correct This is an attestation service. In order to assess the effectiveness of an internal
control system, the assurance provider would have to attest to management‘s
assertion that the internal control was effective in accordance with the COSO
framework, as this is the most common way of expressing the effectiveness of
Chapter 01 - Auditing and Assurance Services
an internal control system. As a result, this is the definition of an attestation
service, as articulated in the book and the professional standards.
d. Incorrect Since there is no assurance about any management assertion when assisting the
client in an IRS audit, this type of work is not considered an attestation service.
1.57 a. Incorrect Although rights and obligations is an important assertion, it is not the most
relevant assertion for the revenue account. Management is more likely to
overstate revenue to improve profitability. As a result, when auditing the
revenue account, the most relevant assertions are likely to be either
existence/occurrence or valuation. In this situation, because of the nature of
revenue and the fact that accuracy is more closely related to valuation, the
valuation assertion is clearly the most important assertion. In addition, the
existence/occurrence option is not an available option.
b. Correct Valuation and allocation is the PCAOB assertion that is most likely to be tested.
In general, management is more likely to overstate revenue to improve
profitability. As a result, when auditing the revenue account, the most relevant
assertions are likely to be either existence/occurrence or valuation. In this
situation, because of the nature of revenue and the fact that accuracy is more
closely related to valuation, the valuation assertion is clearly the most important
assertion. In addition, the existence/occurrence option is not an available option.
c. Incorrect Although presentation and disclosure is an important assertion, it is not the most
relevant assertion for the revenue account. Management is more likely to
overstate revenue to improve profitability. As a result, when auditing the
revenue account, the most relevant assertions are likely to be either
existence/occurrence or valuation. In this situation, because of the nature of
revenue and the fact that accuracy is more closely related to valuation, the
valuation assertion is clearly the most important assertion. In addition, the
existence/occurrence option is not an available option.
d. Incorrect Although completion is an important assertion, it is not the most relevant
assertion for the revenue account. Management is more likely to overstate
revenue to improve profitability. As a result, when auditing the revenue
account, the most relevant assertions are likely to be either existence/occurrence
or valuation. In this situation, because of the nature of revenue and the fact that
accuracy is more closely related to valuation, the valuation assertion is clearly
the most important assertion. In addition, the existence/occurrence option is not
an available option.
1.58 a. Incorrect Although existence is an important assertion, it is not the most relevant assertion
for goodwill account in this situation. By definition, impairment of goodwill is
an accounting charge that companies record when the goodwill
account's carrying value on the balance sheet exceeds its fair value. As a result,
when auditing the goodwill account to determine whether it is impaired or not,
the most relevant assertion is clearly valuation.
b. Incorrect Although completeness is an important assertion, it is not the most relevant
assertion for goodwill account in this situation. By definition, impairment of
goodwill is an accounting charge that companies record when the goodwill
account's carrying value on the balance sheet exceeds its fair value. As a result,
when auditing the goodwill account to determine whether it is impaired or not,
the most relevant assertion is clearly valuation.
c. Incorrect Although presentation and disclosure is an important assertion, it is not the most
relevant assertion for goodwill account in this situation. By definition,
impairment of goodwill is an accounting charge that companies record when the
goodwill account's carrying value on the balance sheet exceeds its fair value. As
a result, when auditing the goodwill account to determine whether it is impaired
or not, the most relevant assertion is clearly valuation.
Chapter 01 - Auditing and Assurance Services
d. Correct Valuation is the correct answer. By definition, impairment of goodwill is an
accounting charge that companies record when the goodwill account's carrying
value on the balance sheet exceeds its fair value. As a result, when auditing the
goodwill account to determine whether it is impaired or not, the most relevant
assertion is clearly valuation.
1.59 a. Correct Rights and obligations is the correct answer. By definition, consignment
inventory is a business model where a product is sold by a retail store but the
title/ownership of the product is retained by a third party until the product is
actually sold by the retailer. As a result, when auditing the inventory account of
an audit client that sells consigned inventory, the rights and obligations assertion
is the most relevant assertion to be audited since ownership of the inventory is in
question.
b. Incorrect Although completeness is an important assertion, it is not the most relevant
assertion for the inventory account in this situation. By definition, consignment
inventory is a business model where a product is sold by a retail store but the
title/ownership of the product is retained by a third party until the product is
actually sold by the retailer. As a result, when auditing the inventory account of
an audit client that sells consigned inventory, the rights and obligations assertion
is the most relevant assertion to be audited since ownership of the inventory is in
question.
c. Incorrect Although existence or occurrence is an important assertion, it is not the most
relevant assertion for the inventory account in this situation. By definition,
consignment inventory is a business model where a product is sold by a retail
store but the title/ownership of the product is retained by a third party until the
product is actually sold by the retailer. As a result, when auditing the inventory
account of an audit client that sells consigned inventory, the rights and
obligations assertion is the most relevant assertion to be audited since ownership
of the inventory is in question.
d. Incorrect Although valuation or allocation is an important assertion, it is not the most
relevant assertion for the inventory account in this situation. By definition,
consignment inventory is a business model where a product is sold by a retail
store but the title/ownership of the product is retained by a third party until the
product is actually sold by the retailer. As a result, when auditing the inventory
account of an audit client that sells consigned inventory, the rights and
obligations assertion is the most relevant assertion to be audited since ownership
of the inventory is in question.
SOLUTIONS FOR EXERCISES AND PROBLEMS
1.60 Audit, Attestation, and Assurance Services
Students may encounter some difficulty with this matching question because the Special Committee on
Assurance Services (SCAS) listed many things that heretofore have been considered ―attestation services‖
(long before assurance services were invented). As a result, we believe that this question is a good vehicle
for discussing the considerable overlap that exists between attestation and assurance services.
 Real estate demand studies: Assurance service
 Ballot for awards show: Assurance service
 Utility rates applications: Assurance service
 Newspaper circulation audits: Assurance service
Chapter 01 - Auditing and Assurance Services
 Third-party reimbursement maximization: Assurance service
 Annual financial report to stockholders: Audit service
 Rental property operations review: Assurance service
 Examination of financial forecasts and projections: Attestation service
 Customer satisfaction surveys: Assurance service
 Compliance with contractual requirements: Attestation service
 Benchmarking/best practices: Assurance service
 Evaluation of investment management policies: Assurance service
 Information systems security reviews: Assurance service
 Productivity statistics: Assurance service
 Internal audit strategic review: Assurance service
 Financial statements submitted to a bank loan officer: Audit service
1.61 Professional Skepticism
In general, students should note that they always need to maintain their level of professional skepticism on
the financial statement audit. There may be times when skepticism should increase. However, even when
it might seem that you can reduce your skepticism, auditors should always maintain their professional
skepticism.
a) The chair of the board of your audit client proposed that the company hire its sales manager as their new
financial controller.
Increase
b) The financial controller at your client mentions that she has just been on maternity leave for three months
and no bank reconciliations were completed during the time she was out of the office.
Increase
c) While auditing the Accounts Receivable account for your audit client, you notice that there is a large
amount that is well past due on the aged accounts receivable schedule.
Increase
d) While auditing the year-end investment balances, you find that your client‘s investment balance exactly
agrees to the statement from the investment custodian. The custodian is a large bank.
Stay the same
e) The new chair of the board of Adams Corporation decided to fire the entire internal audit department. The
chair believed that the work completed by the annual auditor was enough auditing and that they were
already paying enough to the external auditors.
Increase
Chapter 01 - Auditing and Assurance Services
f) While auditing the inventory balance at your audit client, you visited the client‘s warehouse during their
inventory count. You observed the count and found that the client made no mistakes during your
procedures.
Stay the same
g) The sales manager in charge of the Northeast region retired. She was replaced in the region by the assistant
sales manager in the same region.
Stay the same
h) While auditing the Interest Expense account, you notice that there was no increase in the amount during the
current year. However, you noticed that the long-term debt amount doubled during the current year.
Increase
i) While auditing the inventory balance at your audit client, you perform test counts at their warehouse.
While you are counting, you notice a storage bin of inventory that is covered in dust with damaged
products. These items are stored near the garbage dumpsters.
Increase
j) You are auditing cash and during your review of the bank statements you notice unusual cash transfers
between two bank accounts which are inconsistent with the client‘s business.
Increase
k) While auditing accounts payable, the accounts payable clerk told you that the audit client implemented
three new internal control procedures. You tested each new control and found that no exceptions in your
testing concluding that the controls are operating effectively.
Stay the same
l) The chair of the board of your audit client decided to double the staff of the internal audit department from
10 professionals to 20 professionals. The chair wanted to have the largest internal audit department in the
industry and the increase will let the department complete more internal control audits throughout the year.
Stay the same
Chapter 01 - Auditing and Assurance Services
1.62 Management Assertions
PCAOB Assertion Corresponding ASB assertion Nature of assertion
Existence or Occurrence Existence Balance
Occurrence
Cutoff
Transactions
Transactions
Rights and Obligations Rights and Obligations Balances
Completeness Completeness Transactions
Balances
Cutoff Transactions
Valuation and Allocation Accuracy Transactions
Balances
Valuation and Allocation Balances
Presentation and Disclosure Presentation Transactions
Balances
Classification Transactions
Balances
1.63 Management Assertions
Existence or Occurrence - Assertions about existence or occurrence address whether assets or liabilities of the
entity exist at a given date and whether recorded transactions have occurred during a given period. For example,
management asserts that Accounts Receivable on the balance sheet represent valid amounts actually owed to the
company at year end that are due in exchange for goods or services from the company.
Completeness - Assertions about completeness address whether all transactions and accounts that should be
presented in the financial statements are so included. For example, management asserts that all amounts that should
be recorded and included in the financial statements as accounts receivable actually have been recorded (i.e. no
accounts are omitted).
Valuation or Allocation - Assertions about valuation or allocation address whether asset, liability, equity, revenue,
and expense components have been included in the financial statements at appropriate amounts. For example,
management asserts that Accounts Receivable are stated at net realizable value and the allowance for uncollectible
accounts is adequate.
Rights and Obligations - Assertions about rights and obligations address whether assets are the rights of the entity
and liabilities are the obligations of the entity at a given date. For example, management asserts that the Accounts
Chapter 01 - Auditing and Assurance Services
Receivable on the balance sheet really are owned by the company. As a result, they have not factored (i.e., sold) any
of the balances that are listed on the balance sheet.
Presentation and Disclosure - Assertions about presentation and disclosure address whether particular components
of the financial statements are properly classified, described, and disclosed. For example, management asserts that
the presentation of accounts receivable and the related allowance for doubtful accounts have been presented and are
disclosed in accordance with GAAP.
1.64 Other Types of Auditing
For each of the following scenarios, please indicate whether it would be most appropriate to use an internal auditor,
a governmental auditor, or a regulatory auditor:
a) The Department of Defense for the United States plans to audit the cost accounting report for a contract signed
with a key supplier.
Governmental
b) Bigdeal Corporation manufactures paper and paper products and is trying to decide whether to purchase Smalltek
Company. Bigdeal wants to obtain a report on the operational efficiency and effectiveness of the Smalltek sales,
production, and research and development departments.
Internal
c) The FDIC plans to audit the collectability of loans at a bank that they insure.
Regulatory
d) The board of directors would like an efficiency audit completed of its manufacturing plant operations.
Internal
e) The city of New York would like an audit done of a major construction project to make sure that the taxpayer‘s
funds were used in an efficient manner.
Governmental
f) A federal bank examiner decides to audit a bank to determine whether it will remain solvent in the upcoming year.
Regulatory
g) The CEO of Franklin Corporation wants to hire an auditor to take responsibility for auditing the company‘s
compliance with environmental laws and regulations.
Internal
h) The IRS would like to audit the tax returns of a popular restaurant chain.
Regulatory
i) The state of Ohio decided to audit the use of educational grants awarded to cities and towns in the state to make
sure the funds were spent in accordance with the grant program.
Chapter 01 - Auditing and Assurance Services
Governmental
j) The Department of the Interior for the United States plans to audit the use of funds spent by all National Parks.
Governmental
1.65 Auditor as Guarantor. Loot Starkin appears to be uninformed on the following key points:
The auditors did not prepare the Dodge Corporation
financial statement.
Inform your neighbor that Dodge management is
primarily responsible for preparing the financial
statements and deciding upon the appropriate
accounting principles.
An unqualified opinion does not mean that an
investment is safe. Rather, it merely means that the
financial statements are free of material misstatement.
Tell your neighbor that the financial statements
are a historical record of the business‘
performance. The value of Loot‘s investment
depends on future events, including the many
factors that affect market prices. Thus, the
financial statements are just one piece of
information that should be analyzed. Tell Loot
that the unqualified opinion means only that the
statements conform to the appropriate reporting
framework (e.g., GAAP) and that the financial
statements are free of material misstatement.
Chapter 01 - Auditing and Assurance Services
1.66 Identification of Audits and Auditors
The responses to this matching type of question are ambiguous. The engagement examples are real
examples of external, internal, and governmental audit situations. You might point out to students that the
distinctions among compliance, economy and efficiency, and program results audits are not always clear.
The ―solution‖ is shown in the following matrix form, showing some engagement numbers in two or three
cells. The required schedule follows.
Type of Audit Engagement
Financial Economy and Program
Auditor Statement Compliance Efficiency Results
Independent CPA 2, 10
Internal auditor 6, 8 4, 8
Governmental (GAO) 1, 3 1, 3, 9
auditor
IRS auditor 5
Bank examiner 7
Type of Audit Type of Auditor
1. Proprietary school‘s training
expenses
Economy and efficiency or
program results
Governmental (GAO)
auditors
2. Advertising agency financial
statements
Financial statement Independent CPAs
3. Dept. of Defense launch
vehicle
Economy and efficiency or
program results
Governmental (GAO)
auditors
4. Municipal services Economy and efficiency Internal auditors
5. Tax shelters Compliance IRS auditors
6. Test pilot reporting Compliance Internal auditors
7. Bank solvency Compliance Bank examiners
8. Materials inspection by
manufacturer
Compliance or Economy and
Efficiency
Internal auditors
9. States‘ reporting chemical
use data
Program goal Governmental (GAO)
auditors
10. Sports complex forecast Financial statement Independent CPAs
Chapter 01 - Auditing and Assurance Services
1.67 Financial Assertions and Audit Objectives
By definition, management financial statement assertions give rise to questions that can be answered with
evidence. The objectives for the audit of Spillane‘s securities investments at December 31 are to obtain
evidence about the assertions implicit in the financial presentation, specifically:
1. Existence. Obtain evidence that the securities are bona fide and held by Spillane or a responsible
custodian.
Occurrence. Obtain evidence that the loan transaction and securities purchase transactions
actually took place during the year under audit.
2. Completeness. Obtain evidence that all the securities purchase transactions were recorded.
3. Rights. Obtain evidence that Spillane owned the securities.
Obligation. Obtain evidence that $500,000 is the amount actually owed on the loan.
4. Valuation. Obtain evidence of the cost and market value of the securities held at December 31.
Decide whether any write-downs to market are required by the appropriate reporting framework.
5. Presentation and disclosure. Obtain evidence of the committed nature of the assets, which should
mean they should be in a noncurrent classification like the loan. Obtain evidence that restrictions
on the use of the assets are disclosed fully and agree with the loan documents.
1.68 Financial Statement Assertions and Possible Misstatements
Possible Misstatement/Risk
Relevant
Assertions
a) Revenue is overstated because the
controller made up fraudulent invoices and
recorded them. Occurrence
b) Revenue is understated because the
accountant closed the sales cycle a week early
to go on vacation. Completeness
c) Accounts Receivable is overstated because
the accounts receivable clerk forgot to apply
available discounts. Valuation or Allocation
d) Accounts Receivable is overstated because
sales are falsified. Existence
e) Travel expense is overstated because the
sales force charged personal expenses on their
corporate credit card. Occurrence
f) Accounts Payable is understated because
the office manager lost an invoice for
supplies received so it was never recorded. Completeness
g) The cash balance is understated because
funds held in Japan were converted to $USD
at the wrong rate. Valuation or Allocation
Chapter 01 - Auditing and Assurance Services
h) The cash balance recorded on the financial
statements is overstated because the treasurer
is stealing from the company. Existence
i) Inventory is overstated because it is held on
consignment but included in the inventory
balance. Rights and Obligations
j) The cost of goods sold is overstated
because time sheets have not been submitted
for each job. Valuation or Allocation
k) Long Term Debt is overstated due to
misclassification by management. Presentation and Disclosure
1.69 Financial Statement Assertions and Audit Procedures
Audit Procedure
Relevant
Assertions Significant Account
a) The auditor sends a letter to
the bank confirming the amount
of cash in the bank account. Existence Cash
b) The auditor takes a shipping
document and traces it to the
sales invoice and sales journal Completeness Revenue
c) The auditor selects items from
the company's inventory list and
observes those items in the
warehouse Existence Inventory
d) The auditor compares prices
on a vendor invoice to an
approved price list from the
vendor. Valuation or allocation Accounts Payable
e) The auditor reviews recorded
expenses with vendor invoices. Valuation or allocation Expenses
f) The auditor determines
whether inventory has been
pledged as collateral for a loan. Presentation or Disclosure Inventory
g) The auditor reads the Board
of Directors minutes for
approval of stock options. Presentation or Disclosure Common Stock
h) The auditor reviews lease
agreements to evaluate whether
they have been recorded
properly. Completeness Capitalized Leases
i) The auditor selects inventory
items at a retail store to
determine whether any are held
on consignment. Rights and obligations Inventory
j) The auditor sends letters to
customers to confirm amounts
owed to the company Existence Accounts Receivable
Chapter 01 - Auditing and Assurance Services
1.70 Internet Exercise: Professional Certification
These answers will depend on the student‘s state of residence. Many states have recently reduced the
experience requirements by either (1) reducing or eliminating an audit experience requirement and/or (2)
reducing the experience requirement in lieu of additional education. For a quick link to each state, visit the
National Association of State Boards of Accountancy (www.nasba.org).
1.71 Internet Exercise: Professional Certification
The Institute of Internal Auditors does a good job explaining the benefits of becoming a certified internal
auditor. The exam consists of four parts: the Internal Audit Activity‘s Role in Governance, Risk, and
Control; Conducting the Internal Audit Engagement; Business Analysis and Information Technology; and
Business Management Skills. You must have at least a bachelor‘s degree to sit for this exam.
The Institute of Management Accountants also does a good job of explaining the benefits of the
certification. The parts of the exam include Business Analysis, Management Accounting and Reporting,
Strategic Management, and Business Applications. You must have at least a bachelor‘s degree to sit for
this exam.
The Association of Certified Fraud Examiners also does a good job of explaining the benefits of the
certification. The areas of study tested on the exam include criminology and ethics, financial transactions,
fraud investigation, and legal elements of fraud. You must have at least a bachelor‘s degree to sit for this
exam.
The Information Systems Audit and Control Association website explains the benefits of becoming
certified. You must have at least an associates‘ degree to sit for this exam.
1.72 Internet Exercise: Services Offered by the Big Four Public Accounting Firms
These answers will depend on the specific service picked by each student. Each of the firms now offers a
multitude of different services. Thus, these answers are likely to differ substantially. The goal of the
question is to expose students to the wide range of services. So, as long as the student lists two services
that are in alignment with the instructor‘s experience, credit should be awarded.
Apollo Shoes Questions
1) List three relevant facts about Apollo Shoes that you think might have an impact on the financial
statement audit.
This question is designed to get the students to examine the Apollo Shoes Form 10K with a critical
mindset. There are a number of allowable responses to this question. Three prominent responses would
be:
a. Accounts Receivable increased significantly from the prior year.
b. Inventory increased significantly from the prior year.
c. The line of credit balance increased significantly from the prior year.
2) Define what is meant by a significant account or disclosure.
A financial statement account or footnote disclosure is considered significant if there is a chance that the
account or footnote disclosure could contain a material misstatement. As a result, an auditor will have to
conduct some procedures on each significant account or disclosure.
Chapter 01 - Auditing and Assurance Services
3) Identify at least two significant accounts or disclosures from the financial statements of Apollo
Shoes. What makes each item significant?
This question is designed to get the students to examine the Apollo Shoes Trial Balance with a critical
mindset. There are a number of allowable responses to this question. Two prominent responses would be:
a. Accounts Receivable is significant because of the magnitude of the account in relation to total
assets for Apollo Shoes.
b. Inventory is significant because of the magnitude of the account in relation to total assets for
Apollo Shoes.
4) Define what is meant by a relevant assertion.
A relevant assertion is "a management assertion is relevant if there is a reasonable possibility that a material
misstatement exists related to that assertion for the significant account or footnote disclosure being
audited.‖
5) Identify at least one relevant assertion for each of the significant accounts or disclosures
previously identified from the financial statements of Apollo Shoes. What makes each assertion
relevant?
Once again, there are a number of allowable responses to this question. Two responses that related back to
the suggested solution for question #3 would be:
a. Valuation of Accounts Receivable is relevant because of the significant increase in
receivables compared to last year. Importantly, this increase occurred without a significant
increase in sales. What happened? Why are they unable to collect their receivables this year
as compared to last year? Should the allowance for doubtful accounts be increased? As a
result of these questions, the risk of material misstatement for this assertion is high.
b. Existence of Inventory is relevant because the inventory balance is a material amount and the
auditor must make sure that the inventory does really exist. The inventory balance increased
significantly compared to last year. Why? The professional standards require that we
conduct a physical inventory observation to validate the existence of inventory. As a result of
these considerations, the risk of material misstatement for this assertion is high.
CHAPTER 2
Professional Standards
LEARNING OBJECTIVES
Review
Checkpoints
Multiple
Choice
Exercises and
Problems
1. Understand the development and
source of generally accepted auditing
standards.
1, 2, 3, 4 47, 48 52 (*), 53
2. Describe the fundamental principle of
responsibilities and how this principle
5, 6, 7 27, 29, 35, 39, 40 54, 55, 56, 57, 62 (*),
Chapter 01 - Auditing and Assurance Services
relates to the characteristics and
qualifications of auditors.
64 (*), 65 (*), 66 (*),
67 (*), 68 (*)
3. Describe the fundamental principle of
performance and identify major
activities performed in an audit.
8, 9, 10, 11, 12, 13,
14, 15, 16, 17, 18
26, 30, 31, 32, 33,
34, 36, 37, 42, 43,
44, 45
58, 59, 60, 61, 62 (*),
64 (*), 65 (*), 66 (*),
67 (*), 68 (*)
4. Understand the fundamental principle
of reporting and identify the basic
contents of the auditors‘ report.
19, 20 41, 49, 50, 51 63, 64 (*), 65 (*),
66 (*), 67 (*), 68 (*)
5. Understand the role of a system of
quality control and monitoring efforts
in enabling public accounting firms to
meet appropriate levels of professional
quality.
21, 22, 23, 24, 25 28, 38, 46 52 (*), 69, 70, 71
(*) indicates that an item corresponds to multiple learning objectives
Chapter 01 - Auditing and Assurance Services
SOLUTIONS FOR REVIEW CHECKPOINTS
2.1 Generally accepted auditing standards are auditing standards that identify necessary qualifications and
characteristics of auditors and guide the conduct of the audit examination.
The purpose of generally accepted auditing standards is to meet the following objectives of an audit
examination:
 To obtain reasonable assurance about whether the financial statements as a whole are free of
material misstatement, whether due to error or fraud.
 To issue a report on the financial statements
2.2 Currently, the PCAOB is responsible for developing standards for the audits of issuers, while the AICPA is
responsible for developing standards for the audits of nonissuers.
2.3 The AICPA (through the Auditing Standards Board) has responsibility for setting standards for the audits
of nonissuers. This is done through the issuance of Statements on Auditing Standards.
The PCAOB has responsibility for setting standards for the audits of issuers. This is done through the
PCAOB‘s issuance of Auditing Standards.
While the SEC does not have responsibility for setting auditing standards per se, all PCAOB standards
must be approved by the SEC.
2.4 The three fundamental principles are:
1. Responsibilities, which involves having appropriate competence and capabilities, complying with
relevant ethical requirements, maintaining professional skepticism and exercising professional
judgment.
2. Performance, which requires auditors to obtain reasonable assurance about whether the financial
statements as a whole are free of material misstatement by: (1) planning the work and properly
supervising assistants; (2) determining and applying appropriate material levels; (3) identifying
and assessing the risk of material misstatement; and, (4) obtaining sufficient appropriate audit
evidence.
3. Reporting, which requires the auditor to express an opinion (or state that an opinion cannot be
expressed) as to whether the financial statements are presented fairly in accordance with the
applicable financial reporting framework.
2.5 Independence in fact represents auditors‘ mental attitudes (do auditors truly act in an unbiased and
impartial fashion with respect to the client and fairness of its financial statements?). Independence in
appearance relates to financial statement users‘ perceptions of auditors‘ independence.
Auditors can be independent in fact but not perceived to be independent. For example, ownership of a small
interest in a public client would probably not influence auditors‘ behavior with respect to the client.
However, it is likely that third-party users would not perceive auditors to be independent.
2.6 Due care reflects a level of performance that would be exercised by reasonable auditors in similar
circumstances. Auditors are expected to have the skills and knowledge of others in their profession (known
as that of a prudent auditor) and are not expected to be infallible.
Chapter 01 - Auditing and Assurance Services
2.7 Professional skepticism is a state of mind that is characterized by appropriate questioning and a critical
assessment of audit evidence.
Professional judgment is the auditors‘ application of relevant training, knowledge, and experience in
making informed decisions about appropriate courses of action during the audit engagement.
Auditors are required to demonstrate professional skepticism and professional judgment throughout the
entire audit process.
2.8 Reasonable assurance recognizes that a GAAS audit may not detect all material misstatements and
auditors are not ―insurers‖ or ―guarantors‖ regarding the fairness of the entity‘s financial statements.
The audit team provides reasonable assurance by considering various risks relating to the likelihood of
material misstatements and performing audit procedures to control this risk to an acceptably low level.
2.9 An audit plan is a list of audit procedures that are performed to gather sufficient appropriate evidence on
which auditors base their opinion on the financial statements.
Audit plans are prepared during the planning stages of the audit.
2.10 An interim date is a date between the beginning of the year and the year-end. Performing audit procedures
prior to the interim date allows the audit team to spread work over a longer period of time and focus efforts
on the time period between the interim date and year-end, to allow the audit to be completed on a more
timely basis.
2.11 Materiality is the dollar amount that would influence the lending or investing decisions of users; this
concept recognizes that auditors should focus on matters that are important to financial statement users.
Materiality should be considered in planning the audit, performing the audit, and evaluating the effect of
misstatements on the entity‘s financial statements.
2.12 Auditors obtain an understanding of a client, including its internal control, as a part of the control risk
assessment process primarily in order to plan the nature, timing and extent of further audit procedures. A
secondary purpose is because of auditors‘ responsibilities for reporting on client‘s internal controls.
2.13 As the client‘s internal control is more effective (a lower level of control risk), auditors may use less
effective substantive procedures (a higher level of detection risk). Conversely, when the client‘s internal
control is less effective (a higher level of control risk), auditors must use more effective substantive
procedures (a lower level of detection risk).
2.14 Audit evidence is defined as the information used by auditors in arriving at the conclusion on which the
audit opinion is based.
2.15 External documentary evidence is audit evidence obtained from another party to an arm‘s-length transaction
or from outside independent agencies. External evidence is received directly by auditors and is not
processed through the client‘s information processing system.
External-internal documentary evidence is documentary material that originates outside the bounds of the
client‘s information processing system but which has been received and processed by the client.
Internal documentary evidence consists of documentary material that is produced, circulates, and is finally
stored within the client‘s information processing system. Such evidence is either not circulated to outside
parties at all or is several steps removed from third-party attention.
Chapter 01 - Auditing and Assurance Services
2.16 Relevance refers to the nature of information provided by the audit evidence; that is, what assertion(s)
related to the account balance or class of transactions does the evidence support? Reliability refers to the
extent of trust that auditors can place in evidence and is primarily influenced by the source of the evidence.
The appropriateness of audit evidence is related to both relevance and reliability; that is, as evidence is
more relevant and reliable, it is considered to have a higher level of appropriateness.
2.17 The source of evidence affects its reliability as follows (from most to least reliable): (1) evidence directly
obtained by auditors, (2) evidence obtained from external sources, and (3) evidence obtained from internal
sources.
2.18 As auditors need to achieve lower levels of detection risk, more appropriate evidence needs to be obtained.
Thus, auditors should gather higher quality evidence (more reliable evidence). For example, auditors may
choose to obtain evidence from external sources rather than internal sources.
In addition, for lower levels of detection risk, auditors need to gather more sufficient evidence. Because
sufficiency relates to the quantity of evidence, more transactions or components of an account balance
should be examined.
2.19 A financial reporting framework is a set of criteria used to determine the measurement, recognition,
presentation, and disclosure of material items in the financial statements. The financial reporting
framework is related to auditors‘ reporting responsibilities because this framework serves as the basis
against which the financial statements are evaluated and the auditors‘ opinion on the financial statements is
expressed.
2.20 Four types of opinions and their conclusions:
Type Conclusion
Unmodified opinion Financial statements are presented in conformity with GAAP.
Adverse opinion Financial statements are not presented in conformity with GAAP.
Qualified opinion Financial statements are presented in conformity with GAAP,
except for one or more departures or issues of concern.
Disclaimer of opinion An opinion cannot be issued on the financial statements.
2.21 A system of quality control provides firms with reasonable assurance that the firm and its personnel (1)
comply with professional standards and applicable regulatory and legal requirements and (2) issue reports
that are appropriate in the circumstances.
The six elements of a system of quality control are:
1. Leadership responsibilities for quality within the firm (―tone at the top‖)
2. Relevant ethical requirements
3. Acceptance and continuance of client relationships and specific engagements
4. Human resources
5. Engagement performance
6. Monitoring
Chapter 01 - Auditing and Assurance Services
2.22 In deciding whether to accept or continue an engagement with a client, firms should consider:
 The integrity of the client and the identity and business reputation of its owners, key management,
related parties, and those charged with governance.
 Whether the firm possesses the competency, capability, and resources to perform the engagement.
 Whether the firm can comply with the necessary legal and ethical requirements.
If firms decide to withdraw from an engagement, the firm should document significant issues,
consultations, conclusions, and the basis for any conclusions related to the decision to withdraw.
2.23 Procedures used by firms to monitor their quality control standards include:
 Reviews of selected administrative and personnel records.
 Reviews of engagement documentation, reports, and the client‘s financial statements.
 Discussions with firm personnel
 Assessments of the (1) appropriateness of the firm‘s guidance materials and professional aids, (2)
compliance with policies and procedures on independence, (3) effectiveness of continuing
professional education, and (4) decisions regarding the acceptance and continuance of client
relationships and specific engagements.
2.24 The PCAOB‘s monitoring role for firms providing auditing services to issuers includes registering public
accounting firms and conducting inspections of registered public accounting firms.
2.25 The frequency of PCAOB inspections depends upon the number of audits conducted by member firms. For
firms performing audits for more than 100 issuers, inspections are required on an annual basis. For those
performing audits for 100 or fewer issuers, inspections are conducted every three years.
SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS
2.26 a. Correct Gathering audit evidence is a component of the performance principle.
b. Incorrect While reasonable assurance is related to gathering audit evidence, this is not one
of the categories of principles
c. Incorrect The reporting principle relates to the contents of the auditors‘ report
d. Incorrect The responsibilities principle relates to the personal integrity and professional
qualifications of auditors.
2.27 NOTE TO INSTRUCTOR: Since this question asks students to identify the concept that is not related to
the ethical requirements of auditors, the response labeled ―correct‖ is not related to the ethical
requirement of auditors and those labeled ―incorrect‖ are related to the ethical requirements of auditors.
a. Incorrect Due care is related to the ethical requirements of auditors.
b. Incorrect Both independence in fact and independence in appearance are related to the
ethical requirements of auditors.
c. Incorrect Both independence in fact and independence in appearance are related to the
ethical requirements of auditors.
d. Correct While professional judgment is part of the responsibilities principle, it is not
related to the ethical requirements of auditors.
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx
Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12  Complete.docx

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Solution Manual For Auditing and Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley Verified Chapter's 1 - 12 Complete.docx

  • 1. Chapter 01 - Auditing and Assurance Services Solution Manual For Auditing & Assurance Services 9th Edition by Timothy Louwers, Penelope Bagley
  • 2. Chapter 01 - Auditing and Assurance Services CHAPTER 01 Auditing and Assurance Services LEARNING OBJECTIVES Review Checkpoints Multiple Choice Exercises, Problems, and Simulations 1. Define information risk and explain how the financial statement auditing process helps to reduce this risk, thereby reducing the cost of capital for a company. 1, 2, 3 29, 31, 38 65* 2. Define and contrast assurance, attestation, and financial statement auditing services. 4, 5, 6, 7, 8 23, 25, 28, 44, 50 60, 65* 3. Describe and define the assertions that management makes about the recognition, measurement, presentation, and disclosure of the financial statements and explain why auditors use them as a focal point of the audit. 9, 10, 11 36, 39, 40, 41, 45, 46, 47, 48, 49, 52, 53, 54, 55, 57, 58, 59 62, 63, 67, 68, 69 4. Define professional skepticism and explain its key characteristics. 12 24, 37 61 5. Describe the organization of public accounting firms and identify the various services that they offer. 13, 14 30, 42, 56 72 6. Describe the audits and auditors in governmental, internal, and operational auditing. 15, 16, 17, 18 26, 27, 32, 34, 35 64, 66 7. List and explain the requirements for becoming a certified public accountant (CPA) and other certifications available to an accounting professional. 19, 20, 21, 22 33, 43, 51 70, 71 (*) Item relates to multiple learning objectives
  • 3. Chapter 01 - Auditing and Assurance Services SOLUTIONS FOR REVIEW CHECKPOINTS 1.1 Business risk is the risk that an entity will fail to meet its business objectives. When assessing business risk, a professional must consider all possible threats to an entity‘s goals and objectives. Some illustrative examples include the risk that: 1) its existing customers will start buying products or services from its primary competitors; 2) its product lines will become obsolete; 3) its taxes will increase; 4) key government contracts will be lost; 5) key employees will leave the entity; and many other examples exist. 1.2 To help minimize business risk and take advantage of other opportunities presented in today‘s competitive business environment, decision makers such as chief executive officers (CEOs) demand timely, relevant, and reliable information. There are at least four environmental conditions that increase demand for reliable information. First, complexity which implies that events and transactions in today‘s global business environment can be complicated. Most investors do not have the level of expertise needed to properly account for complex transactions. Second is remoteness which implies that decision makers are often separated from current and potential business relationships due to distance and time. For example, investors may not be able to visit distant locations to check up on their investments. Third is time-sensitivity which implies that in today‘s economic environment, investors and other users of financial statements need to make decisions more rapidly than ever before. As a result, the ability to promptly obtain high-quality information is essential. Fourth is a consequence which implies that decisions may very well involve significant investments. As a result, the consequences can be severe if information cannot be obtained 1.3 Of all the different risks discussed in the chapter up to this point, information risk is the one that is most likely to create the demand for independent and objective assurance services is information risk or the probability that the information circulated by an entity will be false or misleading. Because the primary source of information for investors and creditors is the company itself, an incentive exists for that company‘s management to make their business or service appear to be better than it actually may be, to put their best foot forward. As a result, preparers and issuers of financial information (directors, managers, accountants, and other people employed in a business) might benefit by giving false, misleading, or overly optimistic information. This potential conflict of interest between information providers and users which provides the underlying basis for the demand for reliable information. 1.4 The four major elements of the broad definition of assurance services are Independence. CPAs want to preserve their reputation and competitive advantage by always preserving integrity and objectivity when performing assurance services. Professional services. Virtually all work performed by CPAs is defined as ―professional services‖ as long as it involves some element of judgment based on education and experience. Improving the quality of information or its context. The emphasis is on ―information,‖ CPAs‘ traditional area of expertise. CPAs can enhance quality by assuring users about the reliability and relevance of information, and these two features are closely related to the familiar credibility-lending products of attestation and audit services. ―Context‖ is relevance in a different light. For assurance services, improving the context of information refers to improving its usefulness when targeted to particular decision makers in the surroundings of particular decision problems. For decision makers. As the ―consumers‖ of assurance services, decision makers are the beneficiaries of the assurance services. Decision makers may or may not be the ―client‖ that pays the fee and may or may not be one of the parties to an assertion or other information, but they personify the consumer focus of new and different professional work. 1.5 An assurance services engagement is any assignment that improves the quality of information, or its context, for decision makers. Because information (e.g., financial statements) are prepared by managers of an entity who have authority and responsibility for financial success or failure, an outsider may be skeptical that the information truly is objective, free from bias, fully informative, and free from material error, intentional or inadvertent. The services of an independent auditor helps resolve those doubts because the
  • 4. Chapter 01 - Auditing and Assurance Services auditor‘s success depends upon his or her independent, objective, and competent assessment of the information (e.g., the conformity of the financial statements with the appropriate reporting framework). The independent auditor‘s role is to lend credibility to the information; hence, the outsider will likely seek his or her independent opinion about the financial statements. 1.6 An attestation engagement is ―an engagement in which a practitioner is engaged to issue or does issue a written communication that expresses a conclusion about the reliability of a written assertion that is the responsibility of another party‖ (SSAE 10, AT 101.01). To attest means to lend credibility or to vouch for the truth or accuracy of the statements that one party makes to another. The attest function is a term often applied to the activities of independent CPAs when acting as auditors of financial statements. 1.7 An assurance service engagement is one that improves the quality of information, or its context, for decision makers. Thus, an attestation service engagement is one type of an assurance service. Another way of thinking about the issue is to remember that the financial statement audit engagement is one type of an attestation service. Please see exhibit 1.3 in the text which depicts the relationship among assurance, attestation, and auditing engagements. 1.8 According to the American Accounting Association, ―Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between the assertions and established criteria and communicating the results to interested users.‖ In effect, auditors add reliability to the information that is provided to interested users. Of course, this definition is focused on an external reporting context. Students may also discuss how governmental and internal auditors operate as well. In response to ―What do auditors do?‖ students can respond by stating that auditors (1) obtain and evaluate evidence about assertions made by management about economic actions and events, (2) ascertain the degree of correspondence between the assertions and the appropriate reporting framework, and (3) issue an audit report (opinion). Students can also respond more generally by stating that auditors essentially lend credibility to the financial statements presented by management. 1.9 Financial accounting refers to the process of recording, classifying, summarizing, and reporting about a company‘s assets, liabilities, capital, revenues, and expenses in the financial statements in accordance with the applicable financial reporting framework (e.g., GAAP). In so doing, the management team is making several assertions about the financial statements. The financial accounting process is the responsibility of the management team. Financial statement auditing refers to the process whereby professional auditors gather evidence related to the assertions that management makes in the financial statements, evaluates the evidence and concludes on the fairness of the financial statements in a report. They differ because accountants produce the financial statements in accordance with the applicable financial reporting framework. After this is complete, financial statement auditors then perform procedures to ascertain whether the financial statements have been prepared in accordance with the applicable financial reporting framework. 1.10 The two major classifications of ASB assertions with several assertions in each classification are: Assertions About Classes of Transactions and Events, and Related Disclosures Occurrence assertion: The objective is to establish with evidence that transactions giving rise to assets, liabilities, sales, and expenses occurred. Key questions include ―Did the recorded sales transactions really occur?‖ Completeness assertion: The objective is to establish with evidence that all transactions of the period that should be are included in the financial statements (including footnotes). Completeness also refers to proper inclusion in financial statements of all revenue, expense, and related disclosures. Key questions related to
  • 5. Chapter 01 - Auditing and Assurance Services completeness include ―Are the revenue and expense account balances complete?‖ and ―Were all the transactions that should be included reflected properly in the footnote disclosures?‖ Cutoff assertion: The objective is to establish with evidence that all transactions that properly belong in the preceding or following accounting periods are excluded. And, that only those transactions that should be included in the financial statements are included. A key question related to the cutoff assertion includes ―Were all the transactions recorded in the right period?‖ Accuracy assertion: The objective is to establish with evidence that transactions have been recorded at the correct amount. Key questions include ―Were the expenses recorded at the proper dollar amount?‖ Classification assertion: The objective is to establish with evidence that transactions were posted to the correct accounts. Key questions include ―Was this expense recorded in the appropriate account?‖ Presentation assertion: The objective is to establish with evidence that the information has been properly presented and described, and that the disclosures are clearly expressed. Key questions include ―Was the information in the disclosure properly presented and disclosed?‖ Assertions about Account Balances and Related Disclosures Existence assertion: The objective is to establish with evidence that the balance represents assets, liabilities, sales, and expenses that are real and in existence at the balance sheet date. Key questions include ―Does this number truly represent assets that existed at the balance sheet date?‖ Completeness assertion: The objective is to establish with evidence that all balances of the period are in the financial statements. Key questions related to completeness include ―Are the asset and liability accounts in the financial statements complete?‖ Rights and obligations assertion: The objectives related to rights and obligations are to establish with evidence that assets are owned (or rights such as capitalized leases are shown) and liabilities are owed. Key questions related to this assertion include ―Does the company really own the assets? And ―Are related legal responsibilities identified?‖ Accuracy, Valuation and Allocation assertions: The objective is to establish with evidence that balances have been valued correctly. Key questions include ―Are the account balances accurate?‖ ―Are the accounts valued correctly?‖ and ―Are expenses allocated to the period(s) benefited?‖ Presentation assertion: The objective is to establish with evidence that the balance sheet amounts, and related footnote disclosures are complete, properly presented and are understandable to the financial statement users. Key questions relate to ―Is the account properly presented in the correct financial statement category‖ And, ―are the footnote disclosures complete and presented to promote an understanding of the nature of the account?‖ 1.11 In general, management‘s financial statement assertions are important to auditors because they are used when assessing risks by determining the different types of misstatements that could occur for each assertion related to each significant account and disclosure. Next, auditors use the assertions to develop audit procedures that are appropriate to mitigate the risk of material misstatement for each assertion. In essence, the key questions that must be answered about each of the relevant assertions become the focal points for audit procedures. Audit procedures are the means to answer the key questions posed by management‘s financial statement assertions. In fact, the procedures are completed to provide the evidence necessary to persuade the auditor that there is no material misstatement related to each of the relevant assertions identified for an engagement. The ASB assertions differ from the PCAOB assertions in that they provide greater detail and clarity for auditors to conceptualize the type of misstatements that may exist in the financial statements. Thus, the PCAOB assertions are more general than the ASB assertions. Importantly, the PCAOB recognizes that
  • 6. Chapter 01 - Auditing and Assurance Services their assertions are more general and do allow auditors to use the more granular and specific ASB assertions when completing the audit. As a result, largely each of the firms auditing public companies with international operations feature the ASB assertions to guide their auditing processes. Importantly, a student of auditing will note that the ASB assertions are in direct alignment with the PCAOB assertions. This is illustrated in the text in Exhibit 1.4 1.12 By having a belief that a potential conflict of interest always exists between the auditor and the management team, auditors will be skeptical when completing the audit. Indeed, even though the vast majority of audits do not contain fraud, auditors have no choice but to consider the possibility of fraud on every audit. Stated simply, errors and financial reporting frauds have happened in the past, and users of financial statements and audit reports expect auditors to detect material misstatements if they exist. Indeed, auditing firms have long recognized the importance of exercising professional skepticism when making professional judgments. As a student of auditing, you can expect to encounter difficult economic transactions as an auditor. When a difficult transaction is encountered, auditors must take the time to fully understand the economic substance of that transaction and then critically evaluate, with skepticism, the evidence provided by the client to justify its accounting treatment. There are no shortcuts allowed. Rather, auditors must always hold a belief that a potential conflict of interest exist between the auditor and management, and they must be unbiased and objective when making their professional judgments. 1.13 Generally speaking, assurance services involve the lending of credibility to information, whether financial or nonfinancial. CPAs have assured vote counts (e.g., Baseball Hall of Fame), dollar amounts of prizes that sweepstakes have claimed to award, accuracy of advertisements, investment performance statistics, and characteristics claimed for computer software programs. Some specific examples of assurance service engagements performed on nonfinancial information include  eXtensible Business Reporting Language (XBRL) reporting.  Enterprise risk management assessment.  Information risk assessment and assurance.  Third-party reimbursement maximization.  Rental property operations review.  Customer satisfaction surveys.  Evaluation of investment management policies.  Fraud and illegal acts prevention and deterrence.  Internal audit outsourcing. 1.14 There are three major areas of public accounting services  Financial Statement Audit and other types of Assurance services.  Tax services.  Consulting and Advisory services. 1.15 Operational auditing is the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies. The AICPA views operational auditing as a type of consulting or advisory service offered by public accounting firms.
  • 7. Chapter 01 - Auditing and Assurance Services 1.16 The GAGAS issued by the GAO is very clear on this point. Specifically, the elements of expanded-scope auditing include (1) financial and compliance audits, (2) economy and efficiency audits, and (3) program results audits. 1.17 Compliance auditing involves a study of an organization‘s policies, procedures, and, ultimately, its performance in following applicable laws, rules, and regulations. An example would be a school district‘s policies and procedures related to a meal program for its students. In these types of situations, there would be a demand for a compliance audit which would be designed to ensure that the school district complies with the stated policies and procedures of the program. 1.18 Other kinds of auditors include Internal Revenue Service auditors who are required to audit the taxable income and deductions taken by taxpayers in tax returns and determine their correspondence with the standards found in the Internal Revenue Code. They also might have to audit for fraud and tax evasion. Other examples include state and federal bank examiners who are responsible for auditing banks, savings and loan associations, and other financial institutions for evidence of solvency and compliance with banking and other related laws and regulations. 1.19 The purpose of the continuing education requirement is to ensure that CPAs in practice maintain their expertise at a sufficiently high level in light of evolving business conditions and new regulations. For CPAs in public practice, 120 hours of continuing education is required every three years with no less than 20 hours in any one year. For CPAs not in public practice, the general requirement is 120 or fewer (90 in some states) every three years. 1.20 Not everything can be learned in the classroom, and some on-the-job experience is helpful before a person is able to be held out to the public as a licensed professional. Also, the experience requirement tends to ―weed out‖ those individuals who are just looking to become certified without ever being involved in actual accounting work. 1.21 State boards administer the state accountancy laws and are responsible for ensuring that candidates have passed the CPA examination and satisfied the state requirements for education and experience before being awarded a CPA certificate. At the same time, new CPAs must pay a fee to obtain a state license to practice. Thereafter, state boards of accountancy regulate the behavior of CPAs under their jurisdiction (enforcing state rules of conduct) and supervise the continuing education requirements. As a result, the state boards play an important role in the CPA certification and licensure process. 1.22 After becoming a CPA licensed in one state, a person can obtain a CPA certificate and license in another state. The process is known as reciprocity. CPAs can file the proper application with another state board of accountancy, meet the state‘s requirements, and obtain another CPA certificate. Many CPAs hold certificates and licenses in several states. From a global perspective, individuals must be licensed in each country. Similar to CPAs in the United States, chartered accountants (CAs) practice in Australia, Canada, Great Britain, and India.
  • 8. Chapter 01 - Auditing and Assurance Services SOLUTIONS FOR MULTIPLE CHOICE-QUESTIONS 1.23 a. Incorrect This is an attestation to the prize promoter‘s claims. Because attestation and audit engagements are subsets of assurance engagements, this is an example of an assurance engagement. However, each response is an example of an assurance engagement; thus, the answer is (e). b. Incorrect This is an audit engagement to give an opinion on financial statements. Because attestation and audit engagements are subsets of assurance engagements, this is an example of an assurance engagement. However, each response is an example of an assurance engagement; thus, the answer is (e). c. Incorrect This is an assurance engagement on a newspaper‘s circulation data. Because attestation and audit engagements are subsets of assurance engagements, all are assurance engagements. Thus, the answer is (e). d. Incorrect This is an assurance engagement on the performance of golf balls. Because attestation and audit engagements are subsets of assurance engagements, all are assurance engagements. Thus, the answer is (e). e. Correct Because attestation and audit engagements are subsets of assurance engagements, all of the responses are examples of assurance engagements. 1.24 a. Correct The management team is generally trying to put its ―best foot forward‖ when reporting their financial statement information. The auditor must make sure that the management team does not violate the accounting rules when doing so. IN essence, this statement characterizes why professional skepticism is required to be exercised by auditors. b. Incorrect ―Exclusively in the capacity of an auditor‖ is not an idea that relates to an attitude of professional skepticism. c. Incorrect Professional obligations are not related to an attitude of professional skepticism. d. Incorrect While it is true that financial statement and financial data are verifiable, this does not related to the reasons why an auditor needs to begin an audit with an attitude of professional skepticism. 1.25 a. Incorrect While work on a forecast would potentially be covered by the attestation standards, the auditors must provide assurance about some type of management assertion in an attestation engagement. b. Correct This is the basic definition of an attestation service, as articulated in the book and the professional standards. c. Incorrect Since there is no assurance about any management assertion when preparing a tax return with information that has not been reviewed or audited, this type of tax work is not considered an attestation service. d. Incorrect Since there is no assurance about any management assertion when giving expert testimony about particular facts in an income tax case, this type of work is not considered an attestation service. 1.26 a. Incorrect The objective of environmental auditing is to help achieve and maintain compliance with environmental laws and regulations and to help identify and correct unregulated environmental hazards. This answer is therefore incorrect. b. Incorrect The objective of financial auditing is to obtain assurance on the conformity of financial statements with generally accepted accounting principles. This answer is therefore incorrect. c. Incorrect The objective of compliance auditing is the entity‘s compliance with laws and regulations. This answer is therefore incorrect. d. Correct Operational auditing refers to the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies.
  • 9. Chapter 01 - Auditing and Assurance Services 1.27 a. Incorrect This is not the primary objective of an operational audit. However, while completing an operational audit, a professionally skeptical auditor should still be concerned about compliance with financial accounting standards. b. Correct This statement exactly characterizes the goal of an operational audit. In addition, the statement is part of the basic definition of operational auditing. c. Incorrect An operational audit does not focus on the financial statements of an entity. d. Incorrect While analytical tools and skills may be used during an operational audit, they are also a very important aspect of financial auditing. 1.28 a. Correct According to the AICPA definition found in AU 200 (paragraph 11) and in your book, ―the purpose of an audit is to enhance the degree of confidence that intended users can place in the financial statements. This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. As a result, this is the correct response. b. Incorrect The AICPA definition is not limited to the FASB for the appropriate reporting framework that is used as the benchmark when completing an audit. The definition is general enough to include other financial reporting frameworks as well, such as IFRS. c. Incorrect The AICPA definition does not focus on the SEC as an appropriate reporting framework to be used as a benchmark when completing an audit. The definition is focused on the ―applicable‖ financial reporting framework, such as GAAP or IFRS. The reference to the SEC is wrong. d. Incorrect This phrase is not referenced in the AICPA definition found in the auditing standards. This phrase is found in the AAA definition of the audit found in this book. 1.29 a. Incorrect While complexity is an important condition that increases the demand for reliable information, the potential conflict of interest between management and the bank is far and away the biggest factor driving the demand for audited financial statements. b. Incorrect While remoteness is an important condition that increases the demand for reliable information, the potential conflict of interest between management and the bank is far and away the biggest factor driving the demand for audited financial statements. c. Incorrect While the consequences of making a bad decision are an important condition that increases the demand for reliable information, the potential conflict of interest between management and the bank is far and away the biggest factor driving the demand for audited financial statements. d. Correct The potential conflict of interest between management and the bank is far and away the biggest factor driving the demand for audited financial statements. Consider for example a company that was desperate for cash in order to survive. Would it be possible that the management team would present unreliable financial statements to the bank in order to get a desperation loan? Because of this possibility, a financial statement audit is needed to add credibility to the financial statements. 1.30 a. Incorrect According to Section 201 of the Sarbanes-Oxley Act, bookkeeping services are prohibited. b. Incorrect According to Section 201 of the Sarbanes-Oxley Act, internal audit services are prohibited. c. Incorrect According to Section 201 of the Sarbanes-Oxley Act, valuation services are prohibited. d. Correct Sarbanes-Oxley prohibits the provision of all of the services listed in answers a, b, and c; therefore, d (all of the above) is the best response.
  • 10. Chapter 01 - Auditing and Assurance Services 1.31 a. Incorrect Financial statement auditors do not reduce business risk. b. Correct After completing a financial statement audit, information risk has been reduced for investors. c. Incorrect Complexity creates demand for accounting services but is not an objective of the financial statement audit. d. Incorrect Auditors do not directly control the timeliness of financial statements. Management must first provide the information to be audited. 1.32 a. Incorrect A financial statement opinion is the objective of a financial statement audit, not a compliance audit. b. Incorrect A basis for a report on internal control is the objective of an internal control audit under Section 404 of the Sarbanes-Oxley Act, not a compliance audit. c. Incorrect A study of effective and efficient resources is the objective of an operational audit, not a compliance audit. d. Correct A compliance audit refers to procedures that are designed to ascertain that the company‘s personnel are following laws, rules, regulations, and policies. 1.33 a. Incorrect While successful completion of the Uniform CPA is necessary to be licensed as a CPA, a candidate also requires the proper experience and proper education. Thus, letter (d.) is correct. b. Incorrect While proper experience is necessary to be licensed as a CPA, a candidate also requires the successful completion of the Uniform CPA and proper education. Thus, letter (d.) is correct. c. Incorrect While proper education is necessary to be licensed as a CPA, a candidate also requires the successful completion of the Uniform CPA and proper experience. Thus, letter (d.) is correct. d. Correct A candidate requires the successful completion of the Uniform CPA, proper experience and proper education to be licensed as a CPA. 1.34 a. Incorrect The GIAA is not responsible for monitoring the use of public funds by public officials. This is the responsibility of the GAO. b. Incorrect The CIA is not responsible for monitoring the use of public funds by public officials. This is the responsibility of the GAO. c. Incorrect The SEC is not responsible for monitoring the use of public funds by public officials. This is the responsibility of the GAO. d. Correct The mission of the U.S. Government Accountability Office is to ensure that public officials are using public funds efficiently, effectively, and economically. 1.35 a. Incorrect A financial audit is typically not included as part of a performance audit. b. (&d) Correct The two categories of performance audits are economy and efficiency audits and program audits. c. Incorrect A compliance audit is typically not included as part of a performance audit. d. (&b) Correct The two categories of performance audits are economy and efficiency audits and program audits. 1.36 a. Incorrect A review of credit ratings of customers would not provide evidence about the completeness of accounts receivable. Because GAAP requires the accounts receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. b. Incorrect A review of credit ratings of customers would not provide evidence about the existence of accounts receivable. Because GAAP requires the accounts receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. c. Correct A review of credit ratings of customers‘ gives indirect evidence of the collectability of accounts receivable. Because GAAP requires the accounts
  • 11. Chapter 01 - Auditing and Assurance Services receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. d. Incorrect A review of credit ratings of customers would not provide evidence about the rights of accounts receivable. Because GAAP requires the accounts receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. e. Incorrect A review of credit ratings of customers would not provide evidence about the occurrence of accounts receivable. Because GAAP requires the accounts receivable balance to be valued at the amount expected to be collected from customers, the review of credit ratings relates to valuation. 1.37 a. Incorrect Rhonda‘s representations are not sufficient evidence to support assertions made in the financial statements. b. Incorrect Despite Rhonda‘s representations, Jones must gather additional evidence to corroborate Rhonda‘s assertions. c. Incorrect Rhonda‘s representations are a form of evidence (albeit weak) that should neither be disregarded nor blindly regarded without professional skepticism. d. Correct Rhonda‘s assertions are nice. However, to be considered as sufficient to conclude that all expenses have been recorded, they will need corroboration with documentary evidence. Thus, this is the correct response. 1.38 a. Incorrect Although there is a high level of risk associated with client acceptance, this phrase was created by the authors. b. Correct By definition, information risk is the probability that the information circulated by a company will be false or misleading. c. Incorrect Moral hazard is the risk that the existence of a contract will change the behavior of one or both parties to the contract. d. Incorrect Business risk is the probability an entity will fail to meet its strategic objectives. 1.39 a. Correct This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. b. Incorrect This is not an existence test. This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. c. Incorrect This is not a test of valuation. This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. d. Incorrect This is not a test of rights and obligations. This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. e. Incorrect This is not an occurrence test. This is clearly a test of the completeness as the assertion always includes any issues of transaction cutoff, which means that the recording of all revenue, expense, and other transactions must be included in the proper period in accordance with GAAP. 1.40 a. Incorrect This is not a completeness test. This is clearly a test related to rights and obligations as the question that must be answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the
  • 12. Chapter 01 - Auditing and Assurance Services b. Incorrect company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This is not an existence test. This is clearly a test related to rights and c. Incorrect obligations as the question that must be answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This is not a test of valuation. This is clearly a test related to rights and d. Correct obligations as the question that must be answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This is clearly a test related to rights and obligations as the question that must be e. Incorrect answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. This is not an occurrence test. This is clearly a test related to rights and obligations as the question that must be answered with evidence is to establish that amounts reported as assets of the company represent true assets that it really does own and that the amounts reported as liabilities truly represent its obligations. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. 1.41 a. b. Incorrect Correct This is not a test of completeness. This is a test of existence which is completed by auditors to answer the question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP. This is a test of existence. This test is completed by auditors to answer the c. Incorrect question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP. This is not a test of valuation. This is a test of existence which is completed by auditors to answer the question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP.
  • 13. Chapter 01 - Auditing and Assurance Services d. Incorrect This is not a test of rights and obligations. This is a test of existence which is completed by auditors to answer the question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP. e. Incorrect This is not a test of occurrence. This is a test of existence which is completed by auditors to answer the question as to whether the transactions recorded as an asset really represent assets that exist and did add value to the company‘s equipment as compared to routine repair and maintenance expenses under GAAP. Management‘s existence assertion states that the reported assets actually exist. If an addition to the equipment account cannot be located or identified as adding value to the equipment balance, it is possible that the amount should have been classified as repair and maintenance expenses under GAAP. 1.42 a. Incorrect Under Sarbanes-Oxley, public accounting firms are prevented from acting in a managerial decision-making role for an audit client. b. Incorrect Under Sarbanes-Oxley, public accounting firms are prevented from auditing the firm‘s own work on an audit client. c. Incorrect Under Sarbanes-Oxley, public accounting firms may only provide tax consulting services to an audit client with the audit committee‘s approval. d. Correct Sarbanes-Oxley prevents public accounting firms from serving an audit client in any of the preceding listed roles. As a result, each of the responses a, b, and c is incorrect and letter d is the correct response. 1.43 a. Incorrect Substantial equivalency does not refer to the financial statement auditing process. The term relates to the practice of public accountancy in states other than a CPA‘s state of licensure. b. Incorrect Substantial equivalency does not refer to consulting services. The term relates to the practice of public accountancy in states other than a CPA‘s state of licensure. c. Incorrect Substantial equivalency does not refer to other professional organizations. The term relates to the practice of public accountancy in states other than a CPA‘s state of licensure. d. Correct Substantial equivalency relates to the practice of public accountancy in states other than a CPA‘s state of licensure. Under the concept of substantial equivalency, as long as the licensing (home) state requires (1) 150 hours of education, (2) successful completion of the CPA exam, and (3) one year of experience, a CPA can practice (either in person or electronically) in another substantial equivalency state without having to obtain a license in that state. 1.44 a. Correct Auditing is a subset of attestation engagements that focuses on the certification of financial statements. The subject matter is the set of financial statements from management and the criteria is GAAP in the United States. b. Incorrect That is not true. Auditing is one example of an attest engagement. The level of assurance provided is not lower for an attestation engagement. c. Incorrect That is not true. The auditor is not allowed to provide management support for its audit clients. Rather, consulting engagements can focus on providing clients with advice and decision support. d. Incorrect The definition provided is the one for assurance engagements, which is quite broad and includes all engagements that are designed to improve the quality of information, or its context, for decision makers.
  • 14. Chapter 01 - Auditing and Assurance Services 1.45 a. Correct Management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of cash and the fact that is no foreign currency translation calculation, the existence assertion is clearly the most important assertion. b. Incorrect Although rights and obligations is an important assertion, it is not the most relevant assertion for the cash balance. Since management is more likely to overstate assets, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of cash and the fact that is no foreign currency translation calculation, the existence assertion is clearly the most important assertion. c. Incorrect Although valuation is an important assertion, it is not the most relevant assertion for the cash balance. In this situation, because of the nature of cash and the fact that is no foreign currency translation calculation, the existence assertion is clearly the most important assertion. If however, there was a foreign currency translation adjustment, valuation of cash would also be relevant. d. Incorrect Although occurrence is an important assertion, it is not the most relevant assertion for any balance sheet account. Rather, the occurrence assertion is more closely related to income statement accounts because the question that needs to be answered with evidence is whether the transaction really did occur in accordance with GAAP. In this situation, because of the nature of cash and the fact that is no foreign currency translation calculation, the existence assertion is clearly the most important assertion. 1.46 a. Incorrect This evidence would provide evidence about management‘s assertion about rights and obligations and perhaps existence. However, this evidence would not help to value the investment in accordance with GAAP. b. Incorrect While this evidence would potentially be helpful to value an investment in another company, it is not the best answer. If a quote was available from an independent source, this would be a better form of evidence for valuation. c. Incorrect This evidence would provide evidence about management‘s assertion about existence and perhaps rights and obligations. However, this evidence would not help to value the investment in accordance with GAAP. d. Correct Always remember that management is more likely to overstate assets. As a result, when auditing an asset balance like investments, a relevant assertion is likely to be valuation. In this situation, to answer the question of what the investment should be valued at in the balance sheet, an auditor would first seek to obtain a market quotation from an independent source like the Wall Street Journal. 1.47 a. Incorrect This test is not related to presentation and disclosure. A cutoff test is clearly a test of the completeness assertion as the test is designed to insure that all transactions that should have been included in accordance with GAAP have been recorded. b. Correct A cutoff test is clearly a test of the completeness assertion as the test is designed to insure that all transactions that should have been included in accordance with GAAP have been recorded. c. Incorrect This test is not related to rights and obligations. A cutoff test is clearly a test of the completeness assertion as the test is designed to insure that all transactions that should have been included in accordance with GAAP have been recorded. d. Incorrect This test is not related to existence. A cutoff test is clearly a test of the completeness assertion as the test is designed to insure that all transactions that should have been included in accordance with GAAP have been recorded.
  • 15. Chapter 01 - Auditing and Assurance Services 1.48 a. Incorrect This test is designed to test the completeness assertion for the inventory account. It does not provide any evidence related to the rights and obligations assertion. b. Correct This is clearly a test related to rights and obligations as the question that must be answered with evidence is to establish that the inventory reported as assets really is owned by the company. Goods on consignment, by definition, are not owned by the company. Thus, there is a risk that the company is recording assets that they do not own on their balance sheet. c. Incorrect This test is designed to test the completeness assertion for sales revenue. It does not provide evidence related to the rights and obligations assertion for inventory. d. Incorrect This test is designed to test the presentation and disclosure assertion for inventory purchase commitments. It does not provide evidence related to the rights and obligations assertion for inventory. 1.49 a. Incorrect Management is far more likely to understate liabilities than to overstate them. As a result, when auditing the accrued liabilities account, existence or occurrence is not as likely to be violated. Rather, the most relevant assertion is likely to be completeness. b. Correct Management is more likely to understate liabilities. As a result, when auditing the accrued liabilities account, the most relevant assertion is likely to be completeness. c. Incorrect Management is far more likely to understate liabilities. As a result, when auditing the accrued liabilities account, the most relevant assertion is likely to be completeness. Presentation and disclosure may be relevant. However, it is not as likely to contain a material misstatement as completeness. d. Incorrect Management is far more likely to understate liabilities than to overstate them. As a result, when auditing the accrued liabilities account, the most relevant assertion is likely to be completeness. Valuation may be relevant. However, it is not as likely to contain a material misstatement as completeness. 1.50 a. Incorrect This is not correct as an auditing engagement refers to an examination of the financial statements to determine whether the information has been presented in accordance with GAAP. Also, a consulting engagement is one where the professional provides advice and decision support. b. Incorrect This is not correct as a consulting engagement is one where the professional provides advice and decision support. Also, an assurance engagement can include many more types of information than just the financial statements. c. Incorrect This is not correct as an auditing engagement refers to an examination of the financial statements to determine whether the information has been presented in accordance with GAAP. Also, a consulting engagement is one where the professional provides advice and decision support. d. Correct This is correct as an auditing engagement refers to an examination of the financial statements to determine whether the information has been presented in accordance with GAAP and an attestation engagement can include a financial statement audit. In addition, An assurance engagement can apply to all types of information and a consulting engagement is one where the professional provides advice and decision support. 1.51 a. Incorrect Credibility is a reason to become certified. Because all three responses are reasons, (d) is correct. b. Incorrect Advancement and promotion are reasons to become certified. Because all three responses are reasons, (d) is correct. c. Incorrect Monetary reward is a reason to become certified. Because all three responses are reasons, (d) is correct. d. Correct Credibility, advancement, and monetary rewards are all reasons to become certified.
  • 16. Chapter 01 - Auditing and Assurance Services 1.52 a. Incorrect Although existence or occurrence is an important assertion, it is not the most relevant assertion for retained earnings. Restrictions on retained earnings from loans, agreements or state law would need to be disclosed in the footnotes to the financial statements. As a result, presentation and disclosure is clearly the most important assertion. b. Incorrect Although completeness is an important assertion, it is not the most relevant assertion for retained earnings. Restrictions on retained earnings from loans, agreements or state law would need to be disclosed in the footnotes to the financial statements. As a result, presentation and disclosure is clearly the most important assertion. c. Incorrect Although valuation is an important assertion, it is not the most relevant assertion for retained earnings. Restrictions on retained earnings from loans, agreements or state law would need to be disclosed in the footnotes to the financial statements. As a result, presentation and disclosure is clearly the most important assertion. d. Correct Restrictions on retained earnings from loans, agreements or state law would need to be disclosed in the footnotes to the financial statements. As a result, presentation and disclosure is clearly the most important assertion. 1.53 a. Correct Management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of accounts receivable and the fact that valuation is not an option, the existence assertion is clearly the most important assertion. b. Incorrect Although completeness is an important assertion, it is not the most relevant assertion for the accounts receivable balance. Since management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of accounts receivable and the fact that valuation is not an option, the existence assertion is clearly the most important assertion. c. Incorrect Although presentation and disclosure is an important assertion, it is not the most relevant assertion for the accounts receivable balance. Since management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of accounts receivable and the fact that valuation is not an option, the existence assertion is clearly the most important assertion. d. Incorrect Although rights and obligations is an important assertion, it is not the most relevant assertion for the accounts receivable balance. Since management is more likely to overstate assets and understate liabilities. As a result, when auditing an asset balance, the most relevant assertions are likely to be either existence or valuation. In this situation, because of the nature of accounts receivable and the fact that valuation is not an option, the existence assertion is clearly the most important assertion. 1.54 a. Incorrect Although rights and obligations is an important assertion, it is not the assertion being tested in this situation. Most importantly, the auditor did not select items for testing from any financial statement records. Rather, the auditor selected items to be tested from the warehouse, without considering the financial statement records. As a result, this is a test that is designed specifically to test whether all items that should be recorded on the financial statements actually are included on the financial statements. Thus, the assertion being tested is the completeness assertion. The absolute key to understanding this question is to focus on how the items were selected for testing.
  • 17. Chapter 01 - Auditing and Assurance Services b. Correct Most importantly, the auditor did not select items for testing from any financial statement records. Rather, the auditor selected items to be tested from the warehouse, without considering the financial statement records. As a result, this is a test that is designed specifically to test whether all items that should be recorded on the financial statements actually are included on the financial statements. Thus, the assertion being tested is the completeness assertion. The absolute key to understanding this question is to focus on how the items were selected for testing. c. Incorrect Although existence is an important assertion, it is not the assertion being tested in this situation. Most importantly, the auditor did not select items for testing from any financial statement records. Rather, the auditor selected items to be tested from the warehouse, without considering the financial statement records. As a result, this is a test that is designed specifically to test whether all items that should be recorded on the financial statements actually are included on the financial statements. Thus, the assertion being tested is the completeness assertion. The absolute key to understanding this question is to focus on how the items were selected for testing. d. Incorrect Although valuation is an important assertion, it is not the assertion being tested in this situation. Most importantly, the auditor did not select items for testing from any financial statement records. Rather, the auditor selected items to be tested from the warehouse, without considering the financial statement records. As a result, this is a test that is designed specifically to test whether all items that should be recorded on the financial statements actually are included on the financial statements. Thus, the assertion being tested is the completeness assertion. The absolute key to understanding this question is to focus on how the items were selected for testing. 1.55 a. Incorrect Although rights and obligations is an important assertion, it is not the most relevant assertion when testing the pension footnote. The question specifically relates to testing the information contained in the pension footnote. When testing the footnote disclosures, the presentation and disclosure is likely to be the most important assertion being tested. b. Incorrect Although existence is an important assertion, it is not the most relevant assertion when testing the pension footnote. The question specifically relates to testing the information contained in the pension footnote. When testing the footnote disclosures, the presentation and disclosure is likely to be the most important assertion being tested. c. Correct The question specifically relates to testing the information contained in the pension footnote. When testing the footnote disclosures, the presentation and disclosure is likely to be the most important assertion being tested. d. Incorrect Although valuation is an important assertion, it is not the most relevant assertion when testing the pension footnote. The question specifically relates to testing the information contained in the pension footnote. When testing the footnote disclosures, the presentation and disclosure is likely to be the most important assertion being tested. 1.56 a. Incorrect Since there is no assurance about any management assertion provided when completing an engagement to implement an ERP system, this is not considered an attestation service. This is a consulting service. b. Incorrect Since there is no assurance about any management assertion provided when completing an engagement to develop a more efficient payroll process, this is not considered an attestation service. This is a consulting service. c. Correct This is an attestation service. In order to assess the effectiveness of an internal control system, the assurance provider would have to attest to management‘s assertion that the internal control was effective in accordance with the COSO framework, as this is the most common way of expressing the effectiveness of
  • 18. Chapter 01 - Auditing and Assurance Services an internal control system. As a result, this is the definition of an attestation service, as articulated in the book and the professional standards. d. Incorrect Since there is no assurance about any management assertion when assisting the client in an IRS audit, this type of work is not considered an attestation service. 1.57 a. Incorrect Although rights and obligations is an important assertion, it is not the most relevant assertion for the revenue account. Management is more likely to overstate revenue to improve profitability. As a result, when auditing the revenue account, the most relevant assertions are likely to be either existence/occurrence or valuation. In this situation, because of the nature of revenue and the fact that accuracy is more closely related to valuation, the valuation assertion is clearly the most important assertion. In addition, the existence/occurrence option is not an available option. b. Correct Valuation and allocation is the PCAOB assertion that is most likely to be tested. In general, management is more likely to overstate revenue to improve profitability. As a result, when auditing the revenue account, the most relevant assertions are likely to be either existence/occurrence or valuation. In this situation, because of the nature of revenue and the fact that accuracy is more closely related to valuation, the valuation assertion is clearly the most important assertion. In addition, the existence/occurrence option is not an available option. c. Incorrect Although presentation and disclosure is an important assertion, it is not the most relevant assertion for the revenue account. Management is more likely to overstate revenue to improve profitability. As a result, when auditing the revenue account, the most relevant assertions are likely to be either existence/occurrence or valuation. In this situation, because of the nature of revenue and the fact that accuracy is more closely related to valuation, the valuation assertion is clearly the most important assertion. In addition, the existence/occurrence option is not an available option. d. Incorrect Although completion is an important assertion, it is not the most relevant assertion for the revenue account. Management is more likely to overstate revenue to improve profitability. As a result, when auditing the revenue account, the most relevant assertions are likely to be either existence/occurrence or valuation. In this situation, because of the nature of revenue and the fact that accuracy is more closely related to valuation, the valuation assertion is clearly the most important assertion. In addition, the existence/occurrence option is not an available option. 1.58 a. Incorrect Although existence is an important assertion, it is not the most relevant assertion for goodwill account in this situation. By definition, impairment of goodwill is an accounting charge that companies record when the goodwill account's carrying value on the balance sheet exceeds its fair value. As a result, when auditing the goodwill account to determine whether it is impaired or not, the most relevant assertion is clearly valuation. b. Incorrect Although completeness is an important assertion, it is not the most relevant assertion for goodwill account in this situation. By definition, impairment of goodwill is an accounting charge that companies record when the goodwill account's carrying value on the balance sheet exceeds its fair value. As a result, when auditing the goodwill account to determine whether it is impaired or not, the most relevant assertion is clearly valuation. c. Incorrect Although presentation and disclosure is an important assertion, it is not the most relevant assertion for goodwill account in this situation. By definition, impairment of goodwill is an accounting charge that companies record when the goodwill account's carrying value on the balance sheet exceeds its fair value. As a result, when auditing the goodwill account to determine whether it is impaired or not, the most relevant assertion is clearly valuation.
  • 19. Chapter 01 - Auditing and Assurance Services d. Correct Valuation is the correct answer. By definition, impairment of goodwill is an accounting charge that companies record when the goodwill account's carrying value on the balance sheet exceeds its fair value. As a result, when auditing the goodwill account to determine whether it is impaired or not, the most relevant assertion is clearly valuation. 1.59 a. Correct Rights and obligations is the correct answer. By definition, consignment inventory is a business model where a product is sold by a retail store but the title/ownership of the product is retained by a third party until the product is actually sold by the retailer. As a result, when auditing the inventory account of an audit client that sells consigned inventory, the rights and obligations assertion is the most relevant assertion to be audited since ownership of the inventory is in question. b. Incorrect Although completeness is an important assertion, it is not the most relevant assertion for the inventory account in this situation. By definition, consignment inventory is a business model where a product is sold by a retail store but the title/ownership of the product is retained by a third party until the product is actually sold by the retailer. As a result, when auditing the inventory account of an audit client that sells consigned inventory, the rights and obligations assertion is the most relevant assertion to be audited since ownership of the inventory is in question. c. Incorrect Although existence or occurrence is an important assertion, it is not the most relevant assertion for the inventory account in this situation. By definition, consignment inventory is a business model where a product is sold by a retail store but the title/ownership of the product is retained by a third party until the product is actually sold by the retailer. As a result, when auditing the inventory account of an audit client that sells consigned inventory, the rights and obligations assertion is the most relevant assertion to be audited since ownership of the inventory is in question. d. Incorrect Although valuation or allocation is an important assertion, it is not the most relevant assertion for the inventory account in this situation. By definition, consignment inventory is a business model where a product is sold by a retail store but the title/ownership of the product is retained by a third party until the product is actually sold by the retailer. As a result, when auditing the inventory account of an audit client that sells consigned inventory, the rights and obligations assertion is the most relevant assertion to be audited since ownership of the inventory is in question. SOLUTIONS FOR EXERCISES AND PROBLEMS 1.60 Audit, Attestation, and Assurance Services Students may encounter some difficulty with this matching question because the Special Committee on Assurance Services (SCAS) listed many things that heretofore have been considered ―attestation services‖ (long before assurance services were invented). As a result, we believe that this question is a good vehicle for discussing the considerable overlap that exists between attestation and assurance services.  Real estate demand studies: Assurance service  Ballot for awards show: Assurance service  Utility rates applications: Assurance service  Newspaper circulation audits: Assurance service
  • 20. Chapter 01 - Auditing and Assurance Services  Third-party reimbursement maximization: Assurance service  Annual financial report to stockholders: Audit service  Rental property operations review: Assurance service  Examination of financial forecasts and projections: Attestation service  Customer satisfaction surveys: Assurance service  Compliance with contractual requirements: Attestation service  Benchmarking/best practices: Assurance service  Evaluation of investment management policies: Assurance service  Information systems security reviews: Assurance service  Productivity statistics: Assurance service  Internal audit strategic review: Assurance service  Financial statements submitted to a bank loan officer: Audit service 1.61 Professional Skepticism In general, students should note that they always need to maintain their level of professional skepticism on the financial statement audit. There may be times when skepticism should increase. However, even when it might seem that you can reduce your skepticism, auditors should always maintain their professional skepticism. a) The chair of the board of your audit client proposed that the company hire its sales manager as their new financial controller. Increase b) The financial controller at your client mentions that she has just been on maternity leave for three months and no bank reconciliations were completed during the time she was out of the office. Increase c) While auditing the Accounts Receivable account for your audit client, you notice that there is a large amount that is well past due on the aged accounts receivable schedule. Increase d) While auditing the year-end investment balances, you find that your client‘s investment balance exactly agrees to the statement from the investment custodian. The custodian is a large bank. Stay the same e) The new chair of the board of Adams Corporation decided to fire the entire internal audit department. The chair believed that the work completed by the annual auditor was enough auditing and that they were already paying enough to the external auditors. Increase
  • 21. Chapter 01 - Auditing and Assurance Services f) While auditing the inventory balance at your audit client, you visited the client‘s warehouse during their inventory count. You observed the count and found that the client made no mistakes during your procedures. Stay the same g) The sales manager in charge of the Northeast region retired. She was replaced in the region by the assistant sales manager in the same region. Stay the same h) While auditing the Interest Expense account, you notice that there was no increase in the amount during the current year. However, you noticed that the long-term debt amount doubled during the current year. Increase i) While auditing the inventory balance at your audit client, you perform test counts at their warehouse. While you are counting, you notice a storage bin of inventory that is covered in dust with damaged products. These items are stored near the garbage dumpsters. Increase j) You are auditing cash and during your review of the bank statements you notice unusual cash transfers between two bank accounts which are inconsistent with the client‘s business. Increase k) While auditing accounts payable, the accounts payable clerk told you that the audit client implemented three new internal control procedures. You tested each new control and found that no exceptions in your testing concluding that the controls are operating effectively. Stay the same l) The chair of the board of your audit client decided to double the staff of the internal audit department from 10 professionals to 20 professionals. The chair wanted to have the largest internal audit department in the industry and the increase will let the department complete more internal control audits throughout the year. Stay the same
  • 22. Chapter 01 - Auditing and Assurance Services 1.62 Management Assertions PCAOB Assertion Corresponding ASB assertion Nature of assertion Existence or Occurrence Existence Balance Occurrence Cutoff Transactions Transactions Rights and Obligations Rights and Obligations Balances Completeness Completeness Transactions Balances Cutoff Transactions Valuation and Allocation Accuracy Transactions Balances Valuation and Allocation Balances Presentation and Disclosure Presentation Transactions Balances Classification Transactions Balances 1.63 Management Assertions Existence or Occurrence - Assertions about existence or occurrence address whether assets or liabilities of the entity exist at a given date and whether recorded transactions have occurred during a given period. For example, management asserts that Accounts Receivable on the balance sheet represent valid amounts actually owed to the company at year end that are due in exchange for goods or services from the company. Completeness - Assertions about completeness address whether all transactions and accounts that should be presented in the financial statements are so included. For example, management asserts that all amounts that should be recorded and included in the financial statements as accounts receivable actually have been recorded (i.e. no accounts are omitted). Valuation or Allocation - Assertions about valuation or allocation address whether asset, liability, equity, revenue, and expense components have been included in the financial statements at appropriate amounts. For example, management asserts that Accounts Receivable are stated at net realizable value and the allowance for uncollectible accounts is adequate. Rights and Obligations - Assertions about rights and obligations address whether assets are the rights of the entity and liabilities are the obligations of the entity at a given date. For example, management asserts that the Accounts
  • 23. Chapter 01 - Auditing and Assurance Services Receivable on the balance sheet really are owned by the company. As a result, they have not factored (i.e., sold) any of the balances that are listed on the balance sheet. Presentation and Disclosure - Assertions about presentation and disclosure address whether particular components of the financial statements are properly classified, described, and disclosed. For example, management asserts that the presentation of accounts receivable and the related allowance for doubtful accounts have been presented and are disclosed in accordance with GAAP. 1.64 Other Types of Auditing For each of the following scenarios, please indicate whether it would be most appropriate to use an internal auditor, a governmental auditor, or a regulatory auditor: a) The Department of Defense for the United States plans to audit the cost accounting report for a contract signed with a key supplier. Governmental b) Bigdeal Corporation manufactures paper and paper products and is trying to decide whether to purchase Smalltek Company. Bigdeal wants to obtain a report on the operational efficiency and effectiveness of the Smalltek sales, production, and research and development departments. Internal c) The FDIC plans to audit the collectability of loans at a bank that they insure. Regulatory d) The board of directors would like an efficiency audit completed of its manufacturing plant operations. Internal e) The city of New York would like an audit done of a major construction project to make sure that the taxpayer‘s funds were used in an efficient manner. Governmental f) A federal bank examiner decides to audit a bank to determine whether it will remain solvent in the upcoming year. Regulatory g) The CEO of Franklin Corporation wants to hire an auditor to take responsibility for auditing the company‘s compliance with environmental laws and regulations. Internal h) The IRS would like to audit the tax returns of a popular restaurant chain. Regulatory i) The state of Ohio decided to audit the use of educational grants awarded to cities and towns in the state to make sure the funds were spent in accordance with the grant program.
  • 24. Chapter 01 - Auditing and Assurance Services Governmental j) The Department of the Interior for the United States plans to audit the use of funds spent by all National Parks. Governmental 1.65 Auditor as Guarantor. Loot Starkin appears to be uninformed on the following key points: The auditors did not prepare the Dodge Corporation financial statement. Inform your neighbor that Dodge management is primarily responsible for preparing the financial statements and deciding upon the appropriate accounting principles. An unqualified opinion does not mean that an investment is safe. Rather, it merely means that the financial statements are free of material misstatement. Tell your neighbor that the financial statements are a historical record of the business‘ performance. The value of Loot‘s investment depends on future events, including the many factors that affect market prices. Thus, the financial statements are just one piece of information that should be analyzed. Tell Loot that the unqualified opinion means only that the statements conform to the appropriate reporting framework (e.g., GAAP) and that the financial statements are free of material misstatement.
  • 25. Chapter 01 - Auditing and Assurance Services 1.66 Identification of Audits and Auditors The responses to this matching type of question are ambiguous. The engagement examples are real examples of external, internal, and governmental audit situations. You might point out to students that the distinctions among compliance, economy and efficiency, and program results audits are not always clear. The ―solution‖ is shown in the following matrix form, showing some engagement numbers in two or three cells. The required schedule follows. Type of Audit Engagement Financial Economy and Program Auditor Statement Compliance Efficiency Results Independent CPA 2, 10 Internal auditor 6, 8 4, 8 Governmental (GAO) 1, 3 1, 3, 9 auditor IRS auditor 5 Bank examiner 7 Type of Audit Type of Auditor 1. Proprietary school‘s training expenses Economy and efficiency or program results Governmental (GAO) auditors 2. Advertising agency financial statements Financial statement Independent CPAs 3. Dept. of Defense launch vehicle Economy and efficiency or program results Governmental (GAO) auditors 4. Municipal services Economy and efficiency Internal auditors 5. Tax shelters Compliance IRS auditors 6. Test pilot reporting Compliance Internal auditors 7. Bank solvency Compliance Bank examiners 8. Materials inspection by manufacturer Compliance or Economy and Efficiency Internal auditors 9. States‘ reporting chemical use data Program goal Governmental (GAO) auditors 10. Sports complex forecast Financial statement Independent CPAs
  • 26. Chapter 01 - Auditing and Assurance Services 1.67 Financial Assertions and Audit Objectives By definition, management financial statement assertions give rise to questions that can be answered with evidence. The objectives for the audit of Spillane‘s securities investments at December 31 are to obtain evidence about the assertions implicit in the financial presentation, specifically: 1. Existence. Obtain evidence that the securities are bona fide and held by Spillane or a responsible custodian. Occurrence. Obtain evidence that the loan transaction and securities purchase transactions actually took place during the year under audit. 2. Completeness. Obtain evidence that all the securities purchase transactions were recorded. 3. Rights. Obtain evidence that Spillane owned the securities. Obligation. Obtain evidence that $500,000 is the amount actually owed on the loan. 4. Valuation. Obtain evidence of the cost and market value of the securities held at December 31. Decide whether any write-downs to market are required by the appropriate reporting framework. 5. Presentation and disclosure. Obtain evidence of the committed nature of the assets, which should mean they should be in a noncurrent classification like the loan. Obtain evidence that restrictions on the use of the assets are disclosed fully and agree with the loan documents. 1.68 Financial Statement Assertions and Possible Misstatements Possible Misstatement/Risk Relevant Assertions a) Revenue is overstated because the controller made up fraudulent invoices and recorded them. Occurrence b) Revenue is understated because the accountant closed the sales cycle a week early to go on vacation. Completeness c) Accounts Receivable is overstated because the accounts receivable clerk forgot to apply available discounts. Valuation or Allocation d) Accounts Receivable is overstated because sales are falsified. Existence e) Travel expense is overstated because the sales force charged personal expenses on their corporate credit card. Occurrence f) Accounts Payable is understated because the office manager lost an invoice for supplies received so it was never recorded. Completeness g) The cash balance is understated because funds held in Japan were converted to $USD at the wrong rate. Valuation or Allocation
  • 27. Chapter 01 - Auditing and Assurance Services h) The cash balance recorded on the financial statements is overstated because the treasurer is stealing from the company. Existence i) Inventory is overstated because it is held on consignment but included in the inventory balance. Rights and Obligations j) The cost of goods sold is overstated because time sheets have not been submitted for each job. Valuation or Allocation k) Long Term Debt is overstated due to misclassification by management. Presentation and Disclosure 1.69 Financial Statement Assertions and Audit Procedures Audit Procedure Relevant Assertions Significant Account a) The auditor sends a letter to the bank confirming the amount of cash in the bank account. Existence Cash b) The auditor takes a shipping document and traces it to the sales invoice and sales journal Completeness Revenue c) The auditor selects items from the company's inventory list and observes those items in the warehouse Existence Inventory d) The auditor compares prices on a vendor invoice to an approved price list from the vendor. Valuation or allocation Accounts Payable e) The auditor reviews recorded expenses with vendor invoices. Valuation or allocation Expenses f) The auditor determines whether inventory has been pledged as collateral for a loan. Presentation or Disclosure Inventory g) The auditor reads the Board of Directors minutes for approval of stock options. Presentation or Disclosure Common Stock h) The auditor reviews lease agreements to evaluate whether they have been recorded properly. Completeness Capitalized Leases i) The auditor selects inventory items at a retail store to determine whether any are held on consignment. Rights and obligations Inventory j) The auditor sends letters to customers to confirm amounts owed to the company Existence Accounts Receivable
  • 28. Chapter 01 - Auditing and Assurance Services 1.70 Internet Exercise: Professional Certification These answers will depend on the student‘s state of residence. Many states have recently reduced the experience requirements by either (1) reducing or eliminating an audit experience requirement and/or (2) reducing the experience requirement in lieu of additional education. For a quick link to each state, visit the National Association of State Boards of Accountancy (www.nasba.org). 1.71 Internet Exercise: Professional Certification The Institute of Internal Auditors does a good job explaining the benefits of becoming a certified internal auditor. The exam consists of four parts: the Internal Audit Activity‘s Role in Governance, Risk, and Control; Conducting the Internal Audit Engagement; Business Analysis and Information Technology; and Business Management Skills. You must have at least a bachelor‘s degree to sit for this exam. The Institute of Management Accountants also does a good job of explaining the benefits of the certification. The parts of the exam include Business Analysis, Management Accounting and Reporting, Strategic Management, and Business Applications. You must have at least a bachelor‘s degree to sit for this exam. The Association of Certified Fraud Examiners also does a good job of explaining the benefits of the certification. The areas of study tested on the exam include criminology and ethics, financial transactions, fraud investigation, and legal elements of fraud. You must have at least a bachelor‘s degree to sit for this exam. The Information Systems Audit and Control Association website explains the benefits of becoming certified. You must have at least an associates‘ degree to sit for this exam. 1.72 Internet Exercise: Services Offered by the Big Four Public Accounting Firms These answers will depend on the specific service picked by each student. Each of the firms now offers a multitude of different services. Thus, these answers are likely to differ substantially. The goal of the question is to expose students to the wide range of services. So, as long as the student lists two services that are in alignment with the instructor‘s experience, credit should be awarded. Apollo Shoes Questions 1) List three relevant facts about Apollo Shoes that you think might have an impact on the financial statement audit. This question is designed to get the students to examine the Apollo Shoes Form 10K with a critical mindset. There are a number of allowable responses to this question. Three prominent responses would be: a. Accounts Receivable increased significantly from the prior year. b. Inventory increased significantly from the prior year. c. The line of credit balance increased significantly from the prior year. 2) Define what is meant by a significant account or disclosure. A financial statement account or footnote disclosure is considered significant if there is a chance that the account or footnote disclosure could contain a material misstatement. As a result, an auditor will have to conduct some procedures on each significant account or disclosure.
  • 29. Chapter 01 - Auditing and Assurance Services 3) Identify at least two significant accounts or disclosures from the financial statements of Apollo Shoes. What makes each item significant? This question is designed to get the students to examine the Apollo Shoes Trial Balance with a critical mindset. There are a number of allowable responses to this question. Two prominent responses would be: a. Accounts Receivable is significant because of the magnitude of the account in relation to total assets for Apollo Shoes. b. Inventory is significant because of the magnitude of the account in relation to total assets for Apollo Shoes. 4) Define what is meant by a relevant assertion. A relevant assertion is "a management assertion is relevant if there is a reasonable possibility that a material misstatement exists related to that assertion for the significant account or footnote disclosure being audited.‖ 5) Identify at least one relevant assertion for each of the significant accounts or disclosures previously identified from the financial statements of Apollo Shoes. What makes each assertion relevant? Once again, there are a number of allowable responses to this question. Two responses that related back to the suggested solution for question #3 would be: a. Valuation of Accounts Receivable is relevant because of the significant increase in receivables compared to last year. Importantly, this increase occurred without a significant increase in sales. What happened? Why are they unable to collect their receivables this year as compared to last year? Should the allowance for doubtful accounts be increased? As a result of these questions, the risk of material misstatement for this assertion is high. b. Existence of Inventory is relevant because the inventory balance is a material amount and the auditor must make sure that the inventory does really exist. The inventory balance increased significantly compared to last year. Why? The professional standards require that we conduct a physical inventory observation to validate the existence of inventory. As a result of these considerations, the risk of material misstatement for this assertion is high. CHAPTER 2 Professional Standards LEARNING OBJECTIVES Review Checkpoints Multiple Choice Exercises and Problems 1. Understand the development and source of generally accepted auditing standards. 1, 2, 3, 4 47, 48 52 (*), 53 2. Describe the fundamental principle of responsibilities and how this principle 5, 6, 7 27, 29, 35, 39, 40 54, 55, 56, 57, 62 (*),
  • 30. Chapter 01 - Auditing and Assurance Services relates to the characteristics and qualifications of auditors. 64 (*), 65 (*), 66 (*), 67 (*), 68 (*) 3. Describe the fundamental principle of performance and identify major activities performed in an audit. 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18 26, 30, 31, 32, 33, 34, 36, 37, 42, 43, 44, 45 58, 59, 60, 61, 62 (*), 64 (*), 65 (*), 66 (*), 67 (*), 68 (*) 4. Understand the fundamental principle of reporting and identify the basic contents of the auditors‘ report. 19, 20 41, 49, 50, 51 63, 64 (*), 65 (*), 66 (*), 67 (*), 68 (*) 5. Understand the role of a system of quality control and monitoring efforts in enabling public accounting firms to meet appropriate levels of professional quality. 21, 22, 23, 24, 25 28, 38, 46 52 (*), 69, 70, 71 (*) indicates that an item corresponds to multiple learning objectives
  • 31. Chapter 01 - Auditing and Assurance Services SOLUTIONS FOR REVIEW CHECKPOINTS 2.1 Generally accepted auditing standards are auditing standards that identify necessary qualifications and characteristics of auditors and guide the conduct of the audit examination. The purpose of generally accepted auditing standards is to meet the following objectives of an audit examination:  To obtain reasonable assurance about whether the financial statements as a whole are free of material misstatement, whether due to error or fraud.  To issue a report on the financial statements 2.2 Currently, the PCAOB is responsible for developing standards for the audits of issuers, while the AICPA is responsible for developing standards for the audits of nonissuers. 2.3 The AICPA (through the Auditing Standards Board) has responsibility for setting standards for the audits of nonissuers. This is done through the issuance of Statements on Auditing Standards. The PCAOB has responsibility for setting standards for the audits of issuers. This is done through the PCAOB‘s issuance of Auditing Standards. While the SEC does not have responsibility for setting auditing standards per se, all PCAOB standards must be approved by the SEC. 2.4 The three fundamental principles are: 1. Responsibilities, which involves having appropriate competence and capabilities, complying with relevant ethical requirements, maintaining professional skepticism and exercising professional judgment. 2. Performance, which requires auditors to obtain reasonable assurance about whether the financial statements as a whole are free of material misstatement by: (1) planning the work and properly supervising assistants; (2) determining and applying appropriate material levels; (3) identifying and assessing the risk of material misstatement; and, (4) obtaining sufficient appropriate audit evidence. 3. Reporting, which requires the auditor to express an opinion (or state that an opinion cannot be expressed) as to whether the financial statements are presented fairly in accordance with the applicable financial reporting framework. 2.5 Independence in fact represents auditors‘ mental attitudes (do auditors truly act in an unbiased and impartial fashion with respect to the client and fairness of its financial statements?). Independence in appearance relates to financial statement users‘ perceptions of auditors‘ independence. Auditors can be independent in fact but not perceived to be independent. For example, ownership of a small interest in a public client would probably not influence auditors‘ behavior with respect to the client. However, it is likely that third-party users would not perceive auditors to be independent. 2.6 Due care reflects a level of performance that would be exercised by reasonable auditors in similar circumstances. Auditors are expected to have the skills and knowledge of others in their profession (known as that of a prudent auditor) and are not expected to be infallible.
  • 32. Chapter 01 - Auditing and Assurance Services 2.7 Professional skepticism is a state of mind that is characterized by appropriate questioning and a critical assessment of audit evidence. Professional judgment is the auditors‘ application of relevant training, knowledge, and experience in making informed decisions about appropriate courses of action during the audit engagement. Auditors are required to demonstrate professional skepticism and professional judgment throughout the entire audit process. 2.8 Reasonable assurance recognizes that a GAAS audit may not detect all material misstatements and auditors are not ―insurers‖ or ―guarantors‖ regarding the fairness of the entity‘s financial statements. The audit team provides reasonable assurance by considering various risks relating to the likelihood of material misstatements and performing audit procedures to control this risk to an acceptably low level. 2.9 An audit plan is a list of audit procedures that are performed to gather sufficient appropriate evidence on which auditors base their opinion on the financial statements. Audit plans are prepared during the planning stages of the audit. 2.10 An interim date is a date between the beginning of the year and the year-end. Performing audit procedures prior to the interim date allows the audit team to spread work over a longer period of time and focus efforts on the time period between the interim date and year-end, to allow the audit to be completed on a more timely basis. 2.11 Materiality is the dollar amount that would influence the lending or investing decisions of users; this concept recognizes that auditors should focus on matters that are important to financial statement users. Materiality should be considered in planning the audit, performing the audit, and evaluating the effect of misstatements on the entity‘s financial statements. 2.12 Auditors obtain an understanding of a client, including its internal control, as a part of the control risk assessment process primarily in order to plan the nature, timing and extent of further audit procedures. A secondary purpose is because of auditors‘ responsibilities for reporting on client‘s internal controls. 2.13 As the client‘s internal control is more effective (a lower level of control risk), auditors may use less effective substantive procedures (a higher level of detection risk). Conversely, when the client‘s internal control is less effective (a higher level of control risk), auditors must use more effective substantive procedures (a lower level of detection risk). 2.14 Audit evidence is defined as the information used by auditors in arriving at the conclusion on which the audit opinion is based. 2.15 External documentary evidence is audit evidence obtained from another party to an arm‘s-length transaction or from outside independent agencies. External evidence is received directly by auditors and is not processed through the client‘s information processing system. External-internal documentary evidence is documentary material that originates outside the bounds of the client‘s information processing system but which has been received and processed by the client. Internal documentary evidence consists of documentary material that is produced, circulates, and is finally stored within the client‘s information processing system. Such evidence is either not circulated to outside parties at all or is several steps removed from third-party attention.
  • 33. Chapter 01 - Auditing and Assurance Services 2.16 Relevance refers to the nature of information provided by the audit evidence; that is, what assertion(s) related to the account balance or class of transactions does the evidence support? Reliability refers to the extent of trust that auditors can place in evidence and is primarily influenced by the source of the evidence. The appropriateness of audit evidence is related to both relevance and reliability; that is, as evidence is more relevant and reliable, it is considered to have a higher level of appropriateness. 2.17 The source of evidence affects its reliability as follows (from most to least reliable): (1) evidence directly obtained by auditors, (2) evidence obtained from external sources, and (3) evidence obtained from internal sources. 2.18 As auditors need to achieve lower levels of detection risk, more appropriate evidence needs to be obtained. Thus, auditors should gather higher quality evidence (more reliable evidence). For example, auditors may choose to obtain evidence from external sources rather than internal sources. In addition, for lower levels of detection risk, auditors need to gather more sufficient evidence. Because sufficiency relates to the quantity of evidence, more transactions or components of an account balance should be examined. 2.19 A financial reporting framework is a set of criteria used to determine the measurement, recognition, presentation, and disclosure of material items in the financial statements. The financial reporting framework is related to auditors‘ reporting responsibilities because this framework serves as the basis against which the financial statements are evaluated and the auditors‘ opinion on the financial statements is expressed. 2.20 Four types of opinions and their conclusions: Type Conclusion Unmodified opinion Financial statements are presented in conformity with GAAP. Adverse opinion Financial statements are not presented in conformity with GAAP. Qualified opinion Financial statements are presented in conformity with GAAP, except for one or more departures or issues of concern. Disclaimer of opinion An opinion cannot be issued on the financial statements. 2.21 A system of quality control provides firms with reasonable assurance that the firm and its personnel (1) comply with professional standards and applicable regulatory and legal requirements and (2) issue reports that are appropriate in the circumstances. The six elements of a system of quality control are: 1. Leadership responsibilities for quality within the firm (―tone at the top‖) 2. Relevant ethical requirements 3. Acceptance and continuance of client relationships and specific engagements 4. Human resources 5. Engagement performance 6. Monitoring
  • 34. Chapter 01 - Auditing and Assurance Services 2.22 In deciding whether to accept or continue an engagement with a client, firms should consider:  The integrity of the client and the identity and business reputation of its owners, key management, related parties, and those charged with governance.  Whether the firm possesses the competency, capability, and resources to perform the engagement.  Whether the firm can comply with the necessary legal and ethical requirements. If firms decide to withdraw from an engagement, the firm should document significant issues, consultations, conclusions, and the basis for any conclusions related to the decision to withdraw. 2.23 Procedures used by firms to monitor their quality control standards include:  Reviews of selected administrative and personnel records.  Reviews of engagement documentation, reports, and the client‘s financial statements.  Discussions with firm personnel  Assessments of the (1) appropriateness of the firm‘s guidance materials and professional aids, (2) compliance with policies and procedures on independence, (3) effectiveness of continuing professional education, and (4) decisions regarding the acceptance and continuance of client relationships and specific engagements. 2.24 The PCAOB‘s monitoring role for firms providing auditing services to issuers includes registering public accounting firms and conducting inspections of registered public accounting firms. 2.25 The frequency of PCAOB inspections depends upon the number of audits conducted by member firms. For firms performing audits for more than 100 issuers, inspections are required on an annual basis. For those performing audits for 100 or fewer issuers, inspections are conducted every three years. SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 2.26 a. Correct Gathering audit evidence is a component of the performance principle. b. Incorrect While reasonable assurance is related to gathering audit evidence, this is not one of the categories of principles c. Incorrect The reporting principle relates to the contents of the auditors‘ report d. Incorrect The responsibilities principle relates to the personal integrity and professional qualifications of auditors. 2.27 NOTE TO INSTRUCTOR: Since this question asks students to identify the concept that is not related to the ethical requirements of auditors, the response labeled ―correct‖ is not related to the ethical requirement of auditors and those labeled ―incorrect‖ are related to the ethical requirements of auditors. a. Incorrect Due care is related to the ethical requirements of auditors. b. Incorrect Both independence in fact and independence in appearance are related to the ethical requirements of auditors. c. Incorrect Both independence in fact and independence in appearance are related to the ethical requirements of auditors. d. Correct While professional judgment is part of the responsibilities principle, it is not related to the ethical requirements of auditors.