CH-1-4 Introduction to Auditing – Auditing: An International Approach : Book Guide

CHAPTER 1 Introduction to Auditing SOLUTIONS FOR REVIEW CHECKPOINTS 1-1 Auditors add credibility to financial information provided by the accountable party such as management (i.e. auditors make the financial or other information more likely to be true). Other common ways of characterizing this property of audited numbers is that the numbers are more accurate, have higher assurance, or are more reliable. These relate to different dimension of truthfulness, as we discuss later in the text. 1-2 Auditing is the verification of numbers provided by others. To attest means to lend credibility or to vouch for the truth or accuracy of the statements that one party makes to another. The attest function is a term often applied to the activities of independent PAs when acting as auditors of financial statements. Since financial statements are prepared by managers of an entity who have authority and responsibility for financial success or failure, an outsider may be skeptical that the statements are objective, free from bias, fully informative, and free from material error--intentional or inadvertent. The audit opinion of an independent-PA auditor helps resolve those doubts because the auditor's success depends upon his independent, objective, and competent assessment of the conformity of the financial statements with GAAP. The auditor's role is to lend credibility to the statements, hence the outsider will likely seek his independent audit opinion. 1-3 Client: the company, board of directors, agency, or some other person or group who retains (hires) the auditor. Usually the party who pays the fee. Auditee: the entity (e.g., business firm, hospital, city government) whose financial information is under audit. Auditors: report to the client on the auditee's financial or control information. Three party accountability consists of the auditor, the accountable party of the auditee such as management of the auditee, and the users. Users include the client as defined above. Traditionally management hired the auditor so that there was some confusion as to who was the true client. New corporate governance concepts in part attempt to clarify this three party accountability. 1-4 Auditors performing auditing gather evidence related to the assertions management makes in financial statements and render a report. Accountants performing accounting record, classify, and summarize (report) a company's assets, liabilities, capital, revenue, and expense in financial statements. Accountants produce the financial statements, auditors audit them. 1-5 The conditions of complexity, remoteness and consequences produce demands by outside users for financial reports. They cannot produce the reports for themselves because of these conditions. Company managers and accountant produce them. 1-6 Students can refer to the AAA and CICA definitions in Chapter 1. Some instructors may want to extend the consideration of definitions to include the internal and governmental definitions. In response to "what do auditors do," students can refer to Exhibit 1-2 and respond in terms of: (1) obtain and evaluate evidence about assertions management makes about economic actions and events, (2) ascertains the degree of correspondence between the assertions and GAAP, and (3) gives an audit report (opinion). Students can also respond more generally in terms of "lending credibility" to financial statements presented by management (attestation). 1-7 The essence of the risk reduction theory is that audits of financial statements reduce the information risk (probability of materially misleading statements) to users to a socially acceptable level. 1-8 Self-regulation refers to the powers a professional group has in regulating its affairs without intervention by the government or government established external regulator. These affairs include setting of standards, codes of conduct, education requirements, certification, and disciplining of members. Financial analysts and investors depend upon financial reports for making stock purchase and sale decisions. Creditors (suppliers, banks, etc.) use them to decide whether to give trade credit and bank loans. Labor organizations use them to help determine a company's ability to pay wages. Government agencies and Parliament use them in preparing analyses of the economy and in making laws concerning taxes, subsidies, and the like. These various users cannot take it upon themselves to determine whether financial reports are reliable, therefore low in the information risk scale. They do not have the expertise, resources, or time to enter thousands of companies to satisfy themselves about the veracity of financial reports. Thus they hire independent auditors to perform the attest function and reduce the information risk. 1-8 The Canadian board (CPAB) is more self regulatory in that the profession has more influence through having a higher percentage of board membership, the monitoring process is less public and more designed to help firms improve their practices. The CICA continues to set audit standards. The PCAOB, on the other hand, not only sets standards but also has a more confrontational an public approach in its monitoring process. 1-9 Forensic accounting is the broader term that includes fraud auditing. Forensic accounting is the use of accounting for legal or investigative purposes. Fraud auditing is the use of forensic accounting in criminal investigations involving allegations of fraud. Frauds that PAs are most interested in are misappropriation of assets and fraudulent financial reporting (misreporting). 1-10 Fraud is intentional deception resulting in injury to another. Frauds that PAs are most interested in are misappropriation of assets and fraudulent financial reporting (misreporting). 1-12 Operational auditing is the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies. The CICA views operational auditing as a type of management advisory service offered by public accounting firms. 1-13 The elements of comprehensive auditing include: (1) financial and compliance audits, (2) economy and efficiency audits, and (3) program results or effectiveness audits. Public sector is the part of the economy represented by all levels of government. Public companies are companies whose shares are traded on the stock markets. 1-14 A compliance audit involves a study of an organization's policies, procedures, and performance in following laws, rules, and regulations. An example is a company’s compliance with environmental laws. 1-15 Other kinds of auditors: Revenue Canada agents/auditors, provincial and federal bank examiners, provincial insurance commissioner auditors. 1-16 Financial statement audits are intended to provide assurance there are no significant intentional or unintentional misstatements. 1-17 CA’s, CGA’s, and CIA’s 1-18 Examples of attestation services: Vote counts (Academy Awards) Amount of prizes claimed to have been given in sweepstakes advertisements Investment performance statistics Characteristics claimed for computer software programs 1-19 Audits of financial statements? Auditing Standards Work on unaudited financial statements of public companies? Review Engagement Standards Work on unaudited financial statements of public companies? Compilation Engagement Standards (SAS) The three major areas of public accounting services: Accounting and auditing Taxation Management advisory services (consulting) 1-20 The SEC site is more comprehensive but covers only Canadian companies cross listed on U.S. exchanges. 1-21 The IFAC site is at www.ifac.org and click on “standards and guidance.” SOLUTIONS FOR EXERCISES AND PROBLEMS EP1-1 When the PA is hired by Hughes Corporation, he can no longer be considered independent with respect to the annual audit. The annual audit may then be unnecessary in a short-run view and unnecessary to the extent of services exclusive of the attest opinion. It is true that the in-house CPA can perform all the procedural analyses that would be required of an independent audit; however, it is extremely unlikely that he could inspire the confidence of users of financial statements outside the company. He cannot modify the perception of potential conflict of interest that creates demand for the independent audit. As a matter of ethics rules, this PA would be prohibited from signing the standard unqualified attest opinion. EP1-2 You should point out that you will be unable to replace the independent audit with your own communication output as controller. Make the point that you can conduct an effect internal audit function and be of considerable service to management and can even assist the independent auditors with preparation of schedules and general cooperation (thus facilitating the independent audit). Nevertheless, as a member of management, it would be impossible to be truly objective and unbiased about the financial results of management's decisions, hence the directors could not satisfy their obligations to the shareholders' interests. Neither could you issue an opinion to be used by outsiders. Lacking an opinion on the financial statements, the company could find itself in noncompliance with audit requirements of a stock exchange, a Provincial Securities Commission, or the U.S. Securities and Exchange Commission. EP1-3 a. risk of litigation needs offsetting lower information risk (for example, litigation due to share practice decline or failure to meet a bond covenant). b. strength of internal controls (e.g., controls over financial instruments, controls over cash). c. financial health of client (industry factors, economic factors). d. management compensation system (management highly motivated to beat earnings targets, compensation tied to factors over which management has little control may motivate management to “manage earnings”). e. private vs. public company (publicly held company owners are more reliant on financial statements for information about their investment). EP1-4 Financial statements are prepared on basis of GAAP. Knowledge of GAAP is thus indispensable for determining if the financial statements are in conformity with GAAP. For example lease accounting consists of some very specific rules (bright line rules) that the auditor effectively tests compliance with. Unfortunately such detailed rule based accounting leads to what some refer to as a checklist mentality where the form is more important than the substance. Enron’s special purpose entity accounting also comes to mind. EP1-5 Operational Auditing Bigdeal cannot hire the OAG. This government agency does not perform operational audits for private industry. One possibility is the management advisory services department of a large PA firm. The major advantage may be total objectivity. The PA firm has no stake in making a report reflect favorably or unfavorably on Smalltek (provided there are no prior relations of the PA firm with Bigdeal managers that may suggest a bias or with Smalltek). The possible disadvantage is that the PA firm may not possess the required expertise in Smalltek' type of business. Another possibility is the Bigdeal internal audit department. The major advantage may be a thorough appreciation of Bigdeal's managerial effectiveness and efficiency standards and a longstanding familiarity with Bigdeal's business. The possible disadvantage could be that the internal auditors may not be independent enough from internal management pressures for making or breaking the deal for reasons other than Smalltek's efficiency and effectiveness. Another possibility is a nonPA management consulting firm. The major advantage of objectivity would be similar to the PA firm, and such firms often have experts in manufacturing, sales, and research and development management. The major disadvantage could be a lack of appreciation and familiarity with Bigdeal's management standards (as possessed by the Bigdeal internal auditors). EP1-6 The neighbor appears to be uninformed on the following points: 1- According to auditors' dogma, Price Waterhouse did not prepare the Dodge Corporation financial statements, and no auditor prepares a company's statements. Inform your neighbor that Dodge management is primarily responsible for preparing the financial statements and deciding upon the appropriate accounting principles. 2. An unqualified opinion does not mean an investment is safe. Tell your neighbor that the financial statements are history. The value of his investment depends on future events, including the many factors that affect market prices. Tell him the opinion only means that the statements conform to GAAP (and you can add that the auditor knows of no material fraud or error). EP1-7 Identification of Audits and Auditors The responses to this matching type of question are ambiguous. The engagement examples are real examples of external, internal and governmental audit situations. You might point out to students that the distinctions among compliance, economy and efficiency and program results audits are not always clear. The "solution" is shown below in matrix form, showing some engagement numbers in two or three cells. The required schedule follows. Type of Audit Financial Economy, Program Kind of Auditor Statement Compliance Efficiency Results Independent PA 2, 10 Internal Auditor 6, 8 4, 8 Governmental (AGC) 3 1, 3, 9 1, 3 Revenue Canada Auditor X 5 X X Bank Examiner X 7 X X 1. FHA loan interest equity Economy and Efficiency or Program Results Governmental (AGC) 2. Advertising agency financial statements Financial statement Independent CPAs 3. Dept. of Interior policies Compliance or Economy and Efficiency or Program Results Governmental (AGC) 4. Municipal services Economy and Efficiency Internal auditors 5. Tax shelters Compliance Revenue Canada auditors 6. Test pilot reporting Compliance Internal auditors 7. Bank solvency Compliance Bank examiners 8. Materials inspection by manufacturer Compliance or Economy and Efficiency Internal auditors 9. Drug enforcement vehicle seizures Economy and Efficiency Governmental (AGC) 10. Sports complex forecast Financial statement Independent PAs EP1-8 Analysis and Judgment This problem is one of Robert Ashton's cases on judgment and decision making (Accounting Review, January, 1984, pp. 78-97.) Ashton gives credit to Joyce and Biddle, "Anchoring and Adjustment in Probabilistic Inference in Auditing." Journal of Accounting Research, Spring, 1981, pp. 1 The case is set up to illustrate a person's tendency to anchor an estimate on some known information and adjust from that point in the course of performing analysis. This particular case set-up is intended to illustrate conjunctive and disjunctive events. Ashton's "answer key" explains in this manner: Ashton's Answer Key (abridged) This exercise focuses on probability estimates for two types of complex events called "conjunctive" and "disjunctive." The occurrence of a conjunctive event depends on the joint occurrence of all of a number of sub- events, each with a given probability of occurrence. An example is getting three 3's in a row when rolling a die. This is a conjunctive event with probability of 1/6 raised to the third power (1/6 x 1/6 x 1/6), or about 0.005. An example of a disjunctive event is getting at least one of a number of sub-events, such as one 3 in three rolls of the die. The probability of this disjunctive event is about 0.42 If you are asked to estimate the probabilities of the conjunctive and disjunctive events of rolling the die, a natural starting place (anchor) would be to know that the probability of getting one three in one roll is 1/6, or 0.167. Then to estimate the harder conjunctive event (three 3's in a row), a downward adjustment would be required. Conversely, for the disjunctive event (one 3 in three rolls), an upward adjustment would be needed. However, since adjustments from an anchor are usually insufficient, the estimated probability of the conjunctive event will likely be too large, and that of the disjunctive event too small. Form A of the problem (the one in the textbook chapter) is a conjunctive statement of the problem, and it asks for an estimate of the probability of successful product introduction. With the five sub-events considered independent of each other, the best answer is 0.554 (.80 x .90 x .95 x .90 x .90). Students may anchor on the probabilities of the elementary sub-events and fail to adjust sufficiently downward, and their probability estimates will be higher than 0.554. Form B of the problem (reproduced on the next page, not in the textbook) is a disjunctive statement of the same problem, and the best answer is still 0. 554. Form B, however, is stated in terms of failure in the chain of events. (Student responses must be subtracted from 1.000 to make them comparable to Form A.) If students anchor on the probabilities of the elementary disjunctive sub-events in Form B, their probability estimates (subtracted from 1.000) will probably be too low. NOTE TO INSTRUCTORS: You may want to reproduce Form B and give both the textbook problem (conjunctive) and the Form B alternative (disjunctive) to different groups of students to illustrate the anchoring and adjustment behavioral phenomenon. You may also want to give students a response scale to make your classroom discussion easier. Ask them to circle one: .00 .10 .20 .30 .40 .50 .60 .70 .80 .90 1.00 EP1-9 Management certification means that, in the words of SOX, “The CEO and CFO of each issuer shall prepare a statement to accompany the audit report to certify the "appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer." A violation of this section must be knowing and intentional to give rise to liability.” Before SOX, management’s responsibility was implicit, now it is made publicly explicit in writing. The primary effect on auditors is to reduce their legal liabilities by making it clearer that management takes on primary responsibility for financial reporting. Auditors are still needed because as the chapter discusses users may not trust management so any statements management makes does not really address this problem. Management however is now held more accountable. For example, management may no longer claim they didn’t understand technical aspects of accounting and deferred to the auditor’s judgment. EP1-10 Protecting investors is the most likely response. In public sector, protecting the tax payer would be another possible response. In both cases, however, we are talking about capital providers as the 3rd parties and capital users as the 2nd party in a 3 party accountability relationship. There are other issues, however, such as how sophisticated are the 3rd parties. For example, do they understand the limitations of GAAP? How much about GAAP should we expect them to understand? For example, can we assume that they know about the accounting risks associated with GAAP? This question is very open ended. EP1-11 1st party=CRA auditor, 2nd party=taxpayer, 3rd party= Canadian government EP1-12 Most non-auditors feel that an auditor’s prime responsibility is to detect fraud (part of the expectation’s gap). This was the major focus of audits before the 20th century. The switch to fairness of presentation seemed to take place with increased use of estimates in accounting in the 20th century, especially after passage of the SEC Acts. The past decade has brought a renewed interest in fraud detection, especially in the post-Enron environment. CHAPTER 2 Auditors’ Professional Roles and Responsibilities SOLUTIONS FOR REVIEW CHECKPOINTS 2-1 Self-regulation refers to the powers a professional group has in regulating its affairs without intervention by the government or government established external regulator. These affairs include setting of standards, codes of conduct, education requirements, certification, and disciplining of members. Since the failure of Enron in 2001, there has been increased involvement by outside agencies in the monitoring of the audit function. Auditing is increasingly viewed as a key pillar in capital markets, along with regulators and good governance practices. As a result external regulation of the profession has been increasing. In Canada, this has taken the form of increased monitoring of auditors of public companies via CPAB. CPAB however does not have the power to create audit and ethics standards as does the PCAOB in the U.S. Nevertheless, both CPAB and PCAOB are increasingly assertive monitoring the quality of audit practice and sanctioning auditors who do not meet their expectations. A major focus of inspections by CPAB and PCAOB is the quality of the audit. Quality generally refers to degree of conformity with standards and nature of procedures performed and their documentation. "Procedures" relate to acts to be performed. "Standards" deal with measures of the quality of performance of those acts and the objectives to be attained by the use of procedures. The standards are less subject to change. The standards provide the criteria for rejecting, accepting, or modifying a procedure in a given circumstance. An example of the relative stability of standards and procedures is found in the change from non-EDP to EDP systems. New procedures were required to audit EDP systems, but auditing standards remained unchanged and were the criteria for determining the adequacy of the new procedures. The word "procedure" is used in SAS 46 (AU 390)--"Consideration of Omitted Procedures After the Report Date"--to refer to (1) an act to be performed and (2) sufficient competent evidence. SAS 46 speaks of omitted procedures and the relative seriousness of their omission. The importance of any "omitted procedure," however, is the evidence the auditors failed to obtain. Merely omitting technical procedures is only a superficial analysis of an audit problem; the substance is the evidence not obtained. The standard for due audit care is the care which would be exercised by the prudent auditor. The prudent auditor is one who exercises reasonable judgment, who is not expected to be omniscient, who is presumed to have knowledge special to his profession, who is expected to be aware of his own ignorance, who is expected to possess the skills of his profession whether he is a beginner or a veteran. 2-2 The Canadian board (CPAB) is more self-regulatory in that the profession has more influence through having a higher percentage of board membership, themonitoring process is less public and more designed to help firms improve their practices. The CICA continues to set audit standards. The PCAOB, on theother hand, not only sets standards but also has a more confrontational and public approach in its monitoring process. The most important difference is that PCAOB actually sets auditing and professional ethics standards for public company audits in the U.S. In Canada, audit standards are set by the CICA while professional ethics standards are set by the provincial institutes/societies of CGAs, CMAs, and CAs. PCAOB reports are much more detailed disclosing the results of each inspection by firm, whereas CPAB reports are more generic providing an overall evaluation of the state of public company audits in Canada. Students generally find the PCAOB reports more interesting because they learn about problems identified for the firms they have accepted positions in. The CPAB report issued on April 3, 2012 on 2011 inspections was disappointed with the state of audits in Canada, particularly the implementation of audits in higher risk areas. “The Big 4 firms, which audit 94% of reporting issuers by market capitalization, had a GAAS deficiency rate of 20-26% on files inspected by CPAB.” Other audit firms had a 47% GAAS deficiency rate. CPAB found these results consistent with other regulators. This is not just a Canadian problem. 2-3 CA’s, CGA’s, and CMA’s 2-4 Examples of other representations are on the effectiveness of internal controls, vote counts at the Academy Awards, forecasts of financial information, efficiency of public sector activities. Vote counts (Academy Awards) Amount of prizes claimed to have been given in sweepstakes advertisements Investment performance statistics Characteristics claimed for computer software programs Also see the list of value for money audit engagements in chapter 1. 2-5 The three major areas of public accounting services: Accounting and auditing Taxation Management advisory services (consulting) 2-6 The SEC site is more comprehensive but covers only the Canadian companies cross listed on U.S. exchanges. 2-7 "Procedures" relate to acts to be performed. "Standards" deal with measures of the quality of performance of those acts and the objectives to be attained by the use of procedures. The standards are less subject to change. The standards provide the criteria for rejecting, accepting, or modifying a procedure in a given circumstance. An example of the relative stability of standards and procedures is found in the change from non-EDP to EDP systems. New procedures were required to audit EDP systems, but auditing standards remained unchanged and were the criteria for determining the adequacy of the new procedures. The word "procedure" is used in SAS 46 (AU 390)--"Consideration of Omitted Procedures After the Report Date"--to refer to (1) an act to be performed and (2) sufficient competent evidence. SAS 46 speaks of omitted procedures and the relative seriousness of their omission. The importance of any "omitted procedure," however, is the evidence the auditors failed to obtain. Merely omitting technical procedures is only a superficial analysis of an audit problem; the substance is the evidence not obtained. 2-8 The standard for due audit care is the care which would be exercised by the prudent auditor. The prudent auditor is one who exercises reasonable judgment, who is not expected to be omniscient, who is presumed to have knowledge special to his profession, who is expected to be aware of his own ignorance, who is expected to possess the skills of his profession whether he is a beginner or a veteran. 2-9 Three elements of planning and supervision considered essential in audit practice are: 1.A written audit program. 2- An understanding of the client's (auditee's) business. PA firm procedures to allow an audit team member to document disagreements with accounting or auditing conclusions and disassociate himself or herself from the matter. 3. Ensuring that staff have appropriate training and competence to perform the audit. 2-10 The timing of the auditor's appointment matters because the auditor needs time to plan the audit properly and perform the work without undue pressure from too-short deadlines. 2-11 An auditor obtains an understanding of a client's internal control system as a part of the control risk assessment process primarily in order to plan the nature, timing and extent of subsequent substantive audit procedures. Understanding of internal control allows an auditor to gain a measure of comfort as to how much to rely on the information generated by the auditee’s accounting system. A secondary purpose (not covered in Chapter 2) is to obtain information about reportable conditions (control deficiencies) to report to the client. 2-12 CAS 500.5(c )defines audit evidence as “Information used by the auditor in arriving at conclusions on which the auditor’s opinion is based. Audit evidence includes both information contained in the accounting records underlying the financial statements and other information.” Audit evidence is (and includes) all the influences on the mind of an auditor which affect decisions about the fair presentation of propositions (financial or otherwise) submitted for audit. Evidence may be quantified or qualified; it may be objective to a greater or lesser degree; it may be absolutely compelling or only mildly persuasive to a decision. 2-13 The nine important elements of the standard unmodified audit report. 1. Title. The title should contain the word independent, as in independent auditor or independent accountant. 2- Address. The report shall be addressed to the client, which occasionally may be different from the auditee. 3. Notice of Audit. A sentence should identify the financial statements and declare that they were audited. This appears in the introduction paragraph. 4. Responsibilities. The report should state management's responsibility for the financial statements and the auditor's responsibility for the audit report. These statements are also in the introduction paragraph. 5. Description of the Audit. The second paragraph (scope paragraph) should declare that the audit was conducted in accordance with generally accepted auditing standards and describe the principal characteristics of an audit, including a statement of belief that the audit provided a reasonable basis for the opinion. 6. Opinion. The report shall contain an opinion (opinion paragraph) regarding conformity with generally accepted accounting principles. 7. Signature. The auditor shall sign the report, manually or otherwise. 8. Date. The report shall be dated with the date when all significant field work was completed. 9. Auditor’s address 2-14 Handbook Recommendations are the highest level of authoritative support for GAAP. Textbooks, and journal articles are the lowest level. In between are regulatory requirements emerging issues task force guides and Handbook Guidelines. 2-15 Yes. The unmodified opinion sentence contains in the audit report implies, among other things, that the accounting principles used by the company are appropriate in the circumstances. 2-16 Four types of opinions and their messages: Type Message Unmodified opinion Financial statements are presented in conformity with GAAP. Adverse opinion Financial statements are not presented in conformity with GAAP. Qualified opinion Financial statements are presented in conformity with GAAP, except for one or more departures. Disclaimer of opinion Auditor's declaration that no opinion is given. 2-17 Two messages are usually implicit in a standard audit report by their absence: (1) disclosures are adequate, and (2) the accounting principles have been consistently applied. 2-18 The major differences between assurance standards and generally accepted auditing standards lie in the areas of practitioner competence, internal control, reporting, and suitability criteria. GAAS presume knowledge of accounting and require training and proficiency as an auditor (meaning an auditor of financial statements. The assurance standards are more general, requiring training and proficiency in the "assurance function" and knowledge of the "subject matter of the assertions." The assurance standards have no requirement regarding an understanding of the internal control structure for an information system. Considerations of internal control are implicit in the task of obtaining sufficient evidence. Anyway, some kinds of attested information may not have an underlying information control system in the same sense as a financial accounting and reporting system. Reporting is different because assurance on nonfinancial information do not depend upon generally accepted accounting principles. The assurance standards speak of "evaluation suitable criteria," and "conformity with established or stated criteria" and leave the door open for assurance on a wide variety of informational assertions. 2-19 An assurance engagement is: An engagement in which a practitioner is engaged to issue or does issue a written communication that expresses a conclusion concerning a subject matter for which the accountable party in an accountability relationship is responsible. 2-20 The theoretical essence of an assurance engagement is an person's ability to recognize the information being asserted, determine the evidence relevant to the assertions, and make decisions about the correspondence of the information asserted with suitable criteria. 2-21 The assertion is that amateur golfers can drive Wilson golf balls farther than competing brands. The Wilson company is the asserter (2nd party), the PA firm is the assurer (1st party), and the amateur golfer is the 3rd party owed accountability. The criterion is the average drive by the average amateur golfer. This criterion allows objective verification with sufficient numbers of representative amateurs at high (audit) level of assurance. Critical issues: how to define amateur golfer and the population it represents? How to obtain a representative sample of amateur golfers? What are representative golfing conditions? What is a sufficient sample size to determine the average drive with audit level assurance so that the auditor does not commit the logical fallacy of “hasty generalization”? 2-22 This is an example of a policy statement related to consultation ("Establishing Quality Control Policies and Procedures," QC 90.14). 2-23 Practice Inspection is the evaluation of conformity of member’s work with the appropriate standards of the member’s CICA Handbook and appropriate standards of member’s organization. It provides self monitoring by focusing on individual members performance with an emphasis on providing educational feedback to the individual member. 2-24 The PCAOB is harsher in terms of making the monitoring results more public (more readily identifying problem PA firms individually) and appears to be more thorough. In addition PCAOB is developing the quality control standards as well as the audit standards. 2-25 While GAAS relate to the conduct of each audit engagement, quality control standards govern the quality of a PA firm's audit practice as a whole (see CSQC-1 and CAS 220). IFAC gives nine elements of quality control for a PA firm. When a peer review or quality review is conducted, the reviewers "audit" the PA firm's statement of policies and procedures designed to ensure compliance with the nine elements. These statements vary in length and complexity, depending upon the size of the PA firm in Canada. SOLUTIONS FOR EXERCISES AND PROBLEMS EP2-1 a. PAs should not follow clients' suggestions about the conduct of an audit unless the suggestions clearly do not conflict with his professional competence, judgment, honesty, independence, or ethical standards. Where there is no disagreement about the results to be accomplished and the client's suggestion represents a good idea a PA can accept it. Within professional bounds, mutual agreement with the client is all right. The PA must never agree to any arrangement which violates generally accepted auditing standards or the Code of Professional Conduct. b. The reasons against dividing the assignment of audit work solely according to assets, liabilities and income and expenses include the following: 1. Work should be assigned to staff members by considering the degree of difficulty in relation to the technical competence and experience of individual staff members. 2. Sequence of work performed on an examination should be in accordance with an overall audit plan. 3. It is impossible to segregate work areas by major captions because often a close relationship exists among a number of accounts in more than one category, as for example where income is based on assets or expense is based on liabilities. 4. Often a single audit work paper is desirable to substantiate balances in accounts of various types, such as an insurance analysis supporting premium disbursements, the expense portion and the prepaid balance. 5. Duplication of staff effort would be more likely to occur if assignments were made on such a basis. 6. Frequently, the scope of work regarding a single account requires simultaneous participation by the staff, such as in the observation of inventories. 7. Many audit operations are not susceptible to division by category, as for example investigating internal control, testing transactions and writing the report. c. The PA's staff member whose uncle owns the advertising agency should not be assigned to examine Cooper's advertising account. The PA firm is responsible for avoiding relationships which might suggest a conflict of interest. Regardless of whether this staff member could be independent and unbiased in such a situation, outsiders probably will be influenced in their thinking by the fact that his uncle is the owner of the advertising agency. Even if a problem of ethics were not involved, it would be unwise for the PA to assign this staff member because the client's attitude could change significantly and the PA firm's position would be jeopardized if difficulties later arose in connection with the contract. Any situation in which bias exists or might arise should be avoided. EP2-2 The three generally accepted examination standards and their relation to the illustration are as follows: 1. The first standard is that the work is to be adequately planned and assistants, if any, are to be properly supervised. Fulfilling this standard would include the preparation of an audit program for the accounts receivable and reviewing it with the assistant prior to his beginning the examination. These things were not done. Also, the completed working papers should have been reviewed to determine whether an adequate examination was performed. The illustration states that this procedure was followed. 2. The second standard is that an understanding of the internal control structure is to be obtained in order to plan the nature, timing, and extent of other auditing procedures. The case presented makes no mention of any work on the internal control structure. Reliance entirely upon prior year working papers in lieu of an evaluation of the existing internal control is improper because changes may have been made in the system. 3. The third standard is that sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under examination. The assistant's preparation of working papers, confirmation requests and other procedures seem to fulfill the requirements of this standard if the audit work is properly performed and is of sufficient depth. EP2-3 From a theoretical viewpoint (and, in fact, from a practical viewpoint as well) such short notice of a request for an audit causes difficulties with planning the audit work, with staffing, and with reviewing the work--all of these features being elements of the exercise of due audit care. The December 26-January 20 period is a serious time constraint for a first audit. The greatest difficulties involve the third general standard (due audit care) and the three field standards. In view of the short notice and the time constraint, there may be some question as to whether a sufficient first audit could be completed by January 20. EP2-4 You must determine whether an unqualified opinion satisfies the GAAS reporting standard, in particular: a. Determine whether the financial statements are presented in conformity with GAAP. 1. Read the footnote description of accounting policies. 2. Use a GAAP checklist. 3. Review the working papers for any indication of accounting policies not described in the footnote or ones apparently not in conformity with GAAP. 4. Refer to GAAP criteria concerning the "meaning of present fairly" such as (i) The accounting principles are generally acceptable, having authoritative support. (ii) The accounting principles are appropriate in the circumstances. (iii) The financial statements are informative. (iv) The information is reasonably summarized. (v) Material adjustments have not been waived without good reasons. b. Determine whether any accounting changes have been made and whether accounting principles have been applied consistently. c. Determine whether the footnote disclosures are adequate to inform users of any material information evident in the working papers. EP2-5 GAAS in a Computer Environment In an audit of a computer-based system, adequate training and experience must be directly related to EDP. In particular, the auditor should be knowledgeable of what computer systems do, how to test the operations of an EDP system, and how to use EDP-unique documentation. The training and proficiency standard contributes to satisfaction of the independence standard by enabling the auditor to make his own decisions and judgments. Otherwise, he might tend to subordinate his judgment to other persons, possibly to client personnel. When the auditor lacks training and proficiency, it is virtually impossible to maintain an operational independence over audit decisions. An independence of mental attitude is futile if actual decisions are subordinated to others. The exercise of due audit care requires a critical review at every level of audit supervision of the work done and the decisions made by auditors Lacking the requisite skills and lacking independent decisions, the due care expected of an auditor at operational, supervisor, and review levels cannot be delivered. The first field work standard requires adequate planning and supervision of assistants. Training and proficiency in computer systems auditing is necessary in order to plan access to computerized records, programs, and to obtain machine time for conducting audit procedures. The planning should provide for an early examination of the computer system so that further procedures involving non-computer control and accounting features may be planned should they depend upon computer control procedures. Training and proficiency are very important for being able to obtain an understanding of the internal control structure in a computer system. Client personnel will expect audit personnel to be capable of working with a computer system. The third standard of field work requires the auditor to obtain sufficient competent evidential matter to provide a basis for an opinion on financial statements. Documentary evidence relating to a computer system includes program flow charts, logic diagrams, and decision tables that are not normally used in non-computer systems. Since these types of documentation are a part of the evidence, they must be understood by the auditor, and understanding of them comes through training and proficiency in their use. EP2-6 Audit Report Language a. The auditor is reporting to the body that has engaged the auditing services. While the report may be read and used by others who are indirect beneficiaries of the audit, current custom is not to address the report to the unknown class of users. b. The scope paragraph should specifically identify the audited statements by name so that there can be no mistake about the subject of the report. The alternative language is not as precise. c. The standard language effectively bases the audit on an extensive body of written auditing standards that are known to others and can be cited in case of controversy. The alternative language, on the other hand, seems to break loose from profession-wide quality norms and make the audit quality depend more on "the circumstances," which introduces an element of mystery and lack of definition into the report. d. The alternative wording is similar to the typical British audit report, and they seem to be able to live with it, but Canadian auditors believe that "opinion" connotes belief or judgment stronger than impression but less strong than positive knowledge. Canadian auditors do not wish to appear to have full, positive knowledge about the statements on the grounds that it's not feasible to know all there is to know about the financial statements. Also, the standard language leans heavily on GAAP as the criteria for fair presentation whereas the alternative language contains no reference to authoritative accounting criteria. EP2-7 The question requires one to review and discuss the current regulatory development in the audit profession. Some points that can be discussed include: The public accountability boards are intended to provide an additional level of independence for the public accounting function. Public concerns arose that public accountants and auditors lack independence because they are hired by and paid by the Company managers whom they are supposed to be monitoring. Since Company managers are effectively providing their own report cards when they issue their financial statements, the audit role has value because it provides an independent assessment of the validity of the claims managers are making in their financial statements. This independent audit assessment is important to outsiders using the financial statements because it enhances the reliability of that information. Since outsiders may suspect that managers will issue biased information if left to their own devices, they demand an independent assessment of the manager’s claims as this should detect any bias and require the manager to correct it. An effective independent audit function should also act as a deterrent against managers issuing biased reports in the first place. This function is referred to as monitoring. If outsiders question the independence of the auditor it cannot provide this monitoring value. A concern raised by some is that, if auditors lack independence, they themselves require some monitoring. It is this" monitoring the monitor" function that the public accountability boards were established to perform. At this time, the procedures these boards will follow to monitor public accountants and auditors are still evolving. The boards may also become involved in establishing generally accepted auditing standards, quality control review standards, peer review requirements and other specific procedures that public accountants and auditors will be required to adhere to. EP2-8 The case involves identifying a situation in which the audit scope is limited. In situation a) the auditor has been unable to determine the impact of a contract that the client company has entered into. One means by which an auditor might determine the potential financial impact of contract would be to make inquiries of the Company's lawyer and obtain assertions from the lawyer that could be relied on. If this is not possible, the auditor is not in a position to assess whether the contracts would have a material impact on the Company that should be included in the Company's financial statements. Here the auditor has a scope limitation that prevents providing an opinion on whether the financial statements are fairly stated as there is the possibility that the statements exclude a material liability that should either be accrued or disclosed. In this situation, the auditor has a responsibility to ensure that users are aware of the existence of the contract and the auditor's inability to assess the potential impact of contract or to obtain evidence from the Company or its lawyer regarding the potential impact. Users' decisions based on the financial statements may well be affected if they are aware that Company management is bound by a contract yet cannot provide a reasonable explanation of its impact. In situation b) the Company is subject to regulations that can have a financial impact if violated. Determining if a violation has occurred requires scientific information. In this situation, the auditor would be required to try to determine whether any violations had occurred. Appropriate evidence would require obtaining representations from people with scientific qualifications because experts must be qualified in order for auditors to rely on their representations as evidence. In this situation, it is possible that the auditor could obtain reasonable evidence from scientific experts so no scope limitation would arise. However, similar to situation a) if the auditor it is unable to obtain evidence that can confirm whether the financial impact of complying with the environmental regulation has been properly measured and reported, then the scope limitation exists and this should be noted in the audit report. Similar to situation a), users’ decisions may be affected by the fact that the company is not able to provide evidence to the auditor about whether or not it is violating governmental regulations. EP2-9 ITR's statements does not appear to be an assurance engagement, after considering the components of assurance engagements. The parties involved are ITR and Knovel. ⸀ These parties could be involved in an assurance engagement, with Knovel making in assertions regarding a subject matter and ITR providing assurance to third parties regarding that assertion. The subject matter is how long it takes to recover, or "payback", the investment in Knovel's new software product. ⸀ If the objective of the engagement is to provide assurance that this payback is three months, the assurance provider needs to obtain management's acknowledgment of responsibility for the subject matter as it relates to this objective. Since Knovel management cannot be responsible for how a purchaser of a software product implements that product to achieve operational savings and recover the investment in that product over a period such as three months, it would be difficult to identify generally accepted, appropriate criteria for assessing the subject matter in this case. This leads to the conclusion that this is not a subject matter on which an assurance can be provided in accordance with assurance standards set out by the CICA. The accountability relationships would be between the Company and the assurance provider, and between each of these parties and third parties. The third parties would be potential customers that could be making decisions based on the assertion and on the assurance attached to that assertion. These accountability relationships could result in an assurance engagement. The nature of the report that could be issued, in accordance with CICA assurance standards, would be as follows: ⸀ The report would need to identify to whom it is addressed, the objective of the assurance engagements, the entity and the subject matter covered by the engagement, management's assertion, the responsibilities of management and the assurance provider, the standards that were followed in conducting the engagement, the criteria against which subject matter was evaluated, a conclusion indicating the level of assurance being provided, the name of the assurance provider, the date and place where the assurance report was issued. The president may have wanted the ad stopped because, effectively, the ad is providing assurance related to the claim that the Knovel software will payback in three months. Since ITR has not performed an assurance engagement, it has no basis for providing such assurance. Thus it is not appropriate to publicize this claim in a way that implies ITR is providing assurance on it. EP2-10 The question involves the relation between GAAP and providing an audit opinion. One approach to this issue is as follows. a) When an auditor needs to assess whether CICA Handbook Recommendations have been followed but the Handbook is silent on a particular issue, auditors usually go down a hierarchy to find the next highest source of support for the client's accounting solution to a financial reporting problem. The auditor can refer to the positions taken on accounting matters by provincial securities commissions, to accounting pronouncements issued in other countries (for example, the US Financial Accounting Standards Board or the International Accounting Standards Board), industry accounting guidelines and practices followed in financial reports of other companies in the same industry, CICA EIC consensus positions, accounting research reports, textbooks, etc. In using any of these supports, including the CICA Handbook, to determine what is GAAP in a particular situation, the exercise of good professional judgment by the auditor is critical. In applying judgment, the auditor has to take into account the context of the situation, how the information will be used, who the users are and what their level of sophistication and access to other information is, the motives of the preparers of the accounting information, and any other relevant issues that in the auditor’s experience may shed light on the reliability and appropriateness of the reported information. Possible examples of accounting issues that may not be covered in CICA Handbook Recommendations (current at time of writing, but note that CICA Handbook Recommendations are updated frequently) - revenue recognition for complex software sales that combine software and future services such as maintenance -capitalization or expensing of environmental control equipment expenditures b) When the CICA Handbook Recommendations allow for different choices of accounting methods, the auditor needs to consider whether the client's choice is appropriate in the circumstances. Again, the exercise of good professional judgment by the auditor is critical. In applying judgment, the auditor has to take into account the context of the situation, how the information will be used, who the users are and what their level of sophistication and access to other information is, the motives of the preparers of the accounting information, and any other relevant issues that in the auditor’s experience may shed light on the reliability and appropriateness of the reported information. Examples of accounting choices set out in CICA Handbook Recommendations (current at time of writing, but note that CICA Handbook Recommendations are updated frequently) - revenue recognition - amortization method - inventory costs flow method EP2-11 (Some instructors may prefer to defer this question until after Chapter 14 is covered.) The case presents a scenario where events occurring subsequent to the year end potentially have an impact on the information that should be reported in Bunting's year-end financial statements. One possible analysis follows. One issue that is raised is the timeliness of financial reporting. By fixing a set date as of which financial statements are prepared, financial statements can become out of date before they are even issued, especially when business and economic conditions are undergoing rapid change, as is the situation in this case. Another issue is the sensitivity of the Company's operations to information that might be reported in the financial statements. In this case, information regarding the launch of a competing product can have a harmful impact on sales contracts the company is in the process of negotiating. Here Company management is arguing that this is proprietary information and that it has to be kept private. On the other hand, the auditor believes this information has a material impact on the company’s financial position and therefore it must be reported to users. The auditor might also argue that this information exists so it is very likely that potential customers are also aware of it already. By not including the impact in financial statements that are currently being prepared, the company runs the risk of giving the impression that is trying to mislead these potential customers. This can be very damaging to the company's reputation, and have very significant negative impact on its future operations. This negative impression would be aggravated by a qualified audit report which indicates that, not only was management aware of this new development, but it also refused to disclose the information even though the company’s auditor was insisting on disclosure. A further issue is the reliability of estimating the potential impact of the new product on the Bunting's future earnings. As management points out, since the product is untried in the marketplace it may well not operate as advertise. So it is a conjecture to say that its impact on Bunting's operations can be known at this time. This is difficult trade-off for the auditor to make: how should information that is highly relevant to users and their decisions but very difficult to measure reliably the handled in audit engagement? This line of reasoning would suggest that the auditor's may have gone too far in including estimated amounts and their impact on financial statement items in their audit qualification. This may explain why Bunting's management refused to accept the auditor's approach, resulting the qualified audit report. Other valid issues based on the case facts can be identified, analyzed from different perspectives, and concluded on. EP2-12 (Some instructors may prefer to defer this question until after Chapter 4 is covered.) The following are some of the points that can be discussed. Professional skepticism is required to comply with the general standard of auditing and that requires the auditor to conduct the audit with due care. Accepting management representations as being truthful without attempting to verify them by gathering relevant appropriate audit evidence is not exercising the required level of care. The need for the auditor to rely on management representations at some point creates a conflict. Some representations are not amenable to verification using feasible audit procedures. A good example of this is the completeness representation. Management represents that it has presented complete information concerning its liabilities, its revenues, its commitments, etc. but to verify these claims is not feasible. For example, verifying completeness of liabilities would require the auditor to inquire of every possible creditor - this is impossible. In practice this conflict is resolved some extent through the requirements of generally accepted auditing standards. In general, any management claim that can be verified by reasonable audit procedures will be verified, subject to consideration of its materiality. Representations that cannot be verified by reasonable means are documented in management’s "Letter of Representation". Further, management's responsibility for the financial statements is explained in the standard wording of the auditor's report. Also, many companies, especially public companies, include with the financial statements a "Statement of Management's Responsibility" to communicate to users management's role in preparing the financial statements and its responsibility for the assertions, accounting choices and estimates contained in those financial statements. To the extent that these conflicts cannot ever be completely resolved, this a limitation to the assurance that an audit can provide. Audits can never provide 100% assurance, and knowledgeable users are expected to be aware of the limitations of audits. EP2-13 (Some instructors may prefer to defer this question until after Chapter 5 is covered.) The question requires the application of basis assurance principles to a unique setting , United Nations weapons in Iraq. One possible response is as follows. The subject matter is the existence of chemical, biological and nuclear weapons in Iraq. Using the analogy of auditing for missing liabilities in a company, the Iraqi government ("management") represents that there are no hidden weapons (" unrecorded liabilities") An approach for the assessing risks and probabilities of weapons existing. Given the concerns of the UN about the harm that might arise from the Iraqi government possessing weapons of mass destruction, the inspectors would want to reduce the risk of missing hidden weapons to very low level. Two parallel this to an audit of financial statements, this would be like setting the acceptable audit risk very low, which the auditor will do when the consequences to the auditor of missing a misstatement in the financial statements can be very costly (for example, an audit of a public company or a financial institution). The probabilities of weapons existing is comparable to the assessment of inherent risk in a financial statement audit. Based on their resources devoted to the weapons inspection exercise and a heightened attention focused on the inspectors work and findings, it seems the UN assessed the inherent risk that weapons exist as being very high. This may have been based on internal investigations, intelligence reports or other information available to the inspectors but not public knowledge. To implement the inspection, the inspectors would have to follow a systematic process similar to that followed by financial statement auditors. The inspectors would need to obtain a knowledge of the types of weapons and weapon manufacturing equipment that may exist, where such weapons could be concealed, the process involved in creating such weapons and transporting them. This could be paralleled to the "knowledge of business" that the financial statement auditor requires in order to plan and execute the audit. This knowledge would inform the inspectors of the kinds of places that they need to visit and the kinds of evidence that may exist to indicate that weapons have been created or transported to a particular location. Any internal reports or other intelligence that exists concerning the use of public buildings for storing concealed weapons would also be relevant to determining the probabilities that weapons are concealed in particular locations. A planning procedure would need to be followed to scope out the extent of the territory and existing structures and facilities that will need to be inspected the staff required. This will determine the number of inspectors that need to be employed, the types of qualifications they require, the specific procedures they will have to perform and to estimate the time required to complete the inspection. EP2-14 According to some recent CPAB reports PA firms seem to have most problems with meeting the independence requirements and the quality of documentation in their audit files. These problems have been ongoing for the first 10 years of the CPAB’s monitoring. In part this may be why the Handbook now has a special section dealing with standards for quality control for PA firms. CPAB findings seem to increasingly influence the CICA and CICA, in turn, is influencing IFAC. For example, the CICA at the urging of CPAB has recently created three committees to look at research and professional literature related to 1. The audit report 2. Auditor independence, including mandatory rotation of audit firms 3. The role of audit committees. EP2-15 One major source of the expectations gap is the public’s expectations regarding auditor responsibilities to detect fraud. Discuss in class. The profession’s response is discussed in chapter 7. This is a complex problem. Some questions to consider in class. How much assurance can the auditor give that management (or anyone) is honest? Should auditors provide the same assurance for detecting management fraud as for detecting lower level employee fraud? Should the auditor have responsibility only for fraud affecting the financial statements or for any fraud? Does fraud have to be a material amount, or is all fraud automatically material no matter how small the amount? It is also important to keep in mind that accusing somebody of committing fraud (or any criminal act) can lead to libel unless the accusation is proven in a court of law. In Canada’s legal system an individual is considered innocent until a criminal act is proven in a court of law. These are just some of the complications in trying to close the expectations gap. For now it is sufficient for the students to get a general idea of the complexities and this can be done best through class discussion. EP2-16 There definitely seems to be more of an expectations gap in the private sector. Chapter 1 illustrates that public sector auditors have some of the best reputations in Canada. You cannot say the same about partners in the private sector! Some might argue that is due to the fact public sector auditors arguably have more independence than private sector auditors. See application case discussion for chapters1 and 2. For example, when an auditor general decides which organization to audit and what type of audit (VFM? Compliance?)to perform, the auditee cannot say no! Public sector auditors have been very successful in rooting out corruption and waste and this appears to be closer to the public’s image about what all auditors should be doing. See discussion in EP15. Perhaps all audits should be more like VFM audits in meeting the public’s expectations. Again, surveying class attitudes at this point is a good way to get students thinking about what should be the role of auditors and comparing that to what standards actually require. CHAPTER 3 Auditors’ Ethical and Legal Responsibilities SOLUTIONS FOR REVIEW CHECKPOINTS 3.1 This arises from the three party accountability discussed in chapter 1. The auditor is hired because users expect there may be such a conflict. If users completely trusted management there would be no need to have an auditor. This is the only way to detect fraudulent or misleading reporting. The logic is to reduce this potential to an acceptable level of risk. If the auditor assumed this risk was zero to start with the auditor would not need to provide evidence that the possibility is low, and that contradicts the reason users demand an audit. 3-2 No, the auditor cannot detect deception without being skeptical. A non-skeptical auditor on finding evidence of fraud may not treat it with the significance it deserves. The rule that suspicious transactions or evidence of management deceit should automatically be considered material, even when the absolute amounts involved may be very small or insignificant, is an example of skeptical logic in action. Since three party accountability implies some degree of mistrust of management by users, the auditor must incorporate skepticism in his or her reasoning process when management makes assertions about the financial statements it has prepared. 3-3 A professional accountant must be prepared to be agent, spectator, advisor, instructor, judge, critic. 3-4 Apparently, in ethical philosophy, the word "conscience" is used to describe the "undefinable mental process that yields moral decisions." A close kin in the political science terms would be "anarchy." Conscience might not be a sufficient guide for personal ethics decisions because the individual's undefinable mental processes may be based on caprice, immaturity, ignorance, stubbornness, or misunderstanding. Conscience may fail to show the consistency, clarity, practicability, impartiality, and adequacy preferred in ethical standards and behavior. Exactly the same can be said about professional ethics decisions because a nonhypocritical individual can no more split his behavior between personal life and professional life than he can voluntarily split his own personality. 3-5 The rule "Failure to tell the truth is wrong" would (a) require that you not serve as a bank director when a conflict of interest might arise, (b) tell the employer what you know about the forgeries. This rule may be called imperative because it requires the truth regardless of what you might personally feel about the consequences. Strict duty based or imperative theories (e.g., Kant) excuses the individual from undesirable consequences as long as his decisions do not cause other people to be used as means. 3-6 Utilitarian ethics theory requires that a decision maker recognizes value attributes of the consequences of ethical choice alternatives (good v. evil), somehow measure or weigh these, and then decide on the basis of the greater good (or the lesser evil). Duty based ethics does not require that consequences be considered. 3-7 Monastic theories are based on idealizations or simplifications of the real world. The real world is “messy” with the context of a situation, such as whether there is three party or two party accountability, having a major impact on the proper role of an individual. Everyone has multiple social roles in life and it is the conflicts in these multiple roles that seem to cause the most problems for monastic theories. 3-8 In the current audit environment, PAs are expected to better justify their decisions. This need for justification, including the consideration of ethical issues, increases the importance of critical thinking. 3-9 Three specific aspects of on-the-job independence 1. Programming independence 2. Investigative independence 3- Reporting independence 3-9 Professional ethics provides guidance on the conflicts of interest created by the PAs roles, whether as auditor, tax advisor, or management consultant, in helping justify PA’s decisions. 3-10 In a class action lawsuit, a few aggrieved persons with small losses can bring suit on behalf of a large group of similar persons, collectively having large losses (as in a securities offering). Large lawsuits often result in large damage awards, and many lawyers are willing to take suit plaintiffs on a contingency fee bases, that is for 25% - 40% of the amount awarded. Such fees are very lucrative for lawyers, and probably less lucrative for their clients. Anyway, the losses loom large for PAs and their insurance companies. 3-11 Some causes are as follows: ⸀ Failure to report known departures from accounting principles, including misinterpretation of accounting principles. ⸀ Failure to conduct audits properly, including (a) misinterpretation of auditing standards, and (b) faulty implementation of auditing procedures. ⸀ Failure to detect management fraud, fraudulent financial reporting. ⸀ Actual involvement in fraud. ⸀ Also, business failure by clients after rendering an unqualified audit report. 3-12 Lawsuits related to tax practice, about 35 percent. SOLUTIONS FOR EXERCISES AND PROBLEMS EP3-1 Independence, Integrity, and Objectivity Cases a. Interpretation--Honorary Directorships and Trusteeships. The PA will not be considered independent unless: 1. the position is in fact purely honorary, and 2. listings of directors show she is an honorary director and 3. she restricts participation strictly to the use of her name, and 4. she does not vote or participate in management functions. b. Interpretation--Retired Partners and Firm Independence. Since the PA is still active with the firm as an ex- officio member of the income tax advisory committee, meeting monthly, his situation would impair the appearance of the firm's independence. The CPA should either resign from the Palmer board or cease his association with the accounting firm. Another ethics issue arises over Pratt's ability to hear about tax problems of other clients, and his directorship with Palmer would raise appearance questions about confidential information (Rule 301). c. Interpretation--Accounting Services. The PA must be careful to know whether outsiders would perceive relationships that would indicate status as an employee, hence impairing the appearance of independence. In particular, the PA must. 1. Not have any business connection with Harper Corp. or with Marvin Harper that would in fact impair independence, objectivity and integrity, and 2. Impress Marvin Harper (and the board of directors) that they must be able and willing to accept primary responsibility for the financial statements as their own, and 3. Not take managerial responsibility for conducting operations of the Harper Corp. (although the PA's supervision of the bookkeeper seems to have this characteristic), and 4. Conduct the audit in conformity with GAAS and not fail to audit records simply because they were processed under the PA's supervision. This case assumes Harper Corp. is not reporting to the SEC, in which case the PA's audit independence would certainly be impaired as a result of participating in the bookkeeping work. d. Interpretation of--Effect of Family Relationships on Independence The PA's wife's interest is attributed to him, and he would not be independent. The financial interest is considered direct. e. Interpretation The PA is still not independent, so long as the daughter is a dependent child. The financial interest is considered direct. f. Interpretation Still not enough. The grandfather (either the PA's father or his father-in-law) is considered a nondependent close relative, but the appearance of independence is impaired. The grandfather's investment is material (50 percent) in relation to his net financial resources. g. Interpretation Finally. The remote kin (uncle) who is geographically separated and in infrequent contact is far enough removed. h. Interpretation--Meaning of Certain Independence Terminology The firm's independence is not impaired by the attributable managerial relationship so long as the PA is not connected with the ATC audit. i. The PA's promotion changes the situation. When he becomes a partner, a stricter standard will apply and his firm's independence will be considered impaired even if he does not work on the ATC audit. Such occurrences are not really too rare in practice, affecting family relationships other than husband and wife. PA firms' resolutions are that one must forgo partnership or the other must give up his or her job with a client. j. Interpretation Such loans would impair independence. EP3-2 Independence, Integrity, and Objectivity Cases (a, b, c, d, e, f) Interpretation--Effect of Actual or Threatened Litigation on Independence. In general, when the present management of a client company commences or expresses an intention to commence legal actions against the auditor, the auditor and the client management may be placed in adversary positions in which the management's willingness to make complete disclosures and the auditor's objectivity may be affected by self-interest. Independence may be impaired whenever the auditor and his client company or its management are in positions of material adverse interest by reason of actual or threatened litigation. Various situations are hard to generalize, and the responses offered below are guidelines expressed in AICPA Ethics Interpretations 101-6 (Effect of Litigation). SEC Accounting Series Release No. 234 (December 1977) expresses similar guidelines. a. An expressed intention by the client company to begin litigation alleging deficiencies in audit work is considered to impair independence if the auditor concluded that there is a strong possibility that such a claim will actually be filed. b. The commencement of litigation alleging deficiencies in audit work would be considered to impair independence. c. The commencement of litigation by the auditor alleging management fraud or deceit would be considered to impair independence. d. The claim under subrogation by the insurance company would not "normally" affect the auditor's independence. In this case, the client company and members of management are not the nominal plaintiffs However, the idea of "normally" needs to be evaluated. If members of Contrary management are going to testify on behalf of the insurance company's interest and thus act in an adversary relation to the auditor, independence would seem to be impaired. The substance of the situation is essentially the same as if Contrary Corporation was the named plaintiff. e. Litigation not related to the audit work, whether threatened or actual, for an amount that is not material to the audit form or to the financial statements of the client company would not usually be considered to affect the PA-client relationship in such a way as to impair independence. According to the SEC, this situation might impair independence.) f. The class action lawsuit against both auditor and company in itself would not alter fundamental relationships between the company management and directors and the auditor and therefore would not be considered to have an adverse impact on the auditor's independence. These situations, however, should be examined carefully. Actions to be taken When independence is considered impaired, the auditor should (a) withdraw from the audit engagement in order to avoid the appearance that his self-interest would affect his objectivity or (b) issue an opinion denial because of lack of independence. g. Interpretation--Effect on Independence of Financial Interests in Non-clients Having Investor or Investee Relationships with a Member's Client The PA's financial interest in Dove Corp. (investor) is sufficiently large to allow him to influence the actions of Dove, and the PA's (and the PA firm's) independence would be considered impaired. The PA's ability to influence Dove Corp. could permit him to exercise a degree of control over Tale Company (the investee, a client) that would place the PA in a capacity equivalent to that of a member of management. h.i. Interpretation Assuming that the North Country is a profit-seeking enterprise, the independence of the auditors is not impaired by the association of the two individuals who served both as members of the auditing firm and as directors for the client during the period examined as long as they have ended all ties with the bank and are not involved in the audit. j. The auditor's services may consist of advice and technical services, but he must not make management decisions or take positions which might impair his objectivity. The independence of the auditing firm would be compromised by any partner making a decision on loan approvals and the minimum balance checking account policy, but normally not by his performing a computer feasibility study. If the former controller's participation in the feasibility study was objective and advisory, and his advice was subject to effective client review and decision, the firm's independence has not been compromised. It is desirable, however, that the former controller not participate in the audit of the North Country's financial statements. (AICPA Adapted) k. The acceptance by the PA of the unsecured interest-bearing notes in payment of unpaid fees would not be construed as discrediting the PA's independence in his relations with his client because the notes are merely a substitution for an open account payable. The notes are merely a substitution for an open account payable. The rule of professional conduct that prohibits a PA from having any financial interest in a client does not extend to the liability for the PA's fee. If liability for the PA's fee was considered to be financial interest in a client, the present form of the PA-client relationship would not be permitted to continue because often (frequently in engagements for continuing audits) the client's statements being audited include a liability for the CPA's services. Under SEC rules, however, a definite arrangement for paying the notes must be stated by the client. However, the acceptance of two shares of common stock (or prior commitment to accept stock) would be a violation of Rule 204. Any direct financial interest such as common stock holdings are construed as discrediting the PA's independence. (AICPA adapted) l. Interpretation 204 -- Acceptance of a Gift. The rules apply to Johnny if he’s a student member of the provincial institute. The ruling applies to independence of a firm if an employee accepts a gift that is more than token. Independence is impaired because a member cannot permit his employees to break rules he himself is obligated to observe. m. Member as Bank Stockholder. The financial interest is indirect and in respect of the relative size may be considered immaterial. Hence, independence is probably not impaired with respect to the borrowers who are clients. n. Interpretation -- Past Due Fees. Independence is considered impaired. At the time a member issues a report on financial statements, the client should not be indebted for more than one year's fees. In the Groaner case, the debt would be for last year and the current year audit fees. Groaner will have to pay the fees for last year when the current year report is ready (or else get a non-independent disclaimer). The past due fees take on characteristics of a loan within the meaning of Rule 204, and collection may depend on the nature of the audit report on the financial statements. o. Interpretation --Executive Search. Independence would be impaired under Rule 204 since decisions about personnel employment are considered a management function. Some services may be performed to help (advertising, screening, recommending candidates), but PA firms are currently very cautious about these services. They have been criticized by persons sensitive to the MAS-audit independence issue. p. Interpretation. Independence is impaired when an auditor owns limited partnership interests in a partnership in which a client or its officers, directors, or principal stockholders also own interests, when: (1) the PAs interest is more than 20 percent of the limited partnership interests, (2) the interest of the client is more than 20 percent, or (3) the PA knows about the client's investment. (When these limits and conditions are not exceeded, independence is not impaired.) EP3-3 Rules 102, 202, 204, 205, 206, 209, 210, 213, 217, 401, 402 (ICAO) Situation A Rule 205 prevents CA’s, from associating themselves with false or misleading documents. There has been a limitation in scope on this audit because documents were destroyed in a fire. The audit report must be qualified. If it is not, rule 205 has been violated. Rule 202 requires CA’s to perform their duties with integrity and due care. Rule 206 requires CA’s to comply with the recommendations set out in the CICA Handbook. Randi will violate both of these rules if she issues an unqualified audit report. Situation B Improper use of confidential client information is prohibited under rule 209. Rule 210.1 prohibits CA’s from disclosing confidential client information. Lori is in violation of both these rules. Not disclosing the reason does not reduce the violation. Lori may have violated securities commission insider trading rules. Therefore, she may have violated rule 213 which prohibits a CA from associating with any unlawful activity. If Lori is found guilty, she must inform the Institute under rule 102(1). She has also brought disrepute to the profession under rule 210. Rule 204.1 requires auditors to be free of any influence, interest or relationship that would impair real or perceived objectivity. This requirement extends to partners, members of the immediate family and family members who live in the same house. If Tom lives with Lori or is economically dependent on her, Lori’s objectivity has been compromised. (Candidates may also conclude that Tom and Lori are not closely related and there is no problem with objectivity.) Situation C Rule 204 requires a public accountant to practice under his own name. Larry must use “Larry Wilde, CA” so that he does not violate this rule. If Larry uses “accounting services,” he will violate rule 401.1 which specifies that the description of a practice shall be “chartered accountant” or “public accountant”. Rule 217.1 prohibits advertising that is false or misleading, contravenes professional good taste, makes unfavourable reflections on the profession or any member, or includes statements that cannot be substantiated. “Quality Chartered Accountancy Services” implies that other CA services may be lower quality. Also, this statement cannot be substantiated. EP3-4 Rules 203, 205, 210, 217, 301 (ICAO) Rule 203 requires a member to sustain his professional competence by keeping himself informed of developments in professional standards in all functions in which he practises or is relied upon because of his calling. Aileen is unable to answer a specific client request about the new GST. However, there are several mitigating factors. One is that she did not lead the client to believe that she would be providing detailed information before July 1. Rule 205 prevents a member from being associated with a statement which he/she knows is false or misleading. Issuing the newsletter before increasing her understanding of the GST would be a violation of this rule. In addition, Aileen clearly intends to upgrade her understanding of the tax in the near future. Rule 210 deals with the revelation of confidential client information. If Aileen discusses specific details about her client at the conference, she will probably be in violation of this rule. She will have to word her questions and conversations to be discrete. The circulation of a newsletter to clients is permitted by rule 217. However, the newsletter may only be sent to non-clients in response to a specific request for a copy. Asking the client for names of potential recipients would be in violation of the rule preventing solicitation. EP3-5 Common Law Liability Exposure a. Yes. Smith was a party to the issuance of false financial statements and as such is a joint tortfeasor. The elements necessary to establish an action for common law fraud are present. There was a material misstatement of fact, knowledge of falsity (“scienter”), intent that the plaintiff bank rely on the false statement, actual reliance and damage to the bank as a result thereof. If action is based upon fraud there is no requirement that the bank establish privity of contract with the PA. Moreover, if the action by the bank is based upon ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party beneficiary (an exception to the strict privity requirement). Thus, the bank will be able to recover its loss from Smith under either theory. b. No. The lessor was a party to the secret agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if he was damaged indirectly, his own fraudulent actions led to his loss, and the equitable principle of "unclean hands" precludes him from obtaining relief. c. Smith was not independent. His report is improper and he is probably subject to disciplinary action. According to the ethics interpretation on actual or threatened litigation: "An expressed intention by the present management to commence litigation against the auditor alleging deficiencies in audit work for the client is considered to impair independence if the auditor concludes that there is a strong possibility that such a claim will be filed." EP3-6 Litigation Resulting from Bankruptcy of a Client a. Overview Our role is to investigate the work of the auditors who conducted the examination of a now bankrupt real estate company. The client in this investigation, is a bank who loaned money to the real estate company. The bank is asking us to determine whether or not the real estate company’s auditors were negligent in performing their examination (i.e., did the auditors comply with GAAS). This is the basis for a possible court case. Guidelines We should establish whether or not the auditors acted in a manner in which prudent practitioners would in similar circumstances (i.e., did the auditors follow the standards of the profession). We must determine whether or not: - the financial statements were presented in accordance with GAAP, including the CICA Handbook and industry practice (CIPREC) - the audit was conducted in accordance with GAAS as set out in the CICA Handbook, and was consistent with other sources such as the CICA Audit Techniques Study for audits of real estate companies. Outline We should assess the auditor’s independence (e.g., the basis of client billing, the relationship of the auditors to the real estate company), whether the auditors had adequate technical proficiency and if their work was undertaken with due care. By reviewing the auditor’s working papers, we should determine whether or not the examination standards were met and consider the following: - if the audit was properly planned (is there evidence of: knowledge of the real estate industry and of the client’s business; determination of auditor risk and materiality with reference to financial statement users; determination of the audit approach) - if assistants were properly trained and supervised (evidence of working paper review) - if there was a study and evaluation of those internal controls on which the auditor relied in determining the nature, extent and timing of substantive procedures - if sufficient appropriate audit evidence was obtained to support the content of the audit report (consideration of: materiality; results of compliance testing; support for sample sizes; subsequent events; support for specific audit objectives; adequacy of note disclosure) b. The courts will decide the auditors’ liability to the bank based on the following criteria: - did the auditors owe the bank a duty of care? (i.e., was the bank a foreseeable third party who would rely on the financial statements?) - did the auditors breach their duty of care by performing the audit negligently? (i.e., without due care) - did the bank suffer a loss? - was the bank’s loss connected to the auditors’ breach of duty of care? SOLUTIONS FOR DISCUSSION CASES DC3-1 General Ethics This is a thought-type question that deals with the "whatever you can get away with" issue. Of course, an act has the same ethical character whether it is known to others or not. (Remember that an act that affects no one but the agent--rare as such acts may be--is one that has no substantive ethical implications.) The latter part of the question asks the student to project himself into his future business role. DC3-2 Church Gift Ethics Problem 1. Many students' initial reaction to this situation is to refuse to accommodate the member because the deal sounds manipulative. Another way to analyze it is to realize (a) that the member could give the stock without any prior arrangements, (b) the church could sell the stock on the market, and (c) the member could reacquire it on the market. All this accomplishes the same thing as the arrangement except that both parties avoid payment of brokerage commissions. In the author's opinion, a utilitarian weighing of the consequences suggests that the treasurer should accommodate the member. After all, the tax code permits deductibility of such contributions, and the essence of a contribution is accomplished. 2. Having reached the conclusion in (1), one's conclusion would not depend upon the particular financial position of the church. However, the three conditions are given to prompt students who would otherwise reject the deal to think about how particular circumstances might affect their conclusions, if at all. DC3-3 Audit Proposals The audit proposal scenario was adapted from a Wall Street Journal article entitled "Ethics on the Job: Companies Alert Employees to Potential Dilemmas" (July 14, 1986). It was reported to have been used in a company ethics training/awareness session. Cases like this do not pretend to have "solutions" 100 percent acceptable to everyone. The Wall Street Journal reported the following: Some participants said: Dena should do as she's told. She's not on a level where she's supposed to think. She doesn't know all the facts. It may not be what she thinks. Others said: Dena should refuse. The situation has a "bad smell." She should keep her own hands clean. (Caution. Always worry about someone who thinks through his or her nose!) DC3-4 Engagement Timekeeping Records As in all cases of this type, a "solution" is difficult. Some discussion thoughts: 1. Craig is indeed lying by making false timekeeping records. 2. The budget appears to be unrealistic. Apparently, Sarah did not know (or did not care) that seven cash accounts had been added, and the work should take longer (probably in comparison to last year's time budget). 3. Craig does not seem to give credit to Sarah for the possibility of explaining why the work took longer. The case seems to set Sarah up as a tyrant about the budget. 4. Craig compounds the lie by putting the extra time in a budget area where someone else will seem to have fewer hours to do another segment of the work (internal control evaluation). Craig is also improving his chances of getting caught, because surely Sarah can see that his work had little or nothing to do with internal control evaluation. 5. Juggling the time records, if successful, will have an impact on next year's audit staff. Auditors typically use the prior year actual time records to help plan the current time budget. If they are misstated, the next time budget may also be unrealistic. Sooner or later, some poor assistant will have to pay! DC3-5 Audit Overtime Many aspects of this case are similar to 16.36, except that Elizabeth did not put the extra time anywhere else. She just donated four hours of her own time (maybe seven hours if she was not paid for the time worked at home). Of course, her action makes it look like the work can be done in six hours next year. Receiving help from her husband overnight should not raise any new issues. This event just increases the number of unreported hours. (Actually, some students may see a new issue related to Rule 209 --revealing client information to someone outside the firm.) Leaving the work with the husband raises the new issue of having audit work done, unsupervised, by someone not employed by the firm who may be unqualified to do it correctly. Students should ask whether Elizabeth reviewed all her husband's work before putting in the working paper file. (The confidentiality issue can be raised again.) DC3-6 Professional Corporation and Other Issues 1. The formation of a professional corporation to practice public accounting is prohibited by Rule 408 of the ICAO. Currently the only ICAO exception is association with corporations approved by other provincial institutes. However, Rule 402 may be changed in the near future. In the U.S. the formation of a general corporation is permitted by the AICPA, provided state law also permits CPAs to practice in such a corporate form. In this situation the following characteristics, approved by Council, have been specifically violated: a. The insurance service to be provided by Bradley might create a problem if it creates a conflict of interest. b. All shareholders of the corporation shall be persons engaged in the practice of public accounting as defined by the Code of Professional Ethics. Bradley, a 50 percent stockholder, is not so qualified. c. The right to practice as a corporation or association shall not change the obligation of its shareholders, directors, officers, and other employees to comply with the standards of professional conduct established by the AICPA. As indicated herein, Gilbert has not complied with certain standards of professional conduct. 2. A member in the practice of public accounting may have a financial interest in a commercial corporation which performs, for the public, services of a type performed by public accountants and whose characteristics do not conform to resolutions of Council, provided such interest is not material to the corporation's net worth, and the member's interest in and relation to the corporation is solely that of an investor. Certainly Gilbert's 50 percent interest is material to Financial Services, Inc., and Gilbert's status is not that of an investor. In this respect, Gilbert is in violation of Rule 505. 3. Gilbert might be in violation of Rules which state: "...a member shall maintain objectivity and integrity [and] shall be free of conflicts of interest..." The insurance aspect of the business might create conflicts of interest. 4. Rule 404 also prohibits practice under a name which is misleading as to the type of organization. The name, Financial Services, Inc., is probably not a violation. 5. Publication of the ad in the local newspaper does not violate Rule 217 of the Code since the rule permits advertising. 6. Expressing an unqualified opinion on Grandtime's financial statements which did not disclose a material lien on the building asset is a violation of both auditing standards, and accounting principles. 7. Having Bradley inform the insurance company of the prior lien on Grandtime's building is a violation of Rule 210 of the code which enjoins a member from violating the confidential relationship between himself and his client without consent of the client. The lien should have been disclosed in Gilbert's report on Grandtime's statements, but it may not be disclosed by him independently to a third party unless the client agrees to such disclosure. Gilbert should have first exhausted all means to persuade Grandtime to correct the error by recalling the original financial statements and reissuing them in corrected form with a new auditor's report. DC3-7 Lehman Bankruptcy Case This case is discussed in more detail in Chapter 14. When Lehman Bros. America’s fourth largest bank failed in Sept, 2008, it helped set off the financial crisis that is still affecting the world economy. See box in chapter 1 for some background on this crisis. A major fallout from this crisis is that everyone is asking why there were no disclosures of going concern problems for all the financial institutions that had to be bailed. This is a question being asked by regulators, corporate governance experts, and auditors around the world. The details of Lehman Bros. specifically are given in chapter 14. The auditor publicly defended itself by stating “There is no factual or legal basis for a claim to be brought in this contest against an auditor where the accounting for the underlying transaction is in accordance with the Generally Accepted Accounting Principles (GAAP). Lehman’s audited financial statements clearly portrayed Lehman as a highly leveraged operating in a risky and volatile industry.” Note the auditor does not state that the financial statements presented fairly, only that they are in compliance. The issues here seem quite similar to the Continental Vending Case in that the auditor may be hiding behind GAAP in not disclosing up to $50 billion in debt because of an accounting technicality. This detailed guidance has now been dropped from U.S. GAAP. Details provided in discussion case in chapter 14. For now this can be viewed as another illustration that principles- based reasoning in audit judgments may help auditors meet public expectations. CHAPTER 4 Reports on Audited Financial Statements SOLUTIONS FOR REVIEW CHECKPOINTS 4-1 Investors, creditors and other users tend to assume that financial statements are audited and "everything is OK" whenever they know a public accountant has been involved in producing the statements. If an audit has not been performed, accountants need to make the fact known so users will not mislead themselves. If an audit has been performed, accountants must report their work and conclusions for users' benefit. 4-2 Students may identify more than one description of the "most important" distinction between an opinion and other communications. The most important is that opinion is the highest level of assurance possible. An opinion reflects reasonable or high assurance. The word opinion can be used only in high assurance engagement reports. Some may interpret this question in terms of different kinds of opinions that are possible, in that case the most important distinction is between an opinion and a disclaimer All the following are valid, although (a) is intended to be the "Most important": a. An opinion (unqualified, qualified or adverse) is an explicit statement of the auditor's conclusions), while a disclaimer is an (empty) assertion of "no conclusion." b. An (unqualified) opinion is the highest level of assurance, while a disclaimer is the lowest level (no assurance). c. An opinion requires evidence as a basis, while a disclaimer results from lack of evidence. d. Auditors must be independent to give an opinion, while a disclaimer can result from a PA's lack of independence. 4-3 A negative assurance is a statement such as the following: "nothing came to our attention which would indicate that these statements are not fairly presented." A negative assurance does not indicate whether the auditor gave appropriate attention in such a way that he had opportunity to know whether statements were or were not fairly presented. It is too weak a conclusion for an audit. A negative assurance is permitted in letters to underwriters and in certain financial statements that do not purport to present financial position and results of operations, in certain kinds of special reports, and in review engagement reports. 4-4 Assurance refers to the credibility provided by the auditor’s evidence gathering procedures whereas accounting credibility refers only to the proper accounting for the facts as stated by the client. Assurance refers to evidence on the facts whereas accounting refers to properly presenting the facts in accordance with GAAP. 4-5 Scope paragraph a. The objects of the audit are the financial statements--balance sheet(s), income statement(s), and cash flow statement(s), and related footnote disclosure, not the "books and records." b. The description of the audit means: (1) the auditors were trained and proficient. (2) the auditors were independent. (3) due professional care was exercised. (4) the work was planned and supervised (5) internal control was properly studied and evaluated. (6) sufficient appropriate evidential matter was obtained. (7) the GAAS reporting standards were followed. * Professional judgment was exercised in performing the tests and choosing the procedures to perform in the circumstances. 4-6 Major reasons for departure from the standard unmodified opinion are: 1a. GAAP departure from official pronouncements (CICA Handbook Recommendations). 1b. Departure from any other GAAP. 2. Limitation on scope of the audit (resulting in a lack of evidence). 3. Auditor is not independent. 4-7 When an auditor is not independent with respect to a client, a disclaimer of opinion must be rendered. The disclaimer must be issued because the statements cannot be audited in accordance with generally accepted auditing standards. (An accountant, not an auditor, is the person associated with compiled and reviewed financial statements. An accountant can give a compilation--disclaimer--report on compiled unaudited financial statements.) 4-8 An auditor is unable to appropriately gather or evaluate the evidence gathered when he or she is not independent. 4-9 Reports and the evidence dimension Fully sufficient Isolated Pervasive appropriate evidence lack of evidence deficiency evidence Unmodified opinion X Adverse opinion X Opinion qualified for a GAAS departure X 4-10 Immaterial GAAP departures do not matter, and an unqualified opinion can be given. Material departures require an explanatory paragraph and an "except for" qualified opinion. Pervasive departures requires an explanatory paragraph and an adverse opinion. 4-11 In comparison to the standard unqualified report, a report qualified for a scope limitation has: 1. An "except for" phrase in the scope paragraph directing attention to the reason the audit was not in accordance with generally accepted auditing standards. 2. An extra paragraph describing the scope limitation, the accounts or disclosures affected, and the dollar amounts involved, if determinable. 3. An "except for adjustments that might have been determined to be necessary" phrase preceding the opinion sentence. 4-12 In comparison to the standard unqualified report, a report in which the opinion is disclaimed because of a scope limitation has: 1. A change in the introductory paragraph indicating "We have been engaged to audit" in stead of "We have audited," which indicates the nature of the engagement and the attempt to audit, but implies the audit was not completed satisfactorily. 2. The introductory paragraph omits the sentence in which the auditor takes responsibility for an opinion. 3. The scope paragraph is omitted entirely. 4. An extra paragraph describing the scope limitation, the accounts or disclosures affected, and the dollar amounts involved, if determinable. 5. An "opinion" sentence that refers to the extra paragraph and states that no opinion is given. 4-13 The auditor knows about the extent of misstatement in unmodified, adverse, and qualifications based on GAAP departure situations. In all other situations the auditor does not have sufficient evidence or is not independent. 4-14 If there is a departure from accounting principles and sufficient evidence shows the effect to be immaterial, then an unqualified opinion may be rendered. If the effect of the departure is material (but not extremely material) and isolated to a single event, then a qualified opinion may be given. If the effect is extremely material or pervasive (fair presentation is precluded), the auditor should render an adverse opinion. See Exhibit 4-8. 4-15 Pervasive materiality or extremely material would normally result in disclaimer of opinion whereas lesser materiality would result in an audit qualification. See Exhibit 4-8. 4-16 See Exhibit 4-8. 4-17 Unmodified opinions result in the greatest assurance, followed by the qualification which provides less assurance but still positive. The disclaimer of opinion provides no assurance whereas the adverse opinion provides positive assurance of material misstatements. 4-18 When the auditor feels the readers would find useful or important additional information in the auditor’s report such as information on contingencies e.g., see Exhibit 4-8. EOM paragraphs are further discussed in chapter 16. SOLUTIONS FOR EXERCISES AND PROBLEMS EP4-1 Association with Financial Statements. The consequences of being associated with financial statements. "In all cases where an auditor's name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor's examination, if any, and the degree of responsibility he is taking." a. Associated Issue audit report. b. Not associated Tax returns are an exception. c. Associated Issue disclaimer (public company) Issue compilation report (nonpublic). d. Not associated PA is associated with accounting records but not with financial statements. e. Associated Issue a disclaimer (public company). f. Associated Issue interim information review report. (Should have requested client not mention review procedures this way.) g. Not associated Nothing need to be done so long as client doesn't mention PA in the interim statement document. EP4-2 Reports and the Effect of Materiality If the amounts involved are immaterial, the report can be unqualified, otherwise materiality affects the report choice as follows: Materiality Lesser Greater Amounts are material but not pervasive or overwhelming Amounts are very large, pervasive and overwhelm the presentation a. Scope limitation on accounts receivable audit. "Except for" language used to express no opinion on the accounts receivable. Reference to "adjustments, if any." Disclaimer, with separate paragraph describing the restricted scope. b. Departure from GAAP (failure to accrue revenue), but not a departure from a pronouncement. "Except for" language used to qualify the opinion for the GAAP departure. Adverse opinion. c. Departure from an CICA pronouncement that requires capitalization of leases. "Except for" language used to qualify the opinion for the GAAP departure. Adverse opinion. d. Uncertainty related to the amount of damages that might eventually be confirmed by an appeals court ruling. Added paragraph used to warn users and to take no responsibility for failure to accrue the loss. (Otherwise a standard unqualified report) Disclaimer, if auditor thinks the amount that might be awarded seriously threatens the going- concern status of the company. EP4-3 The facts of the case are based on the Enron/Andersen situation. The accounting standards for "variable interest" entities have subsequently been expanded in both Canada and the US to close the "loopholes" that allowed Enron to avoid reporting material liabilities. Key issues raised in the case: ⸀ whether the auditor was qualified and technically proficient enough to assess the complex transactions and structures that Crow Corp. was entering into and how they were being accounted for ⸀ whether adequate audit procedures were performed to assess the impact of the limited partnership’s loan guarantees on the financial position of Crow Corp. is the Company's transactions and partnerships were "too complex" for the auditor to assess this would constitute a limitation on the scope of the auditors work, affecting the auditor's ability to issue a clean audit opinion ⸀ whether the auditor met the standard of due care. Though the financial reporting complies with the letter of GAAP, the auditor would still have a duty to assess whether or not the financial reports presented the substance of these transactions and commitments. The key principle of accounting for "substance over form" is relevant here, since it is the substance of the Company's financial transactions that is relevant to users of its financial statements. ⸀ on a broader level, what responsibilities do auditors have in situations where the requirements of GAAP are deficient in that they allow materially misleading information to be produced that technically complies with GAAP requirements. The auditors opinion is that the financial statements "present fairly in accordance with generally accepted accounting principles". Is it possible for statements to be "in accordance with generally accepted accounting principles" when they omit significant information that would very likely change users decisions and assessments?. Is the onus only on accounting standard setters to ensure the following GAAP always provides full and "fair" presentation? Or do auditors also have a duty to consider, even if the letter of GAAP has been complied with, whether the financial statements are still potentially incomplete or otherwise misleading to users? ⸀ there is a question about the auditor’s ability to independently assess management’s representations when the CFO is a former ZZ partner who was in charge of the Crow Co. audit for many years and knows the intimate details of the procedures that ZZ will be performing its audit ⸀ the auditors independence is also called into question when the auditor appears to need to rely on the expertise of client company personnel to establish whether companies reporting practices comply with generally accepted accounting principles. This becoming an important issue in the audit of accounting estimates including fair values. EP4-4 The question involves distinguishing between a review and an audit. A review report provides only negative assurance that the financial statements are fairly presented in the form a misstatement that nothing has come to the accountants attention that would indicate that the financial statements are not fairly presented. The accountant is only required to apply analytical procedures in a review engagement and is only permitted by the standards to state that nothing has come to the accountants attention to suggest that the financial statements are not fairly stated as a result of performing these review procedures. An audit report provides positive assurance in the form of the auditors opinion. The auditor is required to obtain independent evidence, via procedures such as confirmation and re-performance, to support the opinion that the financial statements are fairly presented. Since an audit provides higher assurance, the banker will believe that the audited information is more reliable and credible. The banker must manage the overall risk that the bank is taking by lending out money. Lending a larger amount of money presents a higher level of risk to the bank, higher assurance that the information reported by the borrower is reliable. Two of the ways that the audit reduces the bank's risk are that 1) the probability of errors and omissions in the information is lower because more extensive verification procedures have been performed, 2) the auditor can be held liable for losses the bank may incur as a result of relying on the audited financial statements if they contain misrepresentations. The bank's policy seems reasonable. Banks are lending out depositors money so they have a duty to ensure that they don't take unreasonable risks. Requiring audit on larger loans is a responsible way of reducing the risk of making bad loans and also sharing the risk with auditors. EP4-5 Arguments with Auditors The auditor may be forced to resign due to lack of independence due to the litigation threat. The following indicates a way the audit report could be modified if management made appropriate disclosures. Otherwise the auditor would most likely have to issue an adverse opinion after making these disclosures in the auditor’s report (assuming the auditor does not resign from the engagement). Kingston: Going Concern Reporting on financial difficulty with an additional explanatory paragraph. Report of Independent Auditors To the Board of Directors and Stockholders Kingston Company (Standard introduction paragraph goes here) (Standard scope paragraph goes here) In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kingston Company as of December 31, 200X, and the results of its operations and its cash flows for the year then ended, in conformity with Canadian generally accepted accounting principles. As shown in the financial statements, the Company has current liabilities that exceed current assets by $1 million. Cash balances have been drawn down to $10,000, and the interest on the long term debt has not been paid. As explained in Note 3 to the financial statements, a customer has sued for $500,000 on a product liability claim. These factors, along with other matters discussed in Note 3, indicate substantial doubt that the Company may be able to continue in existence as a going concern. The financial statements do not include any adjustments relating to these uncertainties. Anderson, Olds & Watershed February 10, 200Y EP4-6 Deficiencies and Errors in Audit Report 1. The audited financial statements are not identified by the proper names of the statements and the proper dates. 2. The date of the previous audit report is not given. 3. The description of the reason for the report change should not refer to "our attorney's meritorious defense." 4. The substantive reason for changing the opinion is not given. 5. The phrase "based upon the preceding" in the opinion introduction is not appropriate and may be misinterpreted as some sort of qualification. 6. The opinion refers only to 2004 financial statements, but should refer to both 2004 and 2003. 7. The consistency phrase is based on the language superseded in 1990. A separate consistency paragraph is no longer required. EP4-7 The case requires one to consider the different impact of an audit versus a review on a company’s minority shareholders. Factors to consider in deciding whether an audit is preferable to a review: ⸀ How knowledgeable is Hans about the Company's financial affairs? Does Hans have access to financial information about the company’s operations? ⸀ How significant is Hans’ investment in the company shares in relation to his personal net worth? Are the shares a large component of his savings, for example for retirement purposes? ⸀ How strong are the company's governance structures? For example, are there independent directors on the board that minority shareholders have access to, or do any minority shareholders sit on Board of Directors? Or do a small number of top executives or majority shareholders control the finances with minimal monitoring? ⸀ Does the shareholders’ agreement provide protections for minority shareholders such as requirements that they be informed of certain financial transactions with related parties, that they receive regular financial statements, that a fixed value or independently appraised value must be used if/when their shares are sold back to the company? ⸀ other valid factors can be listed Facts that would support voting for the audit waiver: ⸀ Hans has free access to financial information and is knowledgeable about the financial affairs of the company ⸀ Hans’ interest in the company shares is an insignificant portion of his net worth ⸀ The company has a strong Board of Directors with independent directors who are able to represent the interests of minority shareholders ⸀ The company has strong internal controls ⸀ Hans has confidence in the integrity of management ⸀ The shareholder agreement includes provisions that protect minority shareholders’ interests and access to reliable information about the company's finances ⸀ other valid facts can be listed Facts that would indicate Hans should vote against the waiver: ⸀ Hans has limited or no access to financial information about the company's operations ⸀ The investment in the company shares represents a large portion of Hans' net worth and his retirement savings ⸀ The company has no Board of Directors or the directors are all executives and/or majority shareholders ⸀ The company has weak internal controls, or controls that can easily be overridden by management ⸀ Hans is uncertain about the integrity of top management, for example he may be concerned about top management paying themselves excessive salaries and bonuses which would undermine the value of Hans’ shares ⸀ The shareholder agreement is vague or provides few specific protections or no protections for minority shareholders ⸀ other valid facts can be listed EP4-8 "Negative assurance" is a conclusion based on performance of review procedures that indicates that the accountant has not come across anything to suggest the financial statements are not in conformity with GAAP. It is a weaker conclusion than that of an audit because review procedures are less rigorous than audit procedures and don't warrant providing a higher level of assurance. An "adverse opinion" is a type of qualified audit opinion. The level of assurance provided by an adverse opinion is in fact HIGH because audit procedures have been performed. However, in the case of an adverse opinion the conclusion of the audit procedures is that the financial statements DO NOT present fairly in accordance with GAAP. It is illustrative to consider the possibility that financial statements that would have received an adverse opinion if an audit had been performed might be given a "clean" negative assurance report conclusion since the less rigorous review procedures may not reveal that the financial statements are not fairly stated while the more rigorous audit procedures would have. Since the problems that would exist in a set of financial statements that warrants an adverse audit opinion would be quite severe, it is likely that review procedures would also detect them. However, the key distinction between performing a review and performing an audit is that the level of assurance that the audit provides is higher, making it far less likely that the audit would miss finding that the financial statements are not fairly presented than if only review procedures were performed. EP4-9 Examples of fact situations in which GAAS Examination Standards of chapter 2 are not met: ⸀ the auditors conducting the procedures were not adequately trained ⸀ the auditors conducting the procedures were inexperienced ⸀ the auditors conducting the procedures were aware that the procedures performed were insufficient to support their conclusion ⸀ the auditors conducting the procedures were not independent of the client, for example they were employees, relatives of client personnel, significant shareholders of the company, or otherwise had interests that might bias their assessment of whether the financial information is fairly presented All of the above violations may result in an insufficient scope for the audit, for example not examining all relevant records, not objectively assessing the strengths of internal controls, not obtaining independent external audit evidence such as confirmation, etc. the violations might also a result in poor judgment, for example not critically analyzing management's representations or choices of accounting policies. The Violations of the General Standards could result in an audit report that is potentially of lower reliability than one issued as a result of audit procedures conducted by people who are properly trained, proficient, and capable of conducting audit with due care and objectivity. EP4-10 Examples of fact situations in which the GAAS Examination Standards are not met: ⸀ the audit engagement was not planned ahead of time in enough detail to ensure that sufficient, appropriate audit evidence would be collected ⸀ the auditors has spent little time getting to understand client business so is not able to identify the risks, understand the systems and procedures for processing data, and plan effective audit procedures ⸀ the planned procedures were not executed in accordance with the plan, for example components of audit tests were omitted, or sample sizes were arbitrarily reduced, or sample items were selected for convenience (e.g. only examining the recent documents or the documents the client selects) rather than being chosen randomly to be representative of the population being sampled, or copies of documents were verified rather than originals. ⸀ the work of less experienced auditors was not reviewed for appropriateness and completeness by more senior audit staff, and/or review comments were not addressed and resolved ⸀ internal controls were not documented, or were not assessed ⸀ internal control assessments were not followed up, for example internal control weaknesses were not investigated to determine whether they had resulted in material misstatements ⸀ internal controls were relied on to reduce the extent of substantial testing, but those controls were not adequately tested ⸀ insufficient or inappropriate evidence was obtained and so there is no reasonable basis to support the audit opinion, for example, bank balances or accounts receivable were not confirmed, or inventory counts were not attended and verified by the auditors ⸀ the auditors discovered errors or misstatements in the financial records but did not determine the extent to which these misstatements might require adjustments to the financial statements All of the above violations may result in an insufficient scope for the audit, for example not understanding the of the business, its risks, and its information processing systems, not performing the necessary procedures to obtain sufficient evidence, not identifying and assessing internal controls, not assessing whether the financial statements contain material misstatements. The Violations of the Examination Standards could result in an audit report that is potentially of lower reliability, and can greatly increase the risk of an audit failure. Failure to understand the business may mean the auditor is not aware of risk areas and does not design the audit to effectively address the higher risk areas. Failure to plan may mean that the auditor is unable to obtain documents and perform procedures that are required to support the opinion because the documents have not been retained or procedures that need to be observed have already taken place. Failure to supervise assistants may result in procedures being performed incorrectly or not completely and could result in less likelihood of detecting a material misstatement in the financial statements. Failure to properly identify and assess internal controls can result in placing inappropriate reliance on management representations and on company records and procedures. Many other valid points could be raised. EP4-11 The question requires one to evaluate the wording used by a qualified audit opinion from different perspectives and reach a conclusion. a) From the perspective of the auditing profession, a critical component of performing an audit is that acceptable criteria exist against which the audited information can be evaluated. Therefore, in a financial statement audit the opinion is given using GAAP as the criteria against which the financial statements are evaluated. Some, but not all, members of the auditing profession assert that it is only possible for an auditor to give an objective opinion with reference to established, generally accepted criteria, as represented by GAAP. However, some members of the auditing profession take the view that the audit opinion has two components. One component is a conclusion on whether the information complies with generally accepted accounting principles. The other component is a conclusion on whether the financial statements are appropriate for the kinds of users decisions that may rely on them. The second component goes beyond whether the financial information complies with the letter of GAAP, but also considers whether information is reliable and relevant for users decisions over and above whether complies with the letter of GAAP. The second component is more subjective and requires more exercise of professional judgment than the first. However, it is possible that GAAP may be deficient at any point in time (e.g., consider the facts of the Enron debacle) since business conditions and practices can change much more quickly than accounting standards can be developed and accepted into practice. Thus we might question if it is sufficient for auditors to only conclude on whether the financial statements conform to current GAAP without taking a step back to conclude on whether the information is misleading, despite being consistent with GAAP. ( e.g., the conclusion of the Kripps case is that the second component is as necessary as the first) b) From the perspective of financial statement users, the primary concern is whether the financial statements are appropriate to support the decisions that they are going to make based on them. Since it is possible that merely complying with GAAP can still lead to information that is not useful for their purposes, financial statement users are more likely to take the ‘two component’ view of the audit opinion discussed in part a). We can also consider the ‘Expectations Gap’ here, which refers to the tendency of users to expect that audits provide a higher level of assurance than the audit profession is actually able to provide, given the inherent limitations in financial reporting, GAAP and auditing. In the 1980s the MacDonald commission recommended that the Expectation Gap could be narrowed from both sides: users could become more aware of the limitations of financial reporting and auditing, and auditors could pay more attention to users’ expectations that audits make financial statements useful for their decisions over and above whether they just comply with GAAP. c) Valid arguments can be made to support various positions, e.g. the view that auditors are only responsible to assess whether financial statements are in accordance with GAAP, that auditors have a further responsibility to assess whether financial statements are reliable for those users that auditors know will be using them, or other views. In any case, the analysis should clearly state the position being taken, and present clear arguments explaining explicitly how they support the position taken on the issue. EP4-12 The question requires assessment of various scope limiting situations. A set of possible analyses follows. a) If the auditor is appointed in the middle of the year and did not observe inventory at the end of the prior year there are no alternatives procedures that can provide the same evidence. If the prior year was audited by another audit firm the auditor may be able to rely on the prior auditor’s work. If the client has strong controls over inventory acquisition, sales and recording, it may be possible to reconstruct inventory movements for the entire year from transaction data which, along with the audited year-end balance, might provide sufficient evidence if inventory and cost of sales are not highly material to the financial statements as a whole. The cost of these alternate procedures would be high, however. b) If the auditors are appointed after the year-end and have missed the opportunity to observe the year-end inventory counts as well as the count of the prior year-end, there are no alternate procedures that can provide the same evidence. It also would not be possible to rely on controls and transaction data verification in this situation since, even if the year-end inventory balance could be reconstructed, without verification of the opening balance there is insufficient evidence to support providing positive assurance. c) If alternative procedures can be performed the auditor can provide an unqualified opinion. If the work of the previous auditor is relied on the fact that the prior year financial statements were audited by another auditor is usually noted in the audit opinion as a separate paragraph. This is not considered a "qualification". d) The answer depends on the auditor’s judgments about how pervasive inventory and cost of sales are to the financial statements as a whole. If inventory/cost of sales are material but a possible misstatement would not render the entire set of financial statements misleading or useless the auditor can issue qualified opinion drawing attention to the scope limitation and the financial statements items that the auditor was unable to verify. If inventory/cost sales is a pervasive component of the company’s financial performance, the auditor would have to give a denial of opinion. EP4-13 The question considers the issues arising from client imposed limits on audit work. Possible analyses and conclusions include the following. a) If the client imposes a scope limitation on the auditor by not permitting accounts receivable confirmations an alternate procedure is to verify subsequent receipt of the account balances This procedure is only available if the customers have paid their accounts by the time the audit work is completed b) An unqualified report can be issued c) The answer depends on the auditor’s judgments about how pervasive sales and accounts receivable are to the financial statements as a whole. If sales/accounts receivable are material but a possible misstatement would not render the entire set of financial statements misleading or useless the auditor can issue qualified opinion drawing attention to the scope limitation and the financial statements items that the auditor was unable to verify. If sales/accounts receivable are with a pervasive component of the company’s financial performance, the auditor would have to give a disclaimer of opinion. EP4-14 The current requirements of Canadian GAAS for contingencies/provisions and uncertainties are that as long as these are reported adequately in the financial statements and notes, in the auditor's judgment, the auditor would issue an unqualified report. Pros: ⸀ focuses on adequacy of the financial statement presentation as a whole ⸀ more standardization of the audit report format, less variability of wording that might confuse users ⸀ simplifies the auditors’ reporting responsibilities ⸀ avoids conveying the impression that the contingencies and uncertainties are more important to the business’s future than they are in management's view Cons: ⸀ does not highlight usual situations that can affect financial condition ⸀ requires financial statement users to read detail in financial statement notes ⸀ may give the impression that the contingencies and uncertainties are less important than they are since the auditor did not find it necessary to draw attention to them in the audit report ⸀ restricts the auditor's ability to draw attention to contingencies and uncertainties that management may be able to underplay by the way they report them in the financial statements Contrast to the former ‘subject-to’ opinions: ⸀ more attention to strong to the existence of the contingencies and uncertainties by including in the audit report ⸀ increases the likelihood that readers will look at its management's descriptions of the contingencies and uncertainties in the financial statements and notes ⸀ puts more onus on the auditor to assess the financial statement presentation as a whole EP4-15 Issues of reporting uncertainties are explored. Some possible interpretations are developed below. a) Strengths: ⸀ avoids making the going concern uncertainty into a ‘self-fulfilling prophesy’ which might have been if the situation is highlighted and perhaps "endorsed" by the auditor in the audit report ( and so may limit the auditor’s liability to the company) ⸀ avoids giving the impression that the audit report provides an assessment of the company's future success Weaknesses: ⸀ does not highlight to users the serious concern about the company’s viability ⸀ requires financial statement users to read detail in financial statement notes ⸀ does not indicate explicitly the auditor’s agreement with management’s disclosure and presentation of the going concern problem b) Various alternatives for expanding what is included in on report can be mentioned here. Ideally, the alternatives should allow users to better understand the company's financial situation and choices, and the auditor’s role in in assessing the company's reporting on this issue. c) Comments to the auditing standard setters can address the strengths and weaknesses noted above and suggest alternative reporting practices. Comments can compare the Canadian approach to that of other countries, for example the US where going concern uncertainty is highlighted in the audit report. Comments relating to the need for auditors to have guidelines in this difficult area could also be made. Assessing the adequacy of companies’ disclosures concerning a going concern uncertainty is one of the most difficult judgments that an auditor would face. This is because underestimating the risk of bankruptcy can have serious financial consequences for financial statement users, making this is an area of high risk for the auditor. On the other hand, jumping the gun before all possibilities to turn the company around can be explored could contribute to driving a company into bankruptcy when, if it had more time to work things out, it may have been able to survive. EP4-16 Reasons include: ⸀ high degree of uncertainty about whether company will succeed in taking actions to prevent bankruptcy ⸀ high level of complexity in the actions the company needs to take to turn its business around, as well as the agreements and cooperation in fact the company has to obtain from creditors and other stakeholders ⸀ unpredictable future events can have significant and rapid impact on a company's financial health and the farther in the future one looks the less predictable are these events Arguments can be presented for or against the one-year requirement. Ideally, the arguments would address issues such as: the feasibility of predicting bankruptcy and the techniques available to do it; the impact of potential bankruptcy on management, creditors, shareholders, another stakeholders such as employees suppliers and customers; the reporting requirements of companies in the auditor's responsibilities to provide assurance on these reports; etc. Alternative reporting methods can be generated addressing the issues discussed above. EP4-17 This question provides instructions for a research project on auditing standard-setting. It involves locating relevant information from accounting profession web sites and publications on how the specific accounting standard on the going concern assumption has evolved over time. By analyzing the evolution of this standard, insights can be gained into what the term "due process" means more generally in the standard-setting process. Hint: Archived issues of CAMagazine is a good source of many exposure drafts and related articles. EP4-18 a) The case facts suggest considerable risk that the company is not a going concern. Preparation of financial statements in accordance with GAAP makes the assumption that the company is a going concern, that is, it will be able to realize its assets and discharge its obligations under normal conditions and terms, without undue duress. when issuing the audit report, the auditor needs to be satisfied that presenting financial statements in accordance with GAAP is not misleading and that's disclosure regarding the going concern issues is adequate. In this case, the long term debt coming due in the following year would make difficult for the auditor to agree to financial statements prepared in accordance with GAAP unless assurances can be obtained that the terms of repayment will be altered or extended so that the company has reasonable probability of meeting them. If there's a high probability that the company will go bankrupt, preparing financial statements on liquidation basis is more appropriate than GAAP. b) If the long term debt were not due until 2025 there may be more probability that the company can survive through the current year, making presentation of financial statements under liquidation basis unnecessary. EP4-19 The question requires evaluation of going concern reporting and audit responses from different perspectives. One evaluation approach is developed below. a) Various valid criticisms can be generated from a user’s perspective. For example, if there are significant uncertainties about the company's ability to continue to operate as a going concern it seems unlikely that the impact will affect only isolated accounts that can be quantified and noted in a qualified audit report paragraph. The user would want to be informed about how to interpret the financial statements as a whole given the pervasiveness of a potential bankruptcy. Also, if management and the auditor can't agree on the likelihood of the company’s ability to continue as a going concern this may affect the auditor's ability to rely on management's representations concerning all aspects of the financial statements, creating a scope limitation. A significant divergence between auditors’ and managers’ viewpoints on the company's financial viability would be an important factor for users in evaluating management and deciding on whether to hold an investment in the company. -other valid points can be raised b) Auditors could respond that the difference between GAAP and liquidation basis does not affect every account. Some accounts would be shown at the same amount under either assumption because their book values approximate their liquidation values. Therefore a qualified opinions may be appropriate. The auditor could argue that the auditor has a duty to report and this requires them to assess the extent to which the financial information is in accordance with GAAP and report their findings. If they find that there are areas of the reports that do comply with GAAP and are not misleading it is their duty is to express that opinion to users. -other valid points can be raised EP4-20 The question requires an exploration of opinion shopping issues. a) The purpose of Section 7600 is to impose some discipline on the process in a situation where the client of one auditor goes shopping for second opinions from different auditors on issues such as the accounting for specific transactions or the type of audit opinion that would be rendered. It is intended to reduce potential abuses that could arise in cases where a client might try to pit one auditor against another to find one willing to accommodate the client’s position on what is appropriate financial statement presentation and what is the appropriate audit opinion to provide. b) Section 7600 establishes procedures that auditors should following in dealing with requests for consultation from parties other than the auditor’s own clients. - the auditor should consider the circumstances and request for advice, its purpose intended use of reported the advice - the auditors should understand the form and substance of the transaction willin question, review applicable GAAP, consult with other professionals if necessary, and perform any research necessary to determine the existence of authoritative support and generate alternatives - when the request comes from a company that already has another auditor, the auditor needs to consult with the other auditor to learn all facts and circumstances - written reports are required and should include: ⸀ description of the nature the engagement in a statement that it was performed in accordance with standards for such engagements ⸀ statement of relevant facts and assumptions and sources of information ⸀ statement of the advice-the conclusion about appropriate accounting principles or the type of audit report, including reasons for the conclusions if appropriate ⸀ statement that a company’s management is responsible for proper accounting treatment in consultation with its own auditors ⸀ statement that any differences in facts, circumstances or assumptions might change the conclusions EP4-21 The case involves an accounting situation where the application of GAAP is not clear, and different applications might be justified depending on the objectives of the financial statement preparers. The decision on whether or not an environmental liability needs to be accrued will have an important impact on management (the financial statement preparers) as well as on users such as investors and creditors. The case requires one to consider this issue from the perspectives of different people who are potentially affected by the accounting information. One possible approach is given below. a) The fact that the same situation could be accounted for in widely different ways (recording liability resulting in a loss or only disclose the liability resulting in a profit) could raise concerns in the public’s eyes about the credibility of financial information. However, these kinds of choices are a necessary part of accounting given the uncertainties that exist in business situations and the need to make a choice and how to reflect these in the financial statements. For two different PA firms to provide two different opinions on how to report the this situation could raise further questions about the credibility of accounting, as well as auditing, in the public's eyes. If the company is then able to choose the accounting method that is obviously in management's best interest this could create distrust of accounting information and the accounting profession in the public's eyes. -other valid points can be raised b) From PA1’s perspective the ability of the client to obtain an opinion undermines PA1’s bargaining position with management in attempting to achieve the form of financial reporting that PA1 believes is most appropriate. PA1 may be concerned about whether management fully discloses to PA2 all relevant facts that underlie PA1’s opinion on this matter. Also there's a question of who is responsible and ultimately would bear the liability if the financial statements mislead users and lead them to sue the auditor. Which PA do they sue? -other valid points can be raised c) From PA2’s perspective the reason that the company is requesting a second opinion would be important to consider. In particular the impact on reporting income/loss and management's bonus suggests a strong bias to avoid accruing the liability. The need to ensure that management is reporting all relevant facts is important. Also PA2 must consider the liability that could arise from expressing an opinion, and therefore the importance of complying with the applicable accounting and auditing standards for reporting on the application of accounting principles to a client of another accountant/auditor (CICA section 7600). -other valid points can be raised d) The Director of Kite is responsible for, among other things, ensuring that management issues appropriate financial reports of the company's performance. In large companies this responsibility may be handled by a component of the Board of Directors, called the audit committee. Management's opinion shopping in this dispute with the auditors could raise concerns about management's willingness to provide unbiased reports to shareholders and other users, and about management's expending company resources to obtain support for accounting choices that favor management's interests over the interests of other users who are entitled to fair and unbiased reporting . -other valid points can be raised EP4-22 The audit evidence obtained in this case is the work of specialists (CAS 620) that support the assumptions underlying the company's choice to defer development costs as assets in its current financial statements. Given the nature of the assets, this evidence is necessary to support the auditor’s opinion that these costs are properly presented as assets under GAAP. The auditor must assess whether the evidence is relevant, whether the specialists are qualified to provide these kinds of opinions, and whether the specialists appear to have done appropriate work to support their report. If the auditor is satisfied that the specialists report provides sufficient and appropriate audit evidence, the auditor provides an unqualified opinion making no reference to reliance on the specialists work. Relying on a specialist’s work has many similarities to relying on the work of another auditor. The primary auditor needs to ⸀ consider the qualifications, competence and integrity of the professionals that are being relied on ⸀ communicate with a professional regarding the nature the assurance required from their work In addition, when an auditor is relying on a secondary auditor some additional considerations are: ⸀ the secondary auditor’s opinion and the financial information it relates to ⸀ obtain a representation for the secondary auditor acknowledging the primary auditor's reliance ⸀ whether or its sufficient to rely on the secondary auditor’s report or whether it is necessary under the circumstances to also review the secondary auditor’s working papers -other valid points can be raised EP4-23 As of the 2012 trial of former Nortel executives, Nortel may need to further restate its financial statements. The company illustrates the problems of reporting on uncertainties in the high tech industry. Perhaps auditors need better guidance from GAAP and a better conceptual framework. A related issue for Nortel is should management bonuses based on numbers that are later restated be returned to the company? The current Nortel website address is: http://www.nortel-canada.com/investor/annual-quarterly-reports/ EP4-24 GAAS Pre 2011 (5510.53): if the disclosure is in conformity with GAAP then reference to going concern is prohibited in the auditor’s report. If the disclosure is not in conformity with GAAP then a report reservation is required. GAAS Post 2010 (CAS 570.33) If adequate disclosure is made in the financial statements, the auditor should express an unqualified opinion but modify the auditor’s report by adding an emphasis of matter paragraph that highlights the existence of a material uncertainty relating to the event or condition that may cast significant doubt on the entity’s ability to continue as a going concern and draws attention to the note in the financial statements that discloses the matters set out in paragraph 32. GAAP (1400.08A) When management is aware, in making its assessment, of material uncertainties related to events or conditions that may cast significant doubt upon the entity's ability to continue as a going concern, those uncertainties shall be disclosed. When financial statements are not prepared on a going concern basis, that fact shall be disclosed, together with the basis on which the financial statements are prepared and the reason why the entity is not regarded as a going concern. [JAN. 2008] Solution Manual for Auditing: An International Approach Wally J. Smieliauskas, Kathiryn Bewley 9780071051415