CH-1-4 An Introduction to Assurance and Financial Statement Auditing – Auditing and Assurance Services: A Systematic Approach : Book Guide

This Document Contains Chapters 1 to 4 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 as compared to other accounting courses. Rather than focusing on learning the rules, techniques, and computations required to prepare financial statements, auditing emphasizes learning a framework of analytical and logical skills. This framework enables auditors to evaluate the relevance and reliability of the systems and processes responsible for financial information as well as the information itself. To be successful, students must learn the framework and then learn to use logic and common sense in applying auditing concepts to various circumstances and situations. Understanding auditing can improve the decision-making ability of consultants, business managers, and accountants by providing a framework for evaluating the usefulness and reliability of information—an important task in many different business contexts. 1-2 There is a demand for auditing in a free-market economy because the agency relationship between an absentee owner and a manager produces a natural conflict of interest due to the information asymmetry that exists between these two parties. As a result, the agent agrees to be monitored as part of his/her employment contract. Auditing appears to be a cost- effective form of monitoring. The empirical evidence suggests that auditing was demanded prior to government regulation. In 1926, before it was required by law, independent auditors audited 82 percent of the companies on the New York Stock Exchange. Additionally, many private companies and municipalities not subject to government regulations, such as the Securities Act of 1933 and Securities Exchange Act of 1934, also purchase various forms of auditing and assurance services. Many private companies seek out financial statement audits in order to secure financing for their operations. Companies preparing to go public also benefit from having an audit. 1-3 The agency relationship between an owner and manager produces a natural conflict of interest because of differences in the two parties’ goals and because of the information asymmetry that exists between them. That is, the manager likely has different goals than the owner, and generally has more information about the "true" financial position and results of operations of the entity than the absentee owner does. If both parties seek to maximize their own self-interest, the manager may not act in the best interest of the owner and may manipulate the information provided to the owner accordingly. 1-4 Independence is a bedrock principle for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report objectively and truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner. Auditor independence is also a regulatory requirement. 1-5 Auditing (broadly defined) is a systematic process of (1) objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the This Document Contains Chapters 1 to 4 degree of correspondence between those assertions and established criteria and (2) communicating the results to interested users. Attest services occur when a practitioner issues a report on subject matter, or an assertion about subject matter, that is the responsibility of another party. Assurance services are independent professional services that improve the quality of information, or its context, for decision makers. 1-6 The phrase systematic process implies that there should be a well-planned, logical approach for conducting an audit that involves objectively obtaining and evaluating evidence. It requires organizing a plan for gathering evidence and documenting steps taken during the audit to evaluate the relevance and validity of the evidence. 1-7 Audit risk is defined as the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated (AS 1101). Materiality is defined as "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement" (FASB Statement of Financial Accounting Concepts No. 8, Chapter 3: Qualitative Characteristics of Useful Accounting Information, which is pending revision at the time of the writing of this book per the Board’s November 2017 decision to revert to a definition of materiality similar to the one found in superseded Concept No. 2). The concept of materiality is reflected in the wording of the auditor's standard audit report through the phrase "the financial statements present fairly in all material respects." This is the manner in which the auditor communicates the notion of materiality to the users of the auditor's report. The auditor's standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements. The term "reasonable assurance" implies that there is some risk that a material misstatement could be present in the financial statements and the auditor will fail to detect it. 1-8 The major phases of the audit are: • Client acceptance/continuance • Preliminary engagement activities • Plan the audit • Consider and audit internal control • Audit business processes and related accounts • Complete the audit • Evaluate results and issue audit report 1-9 Plan the audit: During this phase of the audit, the auditor uses knowledge about the client and any controls in place to plan the audit and perform preliminary analytical procedures. The outcome of the planning process is a written audit plan that sets forth the nature, extent, and timing of the audit procedures to be performed. The purpose of this phase is to plan an effective and efficient audit. 1-10 The auditor's standard unqualified report for a public company client includes the following sections: (1) opinion on the financial statements, (2) basis for opinion, and (3) critical audit matters, as illustrated in this chapter. 1-11 The emergence of advanced audit technologies will help remove many of the tedious tasks that are usually performed by junior auditors. Thus, auditors of all positions and experience will be required to spend additional time reasoning through fundamental business, accounting, and auditing concepts. An auditors’ knowledge in these areas will enable them to provide greater benefit to clients by asking the right questions and identifying new, more effective ways to collect, analyze, and interpret results. In using audit data analytics, for example, auditors must understand the client and its industry, as well as the fundamentals of accounting and auditing, in order to ask the right questions in querying the data and in interpreting the results obtained. 1-12 Auditors frequently face situations where no standard audit procedure exists, such as the example from the text of verifying the inventory of cattle. Such circumstances require that the auditor exercise creativity and innovation when planning and administering audit procedures where little or no guidance or precedent exists. Every client is different, and applying auditing concepts in different situations requires logic and common sense, and frequently creativity and innovation. Answers to Multiple-Choice Questions 1-13 b 1-19 a 1-14 b 1-20 d 1-15 c 1-21 d 1-16 c 1-22 d 1-17 c 1-23 b 1-18 c Solutions to Problems 1-24 There are two major factors that may make an audit necessary for Greenbloom Garden Centers. First, the company may require long-term financing for its expansion into other cities in Florida. Entities such as banks or insurance companies are likely to be the sources of the company's debt financing. These entities normally require audited financial statements before lending significant funds and generally require audited financial statements during the time period the debt is outstanding. There is information asymmetry between the lender of funds and the owner of the business, and this asymmetry results in information risk to the lender. Even if the business could get funding without an audit, a clean audit report by a reputable auditor might very well reduce the lender’s information risk and make the terms of the loan more favorable to the owner. Second, as the company grows, the family will lose control over the day-to-day operations of the stores. An audit can provide an additional monitoring activity for the family in controlling the expanded operations of the company. 1-25 a. Evidence that assists the auditor in evaluating financial statement assertions consists of the underlying accounting data and any additional information available to the auditor, whether originating from the client or externally. b. Management makes assertions about components of the financial statements. For example, an entity's financial statements may contain a line item that accounts receivable amount to $1,750,000. In this instance, management is asserting, among other things, that the receivables exist, the entity owns the receivables, and the receivables are properly valued. Audit evidence helps the auditor determine whether management’s assertions are being met. If the auditor is comfortable that he or she can provide reasonable assurance that all assertions are met for all accounts, he or she can issue a clean audit report. In short, the assertions are a conceptual tool to help the auditor ensure that she or he has “covered all the bases.” c. In searching for and evaluating evidence, the auditor should be concerned with the relevance and reliability of evidence. If the auditor mistakenly relies on evidence that does not relate to the assertion being tested, an incorrect conclusion may be reached about the management assertion. Reliability refers to the ability of evidence to signal the true state of the assertion, i.e., whether it is actually being met or not. 1-26 a. The major phases of the audit and their descriptions are: 1. Client acceptance/continuance. The auditor decides to accept a new client or to retain an existing client. 2. Preliminary engagement activities. This phase involves (1) determining the audit engagement team requirements, (2) ensuring the independence of the audit team and audit firm, and (3) establishing an understanding with the client regarding the services to be performed and the other terms of the engagement. 3. Plan the audit. During this phase of the audit, the auditor uses the knowledge of the client to plan the audit and perform preliminary analytical procedures. The purpose of this phase is to plan an effective and efficient audit. 4. Consider and audit internal control. The auditor understands and evaluates the client’s internal controls in order to assess the risk that they will not prevent or detect a material misstatement. In the case of a public company, the auditor will conduct an audit of internal control over financial reporting. 5. Audit business processes and related accounts. The auditor conducts substantive tests, including analytical procedures and the details of the account balances, searching for material misstatements. 6. Complete the audit. The auditor searches for contingent liabilities and subsequent events, and performs a final review of the evidence gathered. 7. Evaluate results and issue the audit report. Based on the collection and evaluation of evidence, the auditor issues a report on whether the financial statements are fairly presented. b. As the book explains, if the auditor designs procedures to test whether the entity’s internal control over financial transactions is effective, the auditor can obtain additional indirect information regarding whether the account balances are fairly stated: if controls are effective, then the transactions will probably be captured and summarized properly, which means in turn that the account balances are likely to be free of material misstatement. While it is indirect, evidence about internal control is often a relatively cost-effective form of audit evidence about the fairness of account balances. c. Auditors develop an understanding of an entity's internal control in order to establish the scope of the audit. However, during the course of this work, the auditor may become aware of weaknesses in the entity's accounting systems. The auditor is required to communicate this information to management. The auditor may also make suggestions on how to correct the weaknesses. The auditor's work on internal control may also have a preventive effect on the behavior of the entity's employees. If the employees know that their work will be audited, they are less likely to commit errors or fraud. Because of the Sarbanes-Oxley Act, internal control is a topic that is front-and-center in the accounting profession. 1-27 A search of the homepage of most public companies will include links to their latest financial information or 10-K filings. The SEC’s homepage will also include this information along with any other recent filings. Examining the independent auditor’s report and financial statements will allow the student to have a better idea as to how the chapter’s information is applied in real companies. 1-28 Opinion paragraph: “…the financial statements present fairly, in all material respects,…” This sentence indicates that the financial statements are a “fair”, not exact, representation. Also, the idea of materiality is revisited here, indicating that the audit does not provide assurance that there are no immaterial errors in the financial statements. Basis for Opinion paragraph: “[These] standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement…” The use of the term reasonable assurance indicates that there is no guarantee that the financial statements are correct, only reasonable assurance. Also the statement that the financials are “free of material misstatement” indicates that the audit does not provide assurance that the financials are free of error that is not material. “Such procedures include examining, on a test basis, evidence…” The explanation that the auditor uses a test basis indicates that some of the figures were not fully examined, but rather only a sample of information was taken to gather evidence. “We believe that our audits provide a reasonable basis for our opinion.” This statement indicates that the audit is not “proof” that the financial statements are exact, only that there is reasonable evidence about their fairness in accordance with GAAP. Critical Audit Matter paragraph: “…involved especially challenging, subjective, or complex audit judgments.” This sentence prefaces the entire purpose of the paragraph which is to ensure the public is aware that some financial statement amounts and disclosures require extensive judgment by management and auditors, suggesting that the financial statements inherently are not precisely accurate. Solution to Discussion Case 1-29 The memo should cite the following facts: • There is a historical relationship between accounting and auditing. • When parties to the agency relationship (contract) do not possess the same amount of information (information asymmetry) there is a natural conflict of interest between the parties. For example, when an owner and manager are negotiating an employment contract, the owner may assume that the manager likely will use organizational funds for personal uses. Auditing plays an important role in such relationships. The owner and manager will consummate an employment contract only if the manager agrees to be monitored. Auditing can be used to monitor the contract agreed to by the two parties. (As an attorney, Dashawn should be well versed in contract law.) • Auditing is also used to monitor other types of contracts for which no laws or regulations require an audit, for example, contracts between management and debt holders. • There is historical evidence of forms of auditing in the early Greek states and in the United Kingdom during the industrial revolution. More relevant evidence is the fact that 82 percent of the NYSE companies were audited prior to the securities acts. • Additional evidence for the demand for auditing is also provided by the fact that many private companies and municipalities not subject to the securities acts contract for audits. Solution to Internet Assignment 1-30 There are numerous Internet sites that contain accounting information. Following are some suggested sites: • The AICPA's home page (www.aicpa.org) contains extensive information on the organization's activities. For example, it contains the entire report of the Special Committee on Assurance Services. • The American Accounting Association’s home page (www.aaahq.org) has numerous links, including professional organizations, accounting journals, and education sites. • The Association of Certified Fraud Examiners' home page (www.acfe.com) has extensive information on the Association’s certification (CFE) program. • The Institute of Internal Auditors' home page (www.theiia.org) contains detailed information on internal auditing. • The International Federation of Accountants' website (www.ifac.org) provides detailed information on international accounting and auditing standards. • The Government Accountability Office's website (formerly the General Accounting Office, (www.gao.gov) provides detailed information on the GAO’s activities and allows users to obtain copies of GAO reports. • The SEC’s Edgar website (www.sec.gov) contains all filings by public companies with the SEC. It also contains information on other activities by the SEC. • The PCAOB’s website (www.pcaobus.org) offers detailed information about the PCAOB and the standards it has proposed and established. • The major public accounting firms and many smaller firms also maintain websites. Chapter 2 The Financial Statement Auditing Environment Answers to Review Questions 2-1 Auditors can be classified under four types: (1) external auditors, (2) internal auditors, (3) government auditors, and (4) forensic auditors. External auditors: provide reasonable assurance that financial statements are fairly stated for publicly traded and private companies, partnerships, universities, and government entities, but are not employees of the entity being audited Internal auditors: employed by companies to provide independent, objective assurance and consulting services designed to add value and improve an organization’s operations Government auditors: employed by federal, state, and local agencies to provide services similar to internal auditors Forensic auditors: employed by corporations, government agencies, public accounting firms, and consulting and investigative services firms to detect, investigate, and deter fraud and white-collar crime 2-2 Examples of compliance audits include (1) internal auditors determining whether corporate rules and policies are being followed by departments within the organization, (2) an examination of tax returns of individuals and companies by the Internal Revenue Service for compliance with the tax laws, and (3) an audit under the Single Audit Act of 1984 to determine whether an entity receiving federal assistance is in compliance with applicable laws and regulations. Examples of operational audits include (1) an audit by the GAO of the Food and Drug Administration to determine the efficiency and effectiveness of procedures for introducing new drugs to the market, (2) internal auditors examining the effectiveness and efficiency of funds being spent on the entity’s computer resources, and (3) a university hiring an external auditor to examine the effectiveness and efficiency of student advisory services. Examples of forensic audits include (1) an examination by an external auditor of cash disbursements for payments to unauthorized vendors, (2) assistance by an auditor to a law enforcement agency in tracing laundered monies by organized criminals, and (3) an independent auditor helping identify hidden assets as part of a divorce settlement. Student answers will likely be less detailed but should capture the general idea of each type of audit. 2-3 During the late 1990s and early 2000s, accounting firms aggressively sought opportunities to expand their business in non-audit services such as consulting. This expansion from their core audit practice, combined with allegations of auditors refusing to challenge management’s actions, resulted in conflict between regulators and the accounting profession. Subsequent financial fiascos such as those at Enron, WorldCom, Tyco, and many others caused investors to doubt the fundamental integrity of the financial reporting system. Under pressure to restore the public’s confidence, Congress passed the Sarbanes- Oxley Act and created the PCAOB in 2002. 2-4 The accounting profession’s expansion into new areas, combined with changes in the overall business environment, resulted in new regulations and guidelines. The scandals of the late 1990s and early 2000s brought into question the profession’s ability to self-regulate, resulting in new legislation. While these changes have caused pain and turmoil, they highlight the essential importance of auditing in our economic system. Ultimately, the “back to basics” emphasis, along with auditing firms’ renewed focus on thorough and effective financial statement audits, will likely prove healthy for the U.S. financial reporting system and for the profession. Further, somewhat ironically, the SOX-mandated audit of internal control over financial reporting has brought significant new revenues to accounting firms. 2-5 Management is responsible to prepare financial statements that fairly present the company’s financial condition and operations in accordance with established accounting standards. Note that the auditor’s opinion explicitly states that the financial statements are the responsibility of management. The auditor is responsible to issue an opinion in regards to the financial statements prepared by management. In order to issue this opinion, the auditor must plan and perform the audit in accordance with established standards to obtain reasonable assurance that the financial statements are free of material misstatement, whether caused by error or fraud. However, it is important to note that an auditor’s unqualified opinion does not mean that errors or fraud do not exist but rather that there is reasonable assurance that they do not exist in material amounts. 2-6 The essential components of the high-level model of business offered in the chapter include the following: corporate governance, objectives, strategies, processes, controls, transactions, and financial statements. Corporate governance is carried out by management and the board of directors in order to ensure that business objectives are carried out and that company assets are safeguarded. To achieve its objectives, management must formulate strategies and implement various processes which are in turn carried out through business transactions. The entity’s information and internal control systems must be designed to ensure that these transactions are properly executed, captured, and processed in order to produce accurate financial statements. It is important that the auditor obtain a firm understanding of these components in order to understand relevant risks and to plan the nature, timing, and extent of the audit so that it is efficient and effective. 2-7 The information system must maintain a record of all businesses transactions. It should be capable of producing accurate financial reports to summarize the effects of the entity’s transactions. Among other things, internal control is required to ensure that a proper environment is established and that transactions are appropriately conducted and recorded by the information system and company employees. Effective internal control provides safeguards to ensure the (1) reliability of financial reporting, (2) compliance with laws and regulations, and (3) the effectiveness and efficiency of operations. Auditing standards require that the auditor obtain an understanding of the client’s environment, including its internal control, in planning the nature, timing, and extent of testing. 2-8 The AICPA issues the following standards: • Statements on Auditing Standards • Statements on Standards for Attestation Engagements • Statements on Standards for Accounting and Review Services • Statements on Quality Control Standards • Standards for Performing and Reporting on Peer Reviews • Statements on Standards for Consulting Services • Statements on Standards for Tax Services 2-9 The PCAOB is a quasi-governmental organization overseen by the SEC. It was formed to provide governmental regulation of the standards used in conducting public company audits because of a perceived failure of the profession to adequately regulate itself. 2-10 The SEC has congressional authority from the original Securities Acts of 1933 and 1934 to establish accounting and auditing standards for publicly traded companies; however, in the past the SEC has largely delegated this authority to other bodies, including the FASB and the AICPA’s Auditing Standards Board. The Sarbanes-Oxley Act of 2002 gave the SEC the mandate to actively regulate the public accounting profession by establishing and overseeing the PCAOB and its standard-setting process relating to the audits of public companies. The SEC has authority to implement and oversee standards relating to all aspects of the audits of public companies, including standards relating to auditor independence (such as the requirement for audit firms to rotate audit partners off audit engagements every five years). 2-11 The documents most frequently encountered by auditors under the Securities Exchange Act of 1934 are forms 10K, 10Q, and 8K. Forms 10K and 10Q are, respectively, annual and quarterly reports, which include the audited financial statements periodically filed with the SEC by a publicly traded entity. An 8K is filed whenever a “material corporate event” occurs, such as a change of independent auditors. 2-12 The four categories of Principles Underlying an Audit Conducted in Accordance with GAAS are: Purpose of an Audit and Premise upon which an Audit is Conducted This section explains the purpose and value of a financial statement audit and lays out the responsibilities of management and those charged with governance. Responsibilities This section describes the responsibilities of the auditor regarding their capabilities, professional skepticism, and ethical behavior. Performance This section describes the auditor’s responsibilities in performing an effective audit. This includes their reasonable, rather than absolute, assurance that the financial statements are free of material misstatements and the cost versus benefit analysis in determining procedures. Reporting This section describes the responsibility of the auditor for expressing an opinion and providing a written report of that opinion. 2-13 Auditing standards are important for evaluating whether an auditor has done an adequate audit. Users of financial statements desire consistency between audits of various companies. Standards are a way to hold auditors accountable by ensuring that they fulfill the requirements defining what a good audit entails. If the auditor fails to identify a material misstatement, this does not necessarily mean that the auditor has failed to perform a high- quality audit, since an audit can only provide reasonable, rather than absolute, assurance. If a material misstatement goes undetected, the auditor can defend her or his performance by showing conformance with auditing standards. 2-14 Independence is a fundamental principle for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report objectively and truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner. Answers to Multiple-Choice Questions 2-15 b 2-20 a 2-16 a 2-21 a 2-17 d 2-22 c 2-18 d 2-23 c 2-19 c Solutions to Problems 2-24 Item Number Type of Audit Type of Auditor a. Operational Government b. Financial statement External c. Compliance or operational or possibly internal control Internal or external d. Forensic/Financial Internal, external, or forensic e. Operational Government, external, or internal f. Operational Internal or external g. Compliance Government h. Compliance or forensic Government, external, or forensic 2-25 Brief Description of Principles Underlying an Audit Sally Jones' Actions Resulting in Failure to Comply with Principles Underlying an Audit Purpose and Premise of an Audit: An audit is to provide an opinion by an auditor on whether financial statements are presented fairly, in all material respects, according to the applicable framework. Management and those charged with governance are responsible for the preparation and fair presentation of the financial statements and for the design, implementation, and maintenance of internal control over financial reporting. They are also responsible for providing the auditor with all information relevant to the preparation of the financial statements. Jones expressed an opinion regarding the financial statements, but not on whether the financial statements are presented fairly in accordance with generally accepted accounting principles, or any other financial reporting framework. Therefore, she did not fulfill the primary purpose of the audit. Jones did not ensure that management fulfilled its responsibilities for the fair presentation of the financial statements, since that requires making the appropriate footnote disclosures in the financial statements. Responsibilities: Auditors are responsible for having appropriate competence and capabilities to perform the audit; complying with relevant ethical requirements; and maintaining professional skepticism and exercising professional judgment, throughout the planning and performance of the audit. It was inappropriate for Jones to hire the two students to conduct the audit, because they do not have appropriate competence and capabilities. In order to comply with ethical requirements, Jones must be without bias with respect to the client under audit. Because of the financial interest in whether the bank loan is granted to Boucher, Jones is not independent in either fact or appearance with respect to the assignment undertaken. Neither Jones nor her two assistants exercised professional skepticism or professional judgment in performing the audit. Performance: The auditor must obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. To do so, the auditor must plan the work and supervise any assistants; determine an appropriate materiality level; identify and assess risks of material misstatement based on an Jones failed to supervise the assistants. The work performed was not adequately planned. Jones did not study the client or its environment, including internal control, nor did the assistants. Consequently, she could not have identified risks of material misstatements. understanding of the entity and its environment, including its internal control; and obtain sufficient appropriate audit evidence about whether misstatements exist. The auditor is unable to obtain absolute assurance that the financial statements are free from material misstatements. Jones acquired little evidence that would support the fairness of the financial statements. Jones merely checked the mathematical accuracy of the records and summarized the accounts. Several standard audit procedures and techniques were neglected. Reporting: Based on an evaluation of the audit evidence obtained, the auditor expresses an opinion in accordance with the auditor’s findings, or states that an opinion cannot be expressed. The opinion states whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. Although Jones' report contains an expression of opinion, her opinion is not based on the results of a proper audit examination. Jones should disclaim an opinion because she failed to conduct an examination in accordance with generally accepted auditing standards. Jones' opinion made no reference to the applicable financial reporting framework. Also, since the financial statements did not contain adequate disclosures, they could not have been in accordance with any financial reporting framework. Solutions to Discussion Cases 2-26 Merry-Go-Round Part I. a. EY is alleged to have violated the Principles of responsibilities and performance. • The firm is alleged to have violated the Principle of responsibilities in the sense that it appeared that the staff assigned to the engagement did not have sufficient training or experience for the engagement. EY’s relationship with MGR’s landlords and attorneys likely caused them to violate this Principle, which requires compliance with relevant ethical requirements. • Poor staff assignments, the leader’s vacation, and the use of inexperienced personnel all suggest that the engagement was not adequately planned and that assistants were not properly supervised, which violates the Principle of performance. Also, the inadequate nature of EY’s recommendations suggests that they likely did not gain a sufficient understanding of the entity and its operations. b. There are arguments both for and against having formal standards for CPAs who consult. Advantages include potential increase in public trust, some assurance that a minimal level of service quality would be attained, and perhaps more guidance for consultants (to allow them to perform more effective consulting engagements). The primary disadvantage would result from the fact that CPAs who consult compete with consulting firms comprised of non-CPAs. If standards were not thought out carefully, perhaps the standards would put CPAs at a disadvantage relative to non-CPAs in the sense that CPAs would be subject to standards that constrain their activities or perhaps result in their not being able to compete with non-CPAs in the area of fees. Note that CPAs face certain restrictions in providing consulting services to audit clients. These restrictions are covered in a later chapter. 2-27 Merry-Go-Round Part II. a. In one sense, EY acted unethically. That is, it should have disclosed the nature of these relationships to MGR. In another sense, it is difficult to ascertain whether these relationships caused EY to act unethically. Specifically, was EY’s advice affected by its relationship with the landlord? Is this relationship the reason that EY’s cost-cutting suggestions did not go farther? These questions point out the importance of independence in fact and appearance, even when acting in a consulting capacity. Even if EY acted ethically, this relationship creates the appearance of impropriety. b. As mentioned in Part a, the relationship with Rouse could have caused EY to hesitate to suggest that the stores for which Rouse was the landlord be closed for fear of losing business from Rouse. Its relationship with Swidler could have made EY feel that it could not lose the engagement under any circumstances, thereby possibly explaining its apparently lackadaisical attitude towards the engagement. Solutions to Internet Assignments 2-28 A search of the GAO’s homepage will identify recent audits conducted by this agency. 2-29 a. According to its website, the AICPA’s mission is to “provide members with the resources, information, and leadership that enable them to provide valuable services in the highest professional manner to benefit the public as well as employers and clients.” b. The SEC’s website states that its mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” It goes on to emphasize that its purpose is to promote and sustain economic growth. The site also mentions that the SEC promotes the disclosure of important market information, maintains fair dealings, protects against fraud, and enforces its authority. c. During the 1920s, many people began investing heavily in the stock market without fully thinking about the risk that they were taking upon themselves. As a result of poor investment choices and unreliable information, the stock market crashed in 1929. In an attempt to restore confidence in the capital markets, Congress passed the Securities Act of 1933. One year later, the SEC was created by the Securities Exchange Act of 1934. d. The PCAOB’s website provides information on the Board’s organization, policies, and standards. It also indicates that the Board uses an expert advisory group to help the Board develop standards. Though many observers dispute this claim, the Board asserts that its standards are also developed in an open, public process to allow all parties of interest to comment. Section 103 of the Sarbanes-Oxley Act empowers the PCAOB to set auditing standards for audits of public companies. The Dodd-Frank Act amended the Sarbanes-Oxley Act to give the PCAOB the authority to establish auditing and related professional practice standards for audits of the financial statements and selected practices and procedures of broker-dealers. The Board's Office of the Chief Auditor is responsible for developing these standards. e. The International Auditing Practices Committee (IAPC) was founded in 1978. During its first meeting, the group agreed to issue its publications as guidelines rather than standards. The IAPC’s initial work focused on three areas: object and scope of audits of financial statements, engagement letters, and general auditing guidelines. During this initial meeting, the IAPC also agreed to respond to a request from the International Accounting Standards Committee (IASC) chairman and Governors of the Central Banks to develop guidance on inter-bank confirmations. In 1988, the IAPC approved the release of The Auditor’s Report on Financial Statements guidelines. It later developed final guidelines on three key subjects: related parties, going concern, and management representations. In 1985, Chairman Justin Fryer called on the IAPC to act in the interests of the public. He also called on the IAPC to resolve differences in auditing standards where differences exist in different countries and to establish a single set of international standards. The IAPC recognized that a fundamental way to protect the public interest was to require the application of a core set of internationally recognized auditing and assurance standards. IFAC was among the first organizations to refer to international auditing guidelines in its own financial statements. In 1991, the IAPC proposed to IFAC member bodies that the term “guidelines” be replaced with “standards.” With that, International Standards on Auditing, or ISAs, were born. In 2001, IAPC was renamed as the International Auditing and Assurance Standards Board (IAASB). The IAASB then embarked on its first joint project with a national standard setter, the AICPA, which resulted in the development of the suite of audit risk standards. In 2003, IFAC approved a series of reforms designed to strengthen the IAASB’s standard- setting processes so that it are properly responsible to the public interest. By 2007, the IAASB had become arguably the most transparent auditing standard setter in the world. To encourage greater use of its standards and facilitate translation, in 2004 the IAASB launched a project designed to improve the clarity of its pronouncements. It revised its drafting conventions to make the ISAs more readily understood. By the end of 2008, the IAASB had approved all final redrafted auditing standards. The IAASB is currently working on revising its standards for assurance engagements other than audits. f. The IASB is the independent accounting standard-setting body of the IFRS Foundation. The IASB is composed of 16 experts with an appropriate mix of recent practical experience in setting accounting standards, in preparing, auditing, or using financial reports, and in accounting education. The IASB is advised by the IFRS Advisory Council which, along with the IASB, is overseen by the IFRS Foundation trustees. The IFRS Foundation is overseen by a monitoring board of public capital market authorities. The IFRS Foundation is a not-for-profit, private sector body that raises funds to support the operations of the IASB as an independent accounting standard setter. Mandatory levies are issued for listed and non-listed companies in a growing number of countries. The Foundation strives to ensure that its financial support is broad based. The IASB is responsible for the development and publication of IFRSs and for approving Interpretations of IFRSs as developed by the IFRS Interpretations Committee. All meetings of the IASB are held in public and are broadcast through the internet. In fulfilling its standard-setting duties, the IASB follows a thorough, open and transparent process of which the publication of consultative documents, such as discussion papers and exposure drafts for public comment is an important component. The IASB engages closely with stakeholders around the world, including investors, analysts, regulators, business leaders, accounting standard-setters, and the accountancy profession. The SEC has not yet reached a decision as to how, or even whether, the U.S. will adopt IFRS. Currently, the FASB is working to converge many of its standards with those of the IASB. For example, the FASB’s guidance on fair value measurement is largely identical to guidance issued by the IASB. The FASB is currently working on converging its standards regarding revenue recognition, financial instruments, and lease accounting to be more in line with IFRS. Chapter 3 Audit Planning, Types of Audit Tests, And Materiality Answers to Review Questions 3-1 The auditor should inquire of other firm personnel, the client's bankers and attorneys, credit agencies, and other members of the business community who may have knowledge about the integrity of the prospective client and its management. Such inquiries would include: • the identity and business reputation of the client's principal owners, key management, and those charged with governance; • the nature of the client's operations, including its business practices; • information concerning the attitude of the client's principal owners, key management, and those charged with governance toward such matters as internal control or aggressive interpretation of accounting standards; • indications that the client might be involved in money laundering or other criminal activities. 3-2 The successor auditor is responsible for initiating the communication with the predecessor auditor. However, the successor auditor should request permission of the prospective client before contacting the predecessor auditor. The successor auditor's communication with the predecessor auditor should include questions related to the integrity of management, disagreements with management over accounting and auditing issues, communications to those charged with governance regarding fraud and noncompliance with laws or regulations by the entity, communications to management and those charged with governance regarding significant deficiencies and material weaknesses in internal control, and the predecessor auditor's understanding of the change in auditors. 3-3 An engagement letter is used to formalize the arrangement reached between the auditor and client. It serves as a contract that outlines the responsibilities of both parties and is intended to prevent misunderstandings between the two parties. The letter states the responsibilities of the auditor and management, that the audit will be conducted in accordance with auditing standards, that certain types of audit procedures will be conducted and written representations will be obtained from management, and that the audit may not detect all material errors and fraud. Exhibit 3-1 in the text contains a sample engagement letter. In addition, the engagement letter might include: • Arrangements involving the use of specialists or internal auditors. • Any limitation of the liability of the auditor or client, such as indemnification to the auditor for liability arising from knowing misrepresentations to the auditor by management. (Note that regulatory bodies, such as the SEC, may restrict or prohibit such liability limiting arrangements.) • Additional services to be provided relating to regulatory requirements. • Arrangements regarding other services (e.g., assurance, tax, or consulting services). 3-4 The following factors can be used to judge the objectivity of the internal audit function: • Whether the organizational status of the IAF, including the function’s authority and accountability, supports the ability of the function to be free from bias, conflict of interest, or undue influence of others to override professional judgments (e.g., the IAF reports to audit committee or an officer with appropriate authority, or if the function reports to management, whether it has direct access to audit committee). • Whether the IAF is free of any conflicting responsibilities (e.g., having managerial or operational duties or responsibilities that are outside of the IAF). • Whether audit committee oversees employment decisions related to the IAF. • Whether any constraints or restrictions placed on the IAF by management or audit committee exist, for example, in communicating the IAF’s findings to the external auditor. • Whether the internal auditors are members of relevant professional bodies and their memberships obligate their compliance with relevant professional standards relating to objectivity or whether their internal policies achieve the same objectives. The competence of internal audit function can be determined by assessing the following factors: • Whether the IAF is adequately and appropriately resourced relative to the size of the entity and the nature of its operations. • Whether established policies for hiring, training, and assigning internal auditors to internal audit engagements exist. • Whether the internal auditors have adequate technical training and proficiency in auditing. (e.g., the internal auditors’ possession of a relevant professional designation and experience). • Whether the internal auditors possess the required knowledge relating to the entity’s financial reporting and the applicable financial reporting framework and whether the IAF possesses the necessary skills to perform work related to the entity’s financial statements. • Whether the internal auditors are members of relevant professional bodies that oblige them to comply with the relevant professional standards, including continuing professional development requirements. 3-5 An audit committee is a subcommittee of the board of directors composed of independent members. The audit committee is responsible for the financial reporting and disclosure process. The committee should encourage fair reporting from the perspective of the stockholders, creditors, and employees. The audit committee should meet regularly with the external and internal auditors, providing for the independence of the external and internal auditors. 3-6 The auditor should be guided by the results of the client acceptance/continuance process, procedures performed to gain the understanding of the entity, and preliminary engagement activities. Additional steps that should be performed include the following: • Assess business risks. • Establish materiality. • Consider multilocations. • Assess the need for specialists. • Consider violations of laws and regulations. • Identify related parties. • Consider additional value-added services. • Document the overall audit strategy, audit plan, and prepare audit programs. 3-7 Auditing standards distinguish the auditor's responsibilities regarding compliance with the following two categories of laws and regulations: • The provisions of those laws and regulations generally recognized to have a direct effect on the determination of material amounts and disclosures in the financial statements, such as tax and pension laws and regulations (direct and material effects). • The provisions of other laws and regulations that do not have a direct effect on the determination of the amounts and disclosures in the financial statements but compliance with which may be fundamental to the operating aspects of the business, fundamental to an entity's ability to continue its business, or necessary for the entity to avoid material penalties (material but indirect effects). Circumstances that may indicate an illegal act include the following: • Investigations by regulatory organizations and government departments or payment of fines or penalties. • Payments for unspecified services or loans to consultants, related parties, employees, or government officials or government employees. • Sales commissions or agent's fees that appear excessive in relation to those ordinarily paid by the entity, or in its industry, or to the services actually received. • Unusual payments in cash, purchases in the form of cashiers' checks payable to bearer, or transfers to numbered bank accounts. • Unauthorized transactions or improperly recorded transactions. • Noncompliance with laws or regulations cited in reports of examinations by regulatory agencies that have been made available to the auditor. • Failure to file tax returns or pay government duties or similar fees that are common to the entity's industry or the nature of its business. 3-8 Sources of information that may be used to identify related parties include (see AS18, Appendix A): • Inquires of management. • Minutes of the board of directors’ meetings. • Conflict-of-interest statements from management and others. • Financial and reporting information provided to creditors, investors, and regulators. • Contracts or other agreements (including side agreements that may not be formally documented between customers and vendors, and management). • Contracts and other agreements representing significant unusual transactions. 3-9 The engagement partner has the overall responsibility for the engagement and its performance and should supervise the audit engagement team so that the work is performed as directed and supports the conclusions reached. The engagement partner and other engagement team members performing supervisory activities should • Inform engagement team members of their responsibilities, including: o the objectives of the procedures that they are to perform; o the nature, timing, and extent of procedures they are to perform; and o matters that could affect the procedures to be performed or the evaluation of the results of those procedures. • Direct engagement team members to bring any significant accounting and auditing issues they identify to the attention of the engagement partner or other engagement team members performing supervisory activities so they can evaluate those issues and determine appropriate actions. • Review the work of engagement team members to evaluate whether: o the work was performed and documented; o the objectives of the procedures were achieved; and o the results of the work support the conclusions reached. 3-10 The three general types of audit tests are risk assessment procedures, tests of controls, and substantive tests. Risk assessment procedures are used to obtain an understanding of the entity and its environment, including internal control. Examples include inquiries of management and others, analytical procedures, and observation and inspection. It could also include audit data analytics. Tests of controls are audit procedures performed to test the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the relevant assertion level. Examples of tests of controls include inquiries of appropriate management, supervisory, and staff personnel; inspection of documents, reports, and electronic files; walkthroughs; and reperformance of the application of the control by the auditor. Substantive procedures are performed to detect material misstatements (i.e., monetary errors) in a transaction class, an account balance, and disclosure component of the financial statements. Examples of substantive procedures are (1) tests of details (i.e., substantive tests of transactions and test of details of account balances) and (2) substantive analytical procedures. 3-11 Professional standards provide very little specific guidance on how to assess what is material to a reasonable user. As a result, auditing firms should develop policies and procedures to assist their auditors in establishing materiality judgments for clients in order to minimize the variability of such judgments by firm personnel. In other words, firms would prefer to have their auditors establish similar materiality judgments for clients with similar circumstances. 3-12 The three major steps in applying materiality are: Step 1: Determine overall materiality (planning materiality). The auditor should establish a materiality level for the financial statements taken as a whole. This will be referred to as overall materiality. Overall materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of users. Materiality, however, is a relative, not an absolute, concept. Step 2: Determine tolerable misstatement (performance materiality). This step involves determining tolerable misstatement based on overall materiality. Tolerable misstatement is the amount of overall materiality that is used to establish the scope of audit procedures for the individual account balance or class of transactions. Step 3: Evaluate audit findings. Based on the results of the audit procedures conducted, the auditor aggregates misstatements from each account or class of transactions. When the aggregated misstatements are less than the overall materiality, the auditor can conclude that the financial statements are fairly presented. Conversely, when the aggregated misstatements are greater than overall materiality, the auditor should request that the entity to adjust the financial statements. 3-13 Total assets or total revenues may be better bases for entities in certain industries. For example, in a not-for-profit entity, total revenues or total expenses might be more appropriate benchmarks, while for asset-based entities (e.g., mutual funds) net assets might be a better benchmark. 3-14 Qualitative factors that may affect the establishment of the overall materiality (step 1) include: • Material misstatements in prior years; • High risk of fraud; • The entity is close to violating a covenant in a loan agreement; • Small amounts may cause the entity to miss forecasted revenues or earnings, or affect the trend in earnings; • The entity operates in a volatile business environment, has complex operations (multi- locations), or operates in a highly regulated industry. 3-15 Factors that would cause the auditor to use a lower percentage for tolerable misstatement: • High risk of misstatement within the account balance, class of transaction, or disclosure; • Increased number of accounting issues that require significant judgment and/or more estimates with high estimation uncertainty; • A history of material weaknesses, significant deficiencies, and/or a high number of deficiencies in internal control; • High turnover of senior management or key financial reporting personnel. Answers to Multiple-Choice Questions 3-16 d 3-21 b 3-17 d 3-22 a 3-18 a 3-23 d 3-19 c 3-24 d 3-20 d 3-25 b Solutions to Problems 3-26 a. Prior to acceptance of the engagement, Tish & Field should obtain the following information from the predecessor auditor: • Information that might bear on the integrity of management. • Disagreements with management concerning accounting principles, auditing procedures, or other similarly significant matters. • Communications to those charged with governance regarding fraud and noncompliance with laws or regulations by the entity. • Communications to management and those charged with governance regarding significant deficiencies and material weaknesses in internal control. • The predecessor auditor's understanding about the reasons for the change in auditors. b. The additional procedures Tish & Field should perform before accepting the engagement include the following: • Obtain and review available financial information (annual reports, interim financial statements, income tax returns, etc.). • Inquire of third parties about any information concerning the integrity of the prospective client and its management. (Such inquiries should be directed to the prospective client’s bankers and attorneys, credit agencies, and other members of the business community who may have such knowledge.) • Consider whether the prospective client has any circumstances that will require special attention or that may represent unusual business or audit risks, such as litigation or going concern issues. • Determine if the firm is independent of the client and able to provide the desired service. • Determine if the firm has the necessary technical skills and knowledge of the industry to complete the engagement. • Determine if acceptance of the client would violate any applicable regulatory agency requirements or the Code of Professional Conduct. 3-27 The preliminary engagement and planning activities that Parker needs to complete are: • Reading the current year's interim financial statements. • Discussing the scope of the examination with management of the client. • Establishing the timing of the audit work. • Arranging with the client for adequate working space. • Coordinating the assistance of client personnel in data preparation. • Establishing and coordinating staffing requirements, including time budget. • Holding a brainstorming meeting with assistants assigned to the engagement and discussing possible fraud-related issues. • Determining the extent of involvement, if any, of consultants, specialists, and internal auditors. • Considering the effects of applicable accounting and auditing pronouncements, particularly recent ones. • Preparing documentation setting forth the preliminary audit plan. • Establish overall materiality and tolerable misstatement. • Making a preliminary assessment about control risk. • Updating the prior year's written audit program and possibly developing new procedures as warranted by changes in the business. 3-28 a. In addition to the items shown in the EarthWear engagement letter (Exhibit 3-1), the letter generally may include the following items: • Arrangements involving the use of specialists or internal auditors. • Any limitation of the liability of the auditor or client, such as indemnification to the auditor for liability arising from knowing misrepresentations to the auditor by management or alternative dispute resolution procedures. (Note that regulatory bodies, such as the SEC, may restrict or prohibit such liability-limiting arrangements.) • Additional services to be provided relating to regulatory requirements. • Arrangements regarding other services (e.g., assurance, tax, or consulting services). b. The benefits of preparing an engagement letter include the avoidance of possible problems between the CPA and the client concerning (1) the scope of the work, (2) the service to be rendered, and (3) the audit fee. In addition, the "in-charge" auditor conducting the examination can avoid misunderstanding the nature and scope of the engagement if the engagement letter is included in the permanent section of the audit working papers. The letter should eliminate misunderstandings and confusion about the type of financial statements to be examined, the estimated report date, and the type of opinion expected. In this respect, the letter lessens any problems associated with the first standard of fieldwork, which requires the work to be adequately planned and assistants to be properly supervised. In addition to avoiding possible misunderstandings, any legal problems relating to the auditor's failure to perform certain procedures can be reviewed with reference to the contractual commitment assumed. For example, if scope limitations prevent the auditor from performing normal audit procedures, the auditor cannot be legally responsible if a fraud is not detected when clearly it would have been detected if such procedures were performed. The engagement letter is also useful as a reference document when preparing for future engagements. 3-29 a. An audit committee is a subcommittee of the board of directors that is responsible for the financial reporting and disclosure process. Audit committees are required for public companies subject to SOX and may be established by private companies. The audit committee should be composed of independent members of the board. b. Audit committees are formed to satisfy the shareholders' need for assurance that directors are exercising due care in the performance of their duties. For public companies they are required. They may also be formed so that a private company can be more responsive to the needs of those interested in financial reporting. They may also be formed to reinforce auditor's independence, particularly the appearance of independence, from the management of a company whose financial statements are being examined by the auditor. c. The functions of an audit committee may include the following: • Selection of the independent auditor, discussion of audit fee with the auditor, and review of the auditor's engagement letter. • Review of the independent auditor's overall audit plan (scope, purpose, and general audit procedures). • Review of the annual financial statements before submission to the full board of directors for approval. • Review of the results of the auditor's examination including experiences, restrictions, cooperation received, findings, and recommendations. Matters that the auditor believes should be brought to the attention of the directors or shareholders should be considered. • Review of the independent auditor's evaluation of the company's internal control systems. • Review of the company's accounting, financial, and operating controls. • Review of the reports of internal audit staff. • Review of interim financial reports to shareholders before the board of directors approves them. • Review of company policies concerning political contributions, conflicts of interest, and compliance with federal, state, and local laws and regulations, and investigation of compliance with those policies. • Review of financial statements that are part of prospectuses or offering circulars; review of reports before they are submitted to regulatory agencies. • Review of the independent auditor's observations of financial and accounting personnel. • Participation in the selection and establishment of accounting policies; review the accounting for specific items or transactions as well as alternative accounting treatments and their effects. • Review of the impact of new or proposed pronouncements by the accounting profession or regulatory bodies. • Review of the company's insurance program. • Review and discussion of the independent auditor's management letter. 3-30 To determine overall materiality based on the information provided, the auditor would make the following calculation for the full year income before taxes: Quarters Income before taxes 1Q $1,200,000 2Q 1,500,000 3Q 1,350,000 = 1,500,000 x .90 4Q 1,687,500 = 1,350,000 x 1.25 Estimated income before taxes $5,737,500 Using 5% as a benchmark, overall materiality based on the estimated income before taxes would be $287,000 (rounded). 3-31 Scenario 1: a. Because Murphy & Johnson is a profit-oriented entity, income before taxes is likely to be the most appropriate benchmark for determining overall materiality. Murphy & Johnson’s auditor could use 3 – 5% of income before operations for determining overall materiality. If we assume that the auditor uses 5%, overall materiality would be $1.05 million ($21 million  .05). Assume further that the auditor’s firm provides guidance that tolerable misstatement will be set 50% of overall materiality or $525,000. b. In this case, the two detected misstatements exceed overall materiality ($1.25 million versus $1.05 million). Thus, the auditor needs to propose an adjustment to the financial statements. If both of the misstatements are factual (known) misstatements, the auditor should request the client to book both misstatements. If the misstatements are judgmental or projected misstatements, the auditor will have to determine whether the misstatements arose from an accounting estimate or an audit sample. In our example, the auditor’s proposed adjustment would need to be at least $200,000 so that the remaining misstatement would be equal to or less than $1.05 million. The auditor should also understand the cause of the misstatements and determine the impact of the material misstatements on the auditor’s assessment of fraud and control risk. If Murphy & Johnson is a public company, subject to Sarbanes Oxley 404 requirements (see Chapter 7), the material misstatements are strong indicators of material weaknesses in controls. Scenario 2: a. Delta Investments is in the mutual fund industry and total assets would likely be the most appropriate benchmark for determining overall materiality. Delta’s auditor could use .25 - 2% of total assets (see Table 3-5) for determining overall materiality. If we assume that the auditor uses .5%, overall materiality would be $21.5 million ($4.3 billion  .005). Assume further that the auditor’s firm provides guidance that tolerable misstatement will be set 50% of overall materiality or $10.75 million. b. The two detected misstatements are less than both tolerable misstatement and overall materiality so no adjustment to the financial statements would be necessary. However, the auditor should understand the cause of the misstatement and determine the impact of the misstatements on the auditor’s assessment of fraud and control risk. If either of the two misstatements were factual misstatements, the auditor would request that the client make an adjustment. If Delta Investments is a public company, subject to Sarbanes Oxley 404 requirements (see Chapter 7), the misstatements may represent significant weaknesses in controls. Scenario 3: a. Swell Computers is a profit-oriented entity and income before taxes would normally be the most appropriate benchmark for determining overall materiality. However, Swell’s profit ($500,000 income on $7 billion of revenue) is close to breakeven. In this case, Swell’s auditor can use total assets (.25 - 2%) or total revenues (.5 – 5%) for the base. Assume Swell’s auditor decides to use .5% of total assets for determining overall materiality. Thus, overall materiality would be $11.0 million ($2.2 billion  .005). Assume further that the auditor’s firm provides guidance that tolerable misstatement will be set 50% of overall materiality or $5.5 million. Note that other scenario answers are feasible. b. The detected misstatement is less than both tolerable misstatement and overall materiality. However, in this instance the adjustment of $1.5 million turns a profit into a loss. This is one of the qualitative factors that SAB No. 99 requires the auditor to consider (see Chapter 17), so an adjustment to the financial statements would be necessary. In addition, the auditor should understand the cause of the misstatement and determine the impact of the misstatements on the auditor’s assessment of fraud and control risk. If Swell Computer is a public company, subject to Sarbanes Oxley 404 requirements (see Chapter 7), the misstatements may represent significant weaknesses in controls. 3-32 a. Because of the significant drop in income in 2018, the auditor should use some type of “normalized” earnings. One approach would be to use the average of 2015 – 2017 ($584,000,000 + $520,000,000 + $453,000,000 = $1,557,000,000 / 3 = $519,000,000). While the firm allows the use of 3 – 10% for the range of percentages, the loss in the current year might suggest that there is a higher level of risk in 2018. Thus, a percentage in the 3 – 5% range would seem appropriate. Thus, the amount of overall materiality would be in the range of $16 million ($519,000,000 x .03) and $26 million ($519,000,000 x .05) (rounded). Again because of the higher risk, it would most likely be appropriate to use 50% for the calculation of tolerable misstatement. The range for tolerable misstatement would then be $8 million to $13 million. b. The auditor could use the amounts for 2018 total assets and total revenues for the calculations. Thus, overall materiality using total assets would be: ($23,422,000,000 x .0025 = $59 million) and ($23,422,000,000 x .02 = $468 million). Using 50% as the multiplier, tolerable misstatement would be $29 million and $234 million, respectively. When total revenues are used, overall materiality would be: ($20,272,000,000 x .0025 = $51 million) and ($20,272,000,000 x .02 = $405 million). Using 50% as the multiplier, tolerable misstatement would be $26 million and $203 million, respectively. c. If we use overall materiality for comparison purposes, the $50 million in detected misstatements that were “waived,” would be material using the income measures in part a., but not material using total assets or total revenues. The instructor might consider discussing the fact that the $50 million in misstatements is greater than the tolerable misstatement when the lower percentage is applied to total assets and total revenues. Solutions to Discussion Cases 3-33 a. The current-year audit discovered that Forestcrest Woolen Mills had not completed any construction work on the water treatment facility that must be built to comply with the consent decree from the North Carolina EPA. Failure to complete this facility on time can result in fines and possible plant closure under the consent decree. This situation represents a material uncertainty that is likely to be remote at this point in time. However, the auditor should determine if the client will continue work on the facility and if it can be completed within the remaining three years. If the client provides some assurance that work will start on the facility and that construction can be completed on time, the auditor will likely issue a standard unqualified audit report. The completion information can be obtained from the company's president and its construction company. If the client will not provide assurance on the future work on the facility and/or the construction cannot be completed on time, the auditor will have to consider what the potential effects of failure to comply with the consent decree might be. At this point, it is probably too early to consider issuing a "going-concern" opinion on the company. The auditor might require the client to provide more detailed disclosure of the issue in the footnotes to the financial statements. b. If these facts were noted at the end of the seventh year of the consent decree, the auditor would again need information on the possible timely completion of the facility. If the facility can be completed, the auditor would most likely issue a standard unqualified report. If, however, the facility cannot be completed on time and the penalties under the consent decree are significant enough to raise doubts about the company's continued existence, the auditor would likely issue a modified report with an explanatory paragraph for going concern. Solutions to Internet Assignments 3-34 A search of any of these sites should allow the student to identify a company that has recently changed auditors. Once the company has been identified, the student can check the investor relations section on the relevant company’s website. This web page will contain the 8K filed by the company with the SEC. Alternatively, the student can search the SEC website and find the 8K filed by the company and the auditor’s filing for the change. 3-35 The Institute of Internal Auditors (IIA) home page (www.theiia.org) contains detailed information about various activities of the IIA. This includes information on the profession, certification, conferences, products, etc. A search of the website identified information about independence and objectivity. 3-36 A search of the Internet identified a number of potential sources for information on the mail order industry: • The National Mail Order Association (www.nmoa.com) is one site where small to medium-sized organizations can go to get information on education, ideas, resources, and contacts. • The National Retail Federation (www.nrf.com) maintains historical retail statistics. • The International Society for Strategic Marketing (www.issm.org) maintains a site that contains economics statistics from the Census Bureau on various SIC codes related to the mail order industry. • Lastly, a number of the major public accounting firms have industry specialization in retail. The sites of the firms may contain information on the retail industry. Chapter 4 Risk Assessment Answers to Review Questions 4-1 Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Engagement risk is the risk that the auditor is exposed to financial loss or damage to his or her professional reputation from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on. In simple terms, audit risk is the risk that an auditor will issue an unqualified opinion on materially misstated financial statements, while engagement risk relates to the auditor's exposure to financial loss and damage to his or her professional reputation. 4-2 Inherent risk and control risk differ from detection risk in that inherent risk and control risk exist independent of the audit; that is, the levels of inherent risk and control risk are functions of the client and its environment. The auditor has little control over these risks. The auditor can control detection risk through the scope (nature, timing, and extent) of the audit procedures performed. Thus, detection risk has an inverse relationship with inherent risk and control risk. 4-3 Sampling risk refers to the fact that, in many instances, the auditor does not examine 100 percent of the class of transactions or account balance. Since only a subset of the population is examined, it is possible that the sample drawn is not representative of the population and a wrong conclusion may be made on the fairness of the account balance. Professional judgment errors (non-sampling risk) occur because an auditor may use an inappropriate audit procedure, fail to detect a misstatement when applying an appropriate audit procedure, or misinterpret an audit result. 4-4 Standard setters developed the audit risk model as a planning and evaluation tool. Therefore, the model is only as good as the judgments and assessments used as inputs. Following are some limitations. First, since the auditor assesses inherent risk and control risk, such assessments may be higher or lower than the actual inherent risk and control risk that exist for the client. Second, the audit risk model does not consider the possibility of judgment or non-sampling risk (auditor error in assessing risk, choosing audit procedures, and evaluating results). 4-5 In understanding the entity and its environment, the auditor gathers knowledge about: (1) the nature of the entity; (2) industry, regulatory, and other external factors; (3) objectives strategies, and business risks; (4) entity performance measures; and (5) internal control. 4-6 Some examples of conditions and events that may indicate the existence of business risks are: • Significant changes in the entity such as large acquisitions, reorganizations, or other unusual events. • Significant changes in the industry in which the entity operates. • Significant new products or services or significant new lines of business. • New locations. • Significant changes in the IT environment. • Operations in areas with unstable economies. • High degree of complex regulation. 4-7 A company that operates in the coal mining industry faces numerous business risks. The following are selected business risks disclosed by Arch Coal, Inc. –a coal producer in the United States. General Risks: • Coal prices are subject to change and a substantial or extended decline in prices could materially and adversely affect our profitability and the value of our coal reserves. • Our coal mining operations are subject to operating risks that are beyond our control, which could result in materially increased operating expenses and decreased production levels and could materially and adversely affect our profitability. • Competition within the coal industry could put downward pressure on coal prices and, as a result, materially and adversely affect our revenues and profitability. • Decreases in demand for electricity resulting from economic, weather changes, or other conditions could adversely affect coal prices and materially and adversely affect our results of operations. • The use of alternative energy sources for power generation could reduce coal consumption by U.S. electric power generators, which could result in lower prices for our coal. Declines in the prices at which we sell our coal could reduce our revenues and materially and adversely affect our business and results of operations. • Disruptions in the quantities of coal produced by our contract mine operators or purchased from other third parties could temporarily impair our ability to fill customer orders or increase our operating costs. • Our profitability depends upon the long-term coal supply agreements we have with our customers. Changes in purchasing patterns in the coal industry could make it difficult for us to extend our existing long-term coal supply agreements or to enter into new agreements in the future. Risks Related to Environmental, Other Regulations and Legislation: • Extensive environmental regulations, including existing and potential future regulatory requirements relating to air emissions, affect our customers and could reduce the demand for coal as a fuel source and cause coal prices and sales of our coal to materially decline. • Our failure to obtain and renew permits necessary for our mining operations could negatively affect our business. • Federal or state regulatory agencies have the authority to order certain of our mines to be temporarily or permanently closed under certain circumstances, which could materially and adversely affect our ability to meet our customers’ demands. • Extensive environmental regulations impose significant costs on our mining operations, and future regulations could materially increase those costs or limit our ability to produce and sell coal. 4-8 There are three types of misstatements: • Factual Misstatements. These are misstatements about which there is no doubt. For example, an auditor may test a sales invoice and determine that the prices applied to the products ordered are incorrect. Once the products are correctly priced, the amount of misstatement is known. In such cases, the auditor knows the exact amount of the misstatement. • Judgmental Misstatements. These are misstatements that arise from the judgments of management concerning accounting estimates that the auditor considers unreasonable or the selection or application of accounting policies that the auditor considers inappropriate. • Projected Misstatements. These are the auditor’s best estimate of misstatements in populations, involving the projection of misstatements identified in an audit sample to the entire population from which the sample was drawn. 4-9 Misstatements can result from errors or fraud. The term errors refers to unintentional misstatements of amounts or disclosures in financial statements. The term fraud refers to an intentional act by one or more among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. Thus, the primary distinction between errors and fraud is whether the misstatement was intentional or unintentional. Unfortunately, it is often difficult to determine intent. For example, if the auditor detects a misstatement in an account that requires an estimate, such as bad debt expense, it may be difficult to determine whether the misstatement was intentional. Examples of misstatements due to errors or fraud include: • An inaccuracy in gathering or processing data from which financial statements are prepared. • An omission of an amount or disclosure. • A financial statement disclosure that is not presented in accordance with GAAP. • An incorrect accounting estimate arising from overlooking or clear misinterpretation of facts. • Judgments of management concerning accounting estimates that the auditor considers unreasonable or the selection or application of accounting policies that the auditor considers inappropriate. 4-10 The auditor performs the following steps to identify the risks of material misstatement due to fraud: • Discussion among the audit team members regarding the risks of material misstatement due to fraud. • Inquire of management, audit committee, and others about their views on the risks of fraud and how it is addressed. • Consider any unusual or unexpected relationships that have been identified in performing analytical procedures in planning the audit. • Understand the client’s period-end closing process and investigate unexpected period- end adjustments. • Identification and assessment of fraud risk factors. 4-11 There are numerous risk factors that can cause an individual to misappropriate assets, such as cash (see Table 4-5). By requiring that an individual take a vacation, another individual will perform that person’s duties. If some type of misappropriation is taking place, there is a strong probability that the misappropriation will be detected. Such a policy is particularly helpful in a small business that does not have sufficient personnel to provide total segregation of duties or where there is poor oversight by personnel responsible for the asset. 4-12 If Jackal determines that a number of the risks of material misstatements are pervasive to the overall financial statement, he should reconsider the overall audit approach and respond to such pervasive risks by: • Assign more experienced personnel or those with specialized knowledge to assess the risks of material misstatement due to fraud; • Evaluate whether the selection and application of accounting policies by the entity, particularly those related to subjective measurements and complex transactions, may be indicative of fraudulent financial reporting resulting from management's effort to manage earnings, or a bias that may create a material misstatement; and • Incorporate an element of unpredictability in the selection of the nature, timing, and extent of audit procedures. Answers to Multiple-Choice Questions 4-13 d 4-18 c 4-14 a 4-19 b 4-15 c 4-20 a 4-16 a 4-21 c 4-17 c 4-22 a Solutions to Problems 4-23 a. Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. b. Inherent risk is the susceptibility of an assertion in an account or disclosure to a misstatement due to error or fraud that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls. Control risk is the risk that a misstatement that could occur in an assertion about an account or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control. Detection risk is the risk that the procedures performed by the auditor will not detect a misstatement that could be material, either individually or when aggregated with other misstatements. c. Inherent risk and control risk differ from detection risk in that they exist independently of the audit of financial statements, whereas detection risk relates to the auditor's procedures and can be changed at the auditor's discretion. Detection risk has an inverse relationship to inherent and control risk. 4-24 Client No. Detection Risk 1 25% 2 10% 3 67% 4 25% 4-25 Client No. Detection Risk 1 Moderate 2 Low 3 High 4 Low 4-26 a. A public offering would increase the auditor’s exposure to third party litigation and would, therefore, reduce acceptable audit risk relative to a private company audit. b. Bankruptcy increases the auditor’s reputation and litigation risk and would, therefore, reduce acceptable audit risk relative to a private company audit. c. Significant changes to accounting information systems would typically increase control risk, but would have no effect on the acceptable audit risk relative to a private company audit. 4-27 1. a 6. b 2. c 7. c 3. b 8. c 4. a 9. c 5. a 10. c 4-28 a. Two factors are particularly important in assessing the risk of material misstatement for Johnson, Inc. First, one individual, who also has majority control of the stock, dominates the decision making in the company. This factor should lead to a higher assessment for the risk of material misstatement because there is no review of important decisions and actions may be taken that are not in the best interest of the company or its stockholders. Second, Johnson, Inc. is expanding rapidly throughout the southeast. Such expansion may result in material misstatements since decision-making may become decentralized without adequate internal control. The increase in the risk of material misstatement due to these two factors will result in a lower determination of detection risk and an increase in the scope of the auditor's work. b. The factors affecting the assessment of the risk of material misstatement for MaxiWrite Corporation all relate to industry characteristics. First, the industry is very competitive, which can lead to price-cutting and its related effects on revenues. Second, the industry is affected by changes in technology, and MaxiWrite is not one of the industry leaders in technology. Its products usually are not competitive with the industry leaders in terms of performance. Third, the company is not as profitable or financially strong as the major companies in the industry. The industry factors result in an increased assessment of the risk of material misstatement for MaxiWrite Corporation, leading to a lower determination of detection risk and more substantive tests. c. The risk of material misstatement should be increased for the First National Bank of Pond City for the following reasons. First, the audit firm has been the bank's auditors for only two years. Second, there have been contentious accounting issues related to loan loss reserves and the value of collateral. Third, prior audits have indicated the presence of misstatements in the loan loss reserve. Based on these risk factors, detection risk should be set lower and increased substantive tests performed. 4-29 In developing an understanding of the entity and its environment, the auditor obtains information from numerous sources (internal or external) of information about the entity and its environment, including the following: • Procedures performed in client acceptance and continuance process. • Knowledge obtained from performing interim procedures. • Consulting, tax, or other engagements performed for the entity. • Published annual reports and interim reports to shareholders, if applicable. • Minutes of board of directors and/or audit committee meetings. • Entity’s business/strategic plans, budgets, or other documentation. • Reports prepared by analysts, banks, underwriters, rating agencies, and the like. • Individuals knowledgeable about the industry, such as the engagement team members for clients in a similar business/industry. • Audit firm-generated industry guidance, databases, and practice aids, where applicable. • Government statistics. • Economic and financial journals. • Industry or trade journals. • Client press releases, publications, and brochures. • Internal audit reports. 4-30 a. The entity’s market conditions and competition can be significant sources of business risks. For example, decreasing demand for the entity’s products can affect revenues and the value of inventory. Competition in an industry has a similar affect on prices, and therefore revenues. b. An industry that is cyclical or seasonal can affect the demand for the entity’s product and the size of its workforce. It can also cause problems with purchasing raw materials or product components. For example, EarthWear’s sales are much higher during the Christmas holiday season than the rest of the year. If EarthWear misestimates the demand for certain types of products or fails to provide products that are in high demand, revenues will decline. In addition, the company may find itself with obsolete or slow-moving products. EarthWear also has to significantly increase its workforce for the holiday season by employing part-time workers. c. The speed of technological change in an industry can result in an entity holding products that are not competitive. This can result in reduced revenues and over-valued inventory. d. The availability of raw materials or product components and their price can significantly affect an entity. If an entity is unable to obtain raw materials, revenues are likely to decrease because products are not available for sale. If costs of raw materials increase, either profit margins will decrease due to higher costs of goods sold or demand may decrease due to increasing the sales price of finished product. One can see these effects in entities that buy and sell commodities (e.g., oil, precious metals, agricultural products). 4-31 a. An auditor is responsible for obtaining reasonable assurance that the financial statements as a whole are free from material misstatements, whether caused by error or fraud. b. Three conditions are generally present when material misstatements due to fraud occur: 1. Management or other employees have an incentive or are under pressure that provides a reason to commit fraud. 2. Circumstances exist that provide an opportunity for a fraud to be carried out. 3. Those involved are able to rationalize committing a fraudulent act. Some individuals possess an attitude, character, or set of ethical values that allow them to knowingly and intentionally commit a dishonest act. c. The objectives of the brainstorming meeting are to: • Share insights about the entity and its environment and the entity’s business risks. • Provide an opportunity for the team members to discuss how and where the entity might be susceptible to fraud. • Emphasize the importance of maintaining professional skepticism throughout the audit regarding the potential for material misstatement due to fraud. d. The documentation should include: • The risks identified, an evaluation of management’s response to such risks, and the auditor’s assessment of the risk of error or fraud after considering the entity’s response. • The nature, timing, and extent of the procedures performed in response to the risks of material misstatement due to fraud and the results of that work. • Fraud risks or other conditions that caused the auditor to believe that additional audit procedures or other responses were required to address such risks or other conditions. • The nature of communications about error or fraud made to management, the audit committee, and others. 4-32 The following are a sample of the possible business risks that a publicly traded, start-up biotech might have. You might consider having the class examine Item 1A – Risk Factors in a company’s 10-K. a. Business Risks b. Effect on Acceptance Decision 1. Start-up companies usually have large, accumulated deficits and they usually require large capital infusions until they have a viable product. 1. Presents a potential going concern problem and might reduce the likelihood of accepting the client. 2. Drug development programs are very expensive, time consuming, and difficult to design and implement. 2. Potentially affects the long- term (and ultimate) success of the company. The probability of success of the drug(s) would likely affect the auditor’s decision to accept the client. 3. Drug candidates are in various stages of research and development and are prone to the risks of failure inherent in drug development. 3. Same as 2 above. 4. Drug candidates are subject to extensive regulation (e.g., FDA and similar agencies in other countries), and we may not receive required regulatory approvals, or timely approvals, for any of our drug candidates. 4. Same as 2 above. 5. Drug discovery and development is intensely competitive. 5. See 1 and 2 above. 6. Start-up companies frequently enter into partnerships and other strategic alliances (e.g., marketing arrangements) that may lead to disputes and delays in drug development and commercialization. 6. Could lead to lawsuits and might reduce the likelihood of accepting the client. 7. May incur substantial liabilities from any product liability claims. 7. Same as 1 above. Solution to Discussion Case 4-33 Koss Case. 1. This question can be can answered by looking at the tables (Tables 4-5) that contain the fraud risk factors the incentives/pressures, opportunity, and attitudes/rationalizations to misappropriate assets. • Incentives/pressures: Sachdeva’s personal financial obligations due to her excessive spending. • Opportunity: Inadequate internal controls. • Attitudes/rationalizations: Disregard for monitoring and internal controls; lack of oversight and segregation of duties; and a change in Sachdeva’s lifestyle. 2. It is not appropriate for one individual, in this case, Michael Koss to hold 5 C-Level positions. Even in a smaller public company like Koss Corporation, the demands for each job would be such that none of them would be performed adequately. Solutions to Internet Assignments 4-34 The answers to this Internet assignment will be a function of the company assigned by the instructor. However, the responses to the questions will be found in the sources cited in the problem and will be similar to those in the questionnaire provided by your instructor or downloaded from the book’s website. See (Messier, W. F., Jr. 2014. An approach to learning risk-based auditing. Journal of Accounting Education 32: 276-287) for a discussion of the use of this case. If you would like more information about the use of this questionnaire, please contact Professor Messier ([email protected]). Solution Manual for Auditing and Assurance Services: A Systematic Approach William F. Messier, Steven M. Glover, Douglas F. Prawitt 9781260687637, 9780077732509, 9780077732509, 9781259162312