Chapter 01 - An Introduction to Assurance and Financial Statement Auditing

CHAPTER 1
AN INTRODUCTION TO ASSURANCE AND FINANCIAL
STATEMENT AUDITING
Answers to Review Questions
1-1 The study of auditing is more conceptual in nature compared to other accounting courses.
Rather than focusing on learning the rules, techniues, and computations reuired to
prepare financial statements, auditing emphasi!es learning a frame"or# of analytical and
logical s#ills to e$aluate the rele$ance and relia%ility of the systems and processes
responsi%le for financial information, as "ell as the information itself. To %e successful,
students must learn the frame"or# and then learn to use logic and common sense in
applying auditing concepts to $arious circumstances and situations.
&nderstanding auditing can impro$e the decision-ma#ing a%ility of consultants,
%usiness managers, and accountants %y pro$iding a frame"or# for e$aluating the
usefulness and relia%ility of information'an important tas# in many different conte(ts.
1- There is a demand for auditing in a free-mar#et economy %ecause the agency relationship
%et"een an a%sentee o"ner and a manager produces a natural conflict of interest due to
the information asymmetry that e(ists %et"een the o"ner and manager. As a result, the
agent agrees to %e monitored as part of his)her employment contract. Auditing appears to
%e a cost-effecti$e form of monitoring.
The empirical e$idence suggests auditing "as demanded prior to go$ernment
regulation. In 1*+,, %efore it "as reuired %y la", independent auditors audited -+ percent
of the companies on the .e" /or# Stoc# 0(change. Additionally, many pri$ate
companies and municipalities not su%1ect to go$ernment regulations, such as the Securities
Act of 1*22 and Securities 0(change Act of 1*23, also purchase $arious forms of auditing
and assurance ser$ices.
1-! The agency relationship %et"een an o"ner and manager produces a natural conflict of
interest %ecause of differences in the t"o parties4 goals and %ecause of the information
asymmetry that e(ists %et"een them. That is, the manager may "ell ha$e different goals
than the o"ner, and generally has more information a%out the 5true5 financial position and
results of operations of the entity than the a%sentee o"ner does. If %oth parties see# to
ma(imi!e their o"n self-interest, it is li#ely that the manager "ill not act in the %est
interest of the o"ner and may manipulate the information pro$ided to the o"ner
accordingly.
1-" Independence is a %edroc# principle for auditors. If an auditor is not independent of the
client, users may lose confidence in the auditor4s a%ility to report o%1ecti$ely and
truthfully on the financial statements, and the auditor4s "or# loses its $alue. From an
agency perspecti$e, if the principal 6o"ner7 #no"s that the auditor is not independent, the
o"ner "ill not trust the auditor4s "or#. Thus, the agent "ill not hire the auditor %ecause
the auditor4s report "ill not %e effecti$e in reducing information ris# from the perspecti$e
of the o"ner.
1-1
Chapter 01 - An Introduction to Assurance and Financial Statement Auditing
1-# Au$itin% 6%roadly defined7 is a systematic process of 617 o%1ecti$ely o%taining and
e$aluating e$idence regarding assertions a%out economic actions and e$ents to ascertain
the degree of correspondence %et"een those assertions and esta%lished criteria and 6+7
communicating the results to interested users.
Attest ser$ices occur "hen a practitioner issues a report on su%1ect matter, or an assertion
a%out su%1ect matter, that is the responsi%ility of another party.
Assur&n'e ser$ices are independent professional ser$ices that impro$e the uality of
information, or its conte(t, for decision ma#ers.
1-( The phrase systematic process implies that there should %e a "ell-planned, logical
approach for conducting an audit that in$ol$es objectively obtaining and evaluating
evidence.
1-) M&teri&*it+ is defined as 5the magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances, ma#es it pro%a%le that the
1udgment of a reasona%le person relying on the information "ould ha$e %een changed or
influenced %y the omission or misstatement5 6A& 2+0, 8CA9: AS .o. 117. Au$it ris, is
defined as the ris# that the auditor may un#no"ingly fail to appropriately modify his or
her opinion on financial statements that are materially misstated 6A& 2+0, 8CA9: AS
.o. 1+7.
The concept of materiality is reflected in the "ording of the auditor;s standard audit
report through the phrase 5the financial statements present fairly in all material respects.5
This is the manner in "hich the auditor communicates the notion of materiality to the
users of the auditor;s report. The auditor;s standard report states that the audit pro$ides
only reasonable assurance that the financial statements do not contain material
misstatements. The term 5reasona%le assurance5 implies that there is some ris# that a
material misstatement could %e present in the financial statements and the auditor "ill fail
to detect it.
1-- 9n most audits, it is not feasi%le or cost-effecti$e to audit all transactions. For e(ample, in
a small %usiness, the auditor might %e a%le to e(amine all transactions that occurred during
the period. <o"e$er, it is unli#ely that the o"ner of the %usiness could afford to pay for
such an e(tensi$e audit. For a large organi!ation, the sheer $olume of transactions
pre$ents the auditor from e(amining e$ery transaction. Thus, there is a trade-off %et"een
the e(actness or precision of the audit and its cost.
1-. The ma1or phases of the audit are=
Client acceptance)continuance and esta%lishing an understanding "ith the client
8reliminary engagement acti$ities
8lan the audit
Consider and audit internal control
Audit %usiness processes and related accounts
Complete the audit
0$aluate results and issue audit report
1-+
Chapter 01 - An Introduction to Assurance and Financial Statement Auditing
1-1/ The auditor4s understanding of the entity and its en$ironment includes #no"ledge a%out=
1-2
Chapter 01 - An Introduction to Assurance and Financial Statement Auditing
617 the client4s industry, regulatory, and other e(ternal factors, 6+7 the nature of the entity, 627 its
o%1ecti$es and strategies, 637 its measurement and performance re$ie" process, and 6>7 the
entity4s system of internal control.
1-11 The four paragraphs of the auditor;s standard unualified report for a pu%lic company
client are= 617 the introductory paragraph, 6+7 the scope paragraph, 627 the opinion
paragraph, and 637 an e(planatory paragraph referring to the audit of internal control, as
illustrated in this chapter.
1-1 Auditors freuently face situations "here no standard audit procedure e(ists, such as the
e(ample from the te(t of $erifying the in$entory of cattle. Such circumstances reuire that
the auditor e(ercise creati$ity and inno$ation "hen planning and administering audit
procedures "here little or no guidance or precedent e(ists. 0$ery client is different, and
applying auditing concepts in different situations reuires logic and common sense, and
freuently creati$ity and inno$ation.
Answers to Mu*ti0*e-C1oi'e Questions
1-1! % 1-1. a
1-1" % 1-/ d
1-1# c 1-1 d
1-1( c 1- d
1-1) c 1-! %
1-1- c
So*utions to Pro2*e3s
1-" The memo should cite the follo"ing facts=
There is a historical relationship %et"een accounting and auditing.
?hen parties to the agency relationship 6contract7 do not possess the same amount of
information 6information asymmetry7 there is a natural conflict of interest %et"een the
parties. For e(ample, "hen an o"ner and manager are negotiating an employment
contract, the o"ner may assume that the manager li#ely "ill use organi!ational funds
for personal uses. Auditing plays an important role in such relationships. The o"ner
and manager "ill consummate an employment contract only if the manager agrees to
%e monitored. Auditing can %e used to monitor the contract agreed to %y the t"o
parties. 68.S. As an attorney, @ee should %e "ell $ersed on contract la".7
Auditing is also used to monitor other types of contracts for "hich no la"s or
regulations reuire an audit, for e(ample, contracts %et"een management and de%t
holders.
There is historical e$idence of forms of auditing in the early Aree# states and in the
&nited Bingdom during the industrial re$olution. Core rele$ant e$idence is the fact
that -+ percent of the ./S0 companies "ere audited prior to the securities acts.
1-3
Chapter 01 - An Introduction to Assurance and Financial Statement Auditing
Additional e$idence for the demand for auditing is also pro$ided %y the fact that many
pri$ate companies and municipalities not su%1ect to the securities acts contract for
audits.
1-# There are t"o ma1or factors that may ma#e an audit necessary for Areen%loom Aarden
Centers. First, the company may reuire long-term financing for its e(pansion into other
cities in Florida. 0ntities such as %an#s or insurance companies are li#ely to %e the sources
of the company;s de%t financing. These entities normally reuire audited financial
statements %efore lending significant funds and generally reuire audited financial
statements during the time period the de%t is outstanding. There is information asymmetry
%et"een the lender of funds and the o"ner of the %usiness, and this asymmetry results in
information ris# to the lender. 0$en if the %usiness could get funding "ithout an audit, a
clean audit report %y a reputa%le auditor might $ery "ell reduce the lender4s information
ris# and ma#e the terms of the loan more fa$ora%le to the o"ner. Second, as the company
gro"s, the family "ill lose control o$er the day-to-day operations of the stores. An audit
can pro$ide an additional monitoring acti$ity for the family in controlling the e(panded
operations of the company.
1-( a. 0$idence that assists the auditor in e$aluating financial statement assertions consists
of the underlying accounting data and any additional information a$aila%le to the
auditor, "hether originating from the client or e(ternally.
%. Canagement ma#es assertions a%out components of the financial statements. For
e(ample, an entity;s financial statements may contain a line item that accounts
recei$a%le amount to D1,E>0,000. In this instance, management is asserting, among
other things, that the recei$a%les e(ist, the entity o"ns the recei$a%les, and the
recei$a%les are properly $alued. Audit e$idence helps the auditor determine "hether
management4s assertions are %eing met. If the auditor is comforta%le that he or she
can pro$ide reasona%le assurance that all assertions are met for all accounts, he or she
can issue a clean audit report. In short, the assertions are a conceptual tool to help the
auditor ensure that she or he has Fco$ered all the %ases.G
c. In searching for and e$aluating e$idence, the auditor should %e concerned "ith the
rele$ance and relia%ility of e$idence. If the auditor mista#enly relies on e$idence that
does not relate to the assertion %eing tested, an incorrect conclusion may %e reached
a%out the management assertion. Relia%ility refers to the a%ility of e$idence to signal
the true state of the assertion, i.e., "hether it is actually %eing met or not.
1-) a. The ma1or phases of the audit and their descriptions are=
1. Client acceptance)continuance . The auditor decides to accept a ne" client or
to retain an e(isting client.
+. 8reliminary engagement acti$ities . This phase in$ol$es 617 determining the
audit engagement team reuirements, 6+7 ensuring the independence of the
audit team and audit firm, and 627 esta%lishing an understanding "ith the
client regarding the ser$ices to %e performed and the other terms of the
engagement.
2. 8lan the audit . Huring this phase of the audit, the auditor uses the #no"ledge
of the client to plan the audit and perform preliminary analytical procedures.
1->
Chapter 01 - An Introduction to Assurance and Financial Statement Auditing
3. The purpose of this phase is to plan an effecti$e and efficient audit.
>. Consider and audit internal control . The auditor understands and e$aluates the
client4s internal controls in order to assess the ris# that they "ill not pre$ent or
detect a material misstatement. In the case of a pu%lic company, the auditor
"ill conduct an audit of internal control o$er financial reporting.
,. Audit %usiness processes and related accounts . The auditor conducts
su%stanti$e tests, including analytical procedures and the details of the
account %alances, searching for material misstatements.
E. Complete the audit . The auditor searches for contingent lia%ilities and
su%seuent e$ents, and performs a final re$ie" of the e$idence gathered.
-. 0$aluate results and issue the audit report . :ased on the collection and
e$aluation of e$idence, the auditor issues a report on "hether the financial
statements are fairly presented.
%. ?hile audit procedures may %e designed to test a specific assertion, they often
simultaneously pro$ide e$idence on another account or assertion. An e(ample "ould
%e "hen an auditor o%tains e$idence a%out a client4s transactions affecting the
in$entory account and "hether shipments of in$entory to customers "ere included in
the proper period. Such e$idence may also %e rele$ant to the client4s assertions
regarding "hether accounts recei$a%le %alances "ere correct at the end of the period.
c. Auditors de$elop an understanding of an entity;s internal control in order to esta%lish
the scope of the audit. <o"e$er, during the course of this "or#, the auditor may
%ecome a"are of "ea#nesses in the entity;s accounting systems. The auditor is
reuired to communicate this information to management. The auditor may also ma#e
suggestions on ho" to correct the "ea#nesses. The auditor;s "or# on internal control
may also ha$e a pre$enti$e effect on the %eha$ior of the entity;s employees. If the
employees #no" that their "or# "ill %e audited, they are less li#ely to commit errors
or fraud. :ecause of the Sar%anes-9(ley Act, internal control is a topic that is front-
and-center in the accounting profession.
14-A search of the homepage of most pu%lic companies "ill include lin#s to their latest
financial information or 10-B filings. The S0C4s homepage "ill also include this
information along "ith any other recent filings. 0(amining the independent auditor4s
report and financial statements "ill allo" the student to ha$e a %etter idea as to ho" the
chapter4s information is applied in real companies.
14.S'o0e 0&r&%r&015 FThese standards reuire that "e plan and perform the audit to o%tain
reasona%le assurance a%out "hether the financial statements are free of material
misstatement.G The use of the term reasonable assurance indicates that there is no
guarantee that the financial statements are correct, only reasonable assurance. Also the
statement that the financials are Ffree of material misstatementG indicates that the
financials may ha$e some error that is not material.
FAn audit also includes assessing the accounting principles used and significant
estimates madeIG The e(planation that management uses estimates indicates that some
of the figures in the financial statements are not e(act.
1-,
Chapter 01 - An Introduction to Assurance and Financial Statement Auditing
F?e %elie$e that our audits pro$ide a reasona%le %asis for our opinion.G This statement
indicates that the audit is not FproofG that the financial statements are e(act, only that
there is reasona%le e$idence a%out their accuracy.
O0inion 0&r&%r&01= FIthe consolidated financial statements referred to a%o$e present
fairly, in all material respects,IG This sentence indicates that the financial statements are
a FfairG, not e(act, representation. Also, the idea of materiality is re$isited here,
indicating that there may still %e immaterial errors in the financial statements.
So*ution to Dis'ussion C&se
1-!/ Independent audits are a critical component of corporate go$ernance and can enhance the
effecti$eness of the e(amination and super$ision process. Such audits can impro$e the
relia%ility of financial reports and help identify internal control "ea#nesses. Thus, such
audits can %enefit %an# e(aminers in enhancing the safety and soundness of financial
institutions.
So*ution to Internet Assi%n3ent
1-!1 There are numerous Internet sites that contain accounting information. Follo"ing are
some suggested sites=
The AIC8A;s home page 6""".aicpa.org7 contains e(tensi$e information on the
organi!ation;s acti$ities. For e(ample, it contains the entire report of the Special
Committee on Assurance Ser$ices.
The American Accounting Association4s home page 6""".aaah.org7 contains
numerous lin#s, including professional organi!ations, accounting 1ournals, and
education sites.
The Association of Certified Fraud 0(aminers; home page 6""".acfe.com7 contains
e(tensi$e information on the Association4s certification as Certified Fraud 0(aminers
6CF07.
The Institute of Internal Auditors; home page 6""".theiia.org7 contains detailed
information on internal auditing.
The International Federation of Accountants; "e%site 6""".ifac.org7 pro$ides
detailed information on international accounting and auditing standards.
The Ao$ernment Accounta%ility 9ffice;s "e%site 6formerly the Aeneral Accounting
9ffice, 6""".gao.go$7 pro$ides detailed information on the AA94s acti$ities and
allo"s users to o%tain copies of AA9 reports.
The S0C4s 0dgar "e%site 6""".sec.go$7 contains all filings %y pu%lic companies
"ith the S0C. It also contains information on other acti$ities %y the S0C.
The 8CA9:4s "e%site 6""".pcao%us.org7 offers detailed information a%out the
8CA9: and the standards it has proposed and esta%lished.
The ma1or pu%lic accounting firms and many smaller firms also maintain "e%sites.
1-E