Auditing: An International Approach Seventh Canadian Edition Solution Manual

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 1-1Solutions ManualCHAPTER 1Introduction to AuditingSOLUTIONS FOR REVIEW CHECKPOINTSESSENTIALS1-1.In this example of a three-party accountability structure, the owneristhe 'third party', the hired manager is the'first party' and the auditor is the 'second party'. The owner is looking out for his/her own longer-term economicinterests, but has to rely on the actions and information provided by the hired manager, who may have shorterterm concerns (like his/her own compensation and job prospects) and thus act self-interestedly.The owner is accountable for financing the business and treating the manager fairly, particularly in terms ofcompensating his/her efforts and successes appropriately. The manager is accountable for giving reliable and fairreports of the business profit performance to the owner. Give the potential conflicts between the interests of thefirst and third parties, there is information risk-the risk that the financial statement information will not be a fulland fair representation of the transactions and events that really occurred, and will not be reliable for economicdecisions that the owner may base upon it. The auditor is accountable forobjectivelyverifying the fairness andreliability of the information and providing an independent opinion on how well the information reflects theunderlying realities of the entity's operations. The auditor's opinion can benefit both the first and third parties-the owner directly by lowering information risk, and the manager indirectly because if the owner has more basis totrust the manager not to act against the owner's interests the owner will be more willing to share the profits withthe manager (this is referred to as lowering "agency costs," which are charged by the owner/principal and incurredby the manager/agent if the owner does not trust the manager). For the auditor's opinion to have value in givingthe owner some comfort (i.e., "assurance") that the manager's information can be relied on, the auditor must haveno personal interest in either side and be able remain objective.1-2.The concept of reasonable assurance describes a mental attitude that the auditor gains from the conclusionsdrawn from audit examination findings. Based on the examination, if the auditor comes to believe the financialstatements are reliable and fair to the interests of third party users, this belief forms the basis of the opinion theauditor will communicate to financial statement users in the Auditor's Report. An 'audit opinion' provides ahighlevel of assuranceto the user that the auditor believes that the information risk is low, and has evidence tosupport that belief.TEXT1-3Auditors add credibility to financial information provided by the accountable party such as management (i.e.auditors makethe financial or other information more likely to be trueorrepresentationally faithful). Othercommon ways of characterizing this property of audited numbers is that the numbers are more accurate, havehigher assurance, or are more reliable. These relate to different dimension of truthfulness, as we discuss later inthe text.1-4By obtaining more accurateorreliableinformation about the company, Aunt Zhang can obtain a moreaccuratevaluation of the company. This moreaccuratevaluation gives Aunt Zhang more confidence that she will get hermoney’s worth in the investment. The preceding assumes Aunt Zhang is risk averse—a common assumption abouteconomic behavior.1-5Auditing is the verification of numbers provided by others. To attest means to lend credibility or to vouch for thetruth or accuracy of the statements that one party makes to another. The attest function is a term often applied to

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 1-2Solutions Manualthe 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 forfinancial success or failure, an outsider may be skeptical that the statements are objective, free from bias, fullyinformative, and free from material error--intentional or inadvertent. The audit opinion of an independent-PAauditor helps resolve those doubts because the auditor's success depends upon his independent, objective, andcompetent assessment of the conformity of the financial statements with GAAP. The auditor's role is to lendcredibility to the statements, hence the outsider will likely seek his independent audit opinion.1-6Client:the company, board of directors, agency, or some other person or group who retains (hires) theauditor. Usually the party who pays the fee.Auditee:the entity (e.g., business firm, hospital, city government) whose financial information is underaudit.Auditors:reporttothe clientonthe auditee's financial or control information.Three party accountability consists of the auditor, the accountable party ofthe auditee such as management of theauditee, and the users. Users include the client as defined above. Traditionally management hired theauditor sothat there was some confusion as to who was the true client. New corporategovernance concepts in part attemptto clarify this three party accountability.1-7Auditors gather evidence related to the assertions management makes in financial statements and render a report.Accountants record, classify, and summarize (report) a company's assets, liabilities, capital, revenue, and expensein financial statements. Accountants produce the financial statements, auditors audit them.1-8The conditions of complexity, remoteness and consequences produce demands by outside users for financialreports. They cannot produce the reports for themselves because of these conditions. Company managers andaccountant produce them.1-9Students can refer to the AAA and CAS 200 (CPA Canada) definitionsin Chapter 1. Some instructors may want toextend 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 andevaluate evidence about assertions management makes about economic actions and events, (2) ascertains thedegree of correspondence between the assertions and GAAP, and (3) gives an audit report (opinion).Students canalso respond more generally in terms of "lending credibility" to financial statements presented bymanagement (attestation).1-10The 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.These various users cannot take it upon themselves to determine whether financial reports are reliable, thereforelow in the information risk scale. They do not have the expertise, resources, or time to enter thousands ofcompanies1-11Forensic accounting is the broader term that includes fraud auditing. Forensic accounting is the use of accountingfor legal or investigative purposes. Fraud auditing is the use of forensicaccounting in criminal investigationsinvolving allegations of fraud. Frauds that PAs are most interested in are misappropriation of assets and fraudulentfinancial reporting (misreporting).1-12Fraud is intentional deception resulting ina lossto the deceivedparty. Frauds that PAs are most interested in are

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 1-3Solutions Manualmisappropriation of assets and fraudulent financial reporting (misreporting).1-13Operational auditing is the study of business operations for the purpose of making recommendations about theeconomic and efficient use of resources, effective achievement of business objectives, and compliance withcompany policies.CPA Canada views operational auditing as a type of management advisory service offered by public accountingfirms.1-14The elements of comprehensive auditing include: (1) financial and compliance audits, (2) economy and efficiencyaudits, and (3) program results or effectiveness audits. Public sector is the part of the economy represented by alllevels of government. Public companies are companies whose shares are traded on the stock markets.1-15A 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.1-16Otherkinds of auditors: Revenue Canada agents/auditors, provincial and federal bank examiners, provincialinsurance commissioner auditors.1-17Yes, to a reasonable degree. Financial statement audits are intended to provide assurance there areno significantintentional or unintentional misstatements.1-19IAASB stands for International Auditing and Assurance Standards Board. Its ISAs are the basis for Canada’s CASsused throughout thistext. TheIFAC site is atwww.ifac.org andclick on “standards and guidance.”SOLUTIONS FOR MULTIPLE CHOICEQUESTIONSMC 1-1 LO1When people speak of the assurance function, they are referring to the work of auditors ina.lending credibility to a client’s financial statements.b.detecting fraud andembezzlement in a company.c.lending credibility to an auditee’s financial statements.d.performing a program results audit in a government agency.MC 1-2 LO1Company A hired Sampson & Delila, CPAs, to audit the financial statements of Company B and deliver theaudit report to Megabank. Which is the client?a.Megabankb.Sampson & Delilac.Company Ad.Company BMC 1-3 LO1According to theCPA Canada, the objective of an audit of-financial statements isa.an expression of opinion on thefairness with which they present financial position, results of operations, andcash flows in conformity with generally accepted accounting principles.b.an expression of opinion on the fairness with which they present financial position, results of operations, and cashflows in conformity with accounting standards promulgated by the Financial Accounting Standards Board.c.an expression of opinion on the fairness with which they present financial position, results of operations, and cashflows in conformity with accounting standards promulgated by theCPACanadaAccounting Standards Committee.d.to obtain systematic and objective evidence about-financial assertions and report the results to interested users.MC 1-4 LO4Bankers who areprocessing loan applications from companies seeking large loans will probably ask forfinancial statements audited by an independent PA becausea.financial statements are too complex for them to analyze themselves.

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 1-4Solutions Manualb.they are too far away from company headquarters to perform accounting and auditing themselves.c.the consequences of making a bad loan are very undesirable.d.they generally see a potential conflict of interest between company managers who want to get loans and theirneeds for reliable financial statements.MC 1-5 LO4Operational audits of a company’s efficiency and economy of managing projects and of the results ofprograms are conducted by whom?a.Financial statement auditorsb.The company’s internal auditorsc.Taxauditors employed by the federal governmentd.Fraud auditorsMC 1-6 LO3Independent auditors of financial statements perform audits that reduce and controla.the business risks faced by investors.b.the information risk faced by investors.c.the complexity of financial statements.d.quality reviews performed by other PA firms.MC 1-7 LO4The primary objective of compliance auditing is toa.give an opinion on financial statements.b.develop a basis for a report on internal control.c.perform a study of effective and efficient use of resources.d.determine whether auditee personnel are following laws, rules, regulations, and policies.SOLUTIONS FOR EXERCISES AND PROBLEMSEP1-1When the PA is hired by Hughes Corporation, he can no longer be considered independent with respect to theannual audit. The annual audit may then be unnecessary in a short-run view and unnecessary to the extent ofservices exclusive of the attest opinion. It is true that the in-house PA can perform all the procedural analyses thatwould be required of an independent audit; however, it is extremely unlikely that he could inspire the confidenceof users of financial statements outside the company. He cannot modify the perception of potential conflict ofinterest that creates demand for the independent audit. As a matter of ethics rules, this PA would be prohibitedfrom signing the standard unqualified attest opinion.EP1-2You should point out that you will be unable to replace the independent audit withyour own communicationoutput as controller. Make the point that you can conduct an effectiveinternal audit function and be ofconsiderable service to management and can even assist the independent auditors with preparation of schedulesand general cooperation (thus facilitating the independent audit).Nevertheless, as a member of management, it would be impossible to be truly objective and unbiased about thefinancial results of management's decisions, hence the directors could not satisfy their obligations to theshareholders' 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 auditrequirements of a stock exchange, a Provincial Securities Commission, or the U.S. Securities and ExchangeCommission.EP1-3a.risk of litigation needs offsetting lower information risk (for example,litigation due to share practice declineor 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

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 1-5Solutions Manualtied to factors over which management haslittle control may motivate management to “manageearnings”).e.private vs. public company (publicly held company owners are more reliant on financial statements forinformation about their investment).EP1-4Financial statements are prepared on basis of GAAP. Knowledge of GAAP is thus indispensable for determining ifthe financial statements are in conformity with GAAP. For example lease accounting used to consist of some veryspecific rules (bright line rules) that the auditor effectively testedcompliance with. Unfortunately such detailedrule based accounting leads towhat somerefer to as a checklist mentality where the form is more important thanthe substance. Enron’s special purpose entity accounting also comes to mind.EP1-5Operational AuditingBigdealcannot 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 betotal objectivity. The PA firm has no stake in making a report reflect favorably or unfavorably on Smalltek (providedthere are no prior relations of the PA firm with Bigdeal managers that may suggest a bias or with Smalltek). Thepossible 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 appreciationof Bigdeal's managerial effectiveness and efficiency standards and a longstanding familiarity with Bigdeal'sbusiness. The possible disadvantage could be that the internal auditors may not be independent enough frominternal management pressures for making or breaking the deal for reasons other than Smalltek's efficiency andeffectiveness.Another possibility is a nonPA management consulting firm. The major advantage of objectivity would be similar tothe PA firm, and such firms often have experts in manufacturing, sales, and research and developmentmanagement. The major disadvantage could be a lack of appreciation and familiarity with Bigdeal's managementstandards (as possessed by the Bigdeal internal auditors).EP1-6The neighbor appears to be uninformed on the following points:1.According to auditors' dogma, Price Waterhouse didnotpreparethe Dodge Corporation financialstatements, and no auditorpreparesacompany's statements.Inform your neighbor that Dodge management isprimarily responsible for preparing the financialstatements and deciding upon the appropriateaccounting principles.2.An unqualified opinion does not mean an investmentissafe.Tell your neighbor that the financial statementsarehistory. The value of his investment dependson future events, including the many factors thataffect market prices. Tell him the opinion onlymeans that the statements conform to GAAP(and you can add that the auditor knows of nomaterial fraud or error).EP1-7Identification of Audits and AuditorsThe responses to this matching type of question are ambiguous. The engagement examples are real examples ofexternal, internal and governmental audit situations. You might point out to students that the distinctions among

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 1-6Solutions Manualcompliance, economy and efficiency and program results audits are not always clear. The "solution" is shownbelow in matrix form, showing some engagement numbers in two or three cells. The required schedule follows.Type of AuditFinancialEconomy,ProgramKind of AuditorStatementComplianceEfficiencyResultsIndependent PA2, 10Internal Auditor6, 84, 8Governmental (auditors)31, 3, 91, 3CRAAuditorX5XXBank ExaminerX7XX1.FHA loan interest equityEconomy and Efficiency orProgram ResultsGovernmental (AGC)2.Advertising agency financialstatementsFinancial statementIndependent PAs3.Dept. of Interior policiesCompliance or Economy andEfficiency or Program ResultsGovernmental (AGC)4.Municipal servicesEconomy andEfficiencyInternal auditors5.Tax sheltersComplianceCRAauditors6.Test pilot reportingComplianceInternal auditors7.Bank solvencyComplianceBank examiners8.Materials inspection bymanufacturerCompliance or Economy andEfficiencyInternal auditors9.Drug enforcement vehicleseizuresEconomy and EfficiencyGovernmental (AGC)10.Sports complex forecastFinancial statementIndependent PAsEP1-8Analysis and JudgmentThis 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 inAuditing."Journal of Accounting Research, Spring, 1981, pp. 1The case is set up to illustrate a person's tendency to anchor an estimate on some known information and adjustfrom that point in the course of performing analysis. This particular case set-up is intended to illustrateconjunctiveanddisjunctiveevents. 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 aconjunctiveevent depends on thejoint 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 aconjunctive eventwith probability of 1/6 raisedto the third power (1/6 x 1/6 x 1/6), or about 0.005.An example of adisjunctive eventis gettingat least oneof a number of sub-events, such asone3 in three rolls ofthe die. The probability of this disjunctive event is about 0.42

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 1-7Solutions ManualIf you are asked to estimate the probabilities of the conjunctive and disjunctive events of rolling the die, a naturalstarting place (anchor) would be to know that the probability of gettingonethree inoneroll is 1/6, or 0.167. Thento 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 willlikely be too large, and that of the disjunctive event too small.Form Aof the problem (the one in the textbook chapter) is a conjunctivestatement of the problem, and it asks foran estimate of the probability ofsuccessfulproduct introduction. With the five sub-events considered independentof each other, the best answer is 0.554 (.80 x .90 x .95 x .90 x .90). Students may anchor on the probabilities of theelementary sub-events and fail to adjust sufficiently downward, and their probability estimates will behigherthan0.554.Form Bof the problem (reproducedbelow, 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 offailurein the chain of events. (Studentresponses must be subtracted from 1.000 to make them comparable to Form A.) If students anchor on theprobabilities of the elementary disjunctive sub-events in Form B, their probability estimates (subtracted from1.000) will probably betoo low.As part of your regular year-end audit of a publicly-held client, you must make an estimate of the probability ofsuccess of its proposed new product line. The client has experienced financial difficulty during the last few yearsand--in your judgment--a successful introduction of the new product line is necessary for the client to remain agoing concern.Any oneof the following occurrences will prevent successful introduction of the new product line: (1) unsuccessfullabor negotiations between the construction firms contracted to build the necessary addition to the present plantand the building trades unions; (2) unsuccessful defense of patent rights; (3) failure to obtain product approval bythe FDA; (4) failure to successfully negotiate a long-term raw materials contract with a foreign supplier; and (5)failure to successfully conclude distribution contract talks with a large national retail distributor.In view of the circumstances, you contact experts who have provided your audit firm with reliable estimates in thepast. The labor relations expert estimates that there is a 20 percent chance that labor negotiations will not besuccessfully resolved before the strike deadline. Legal counsel advises that there is a 10 percent chance that thepatent rights defense will not be successful. The expert on FDA product approvals estimates the probability offailing to obtain approval at five percent. The experts in the two remaining areas estimate the probabilities offailing to resolve (a) the raw materials contract and (b) the distribution contract talks to be 10 percent in each case.Assume these estimates are reliable.Required:What is your assessment of the probability that the product introduction will fail? (Hint: You can assume the fivesteps are independent of each other.)NOTE TO INSTRUCTORS:You may want to reproduce Form B and give both the textbook problem (conjunctive) andthe Form B alternative (disjunctive) to different groups of students to illustrate the anchoring and adjustmentbehavioral phenomenon.You may also want to give students a response scale to make your classroom discussion easier. Ask them to circleone:

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 1-8Solutions Manual.00.10.20.30.40.50.60.70.80.901.00EP1-9Information Risk Questions.Examples of misstatements that create audit risk: the balance sheet does not balance, cash is understated,inventory is overstated, and unrecorded payables. Examples of misstatements that create accounting risk: acompany that will fail in the next3months recordsallassets and liabilities assumingthatthe going concernassumption is true, impaired goodwill is not written down,the allowance for doubtful accounts has not beenadjusted for changed economic circumstances,and thefair value assets have not been updated for changes infuture cash flows.Accounting misstatements relate to future events whereas audit misstatements relate to factsabout the present or past events.EP1-10The audit society.An example from the Auditor General of Ontario is given in the text. There was extensive coverage in Globe andMail, Toronto Star, and localTVnews coverage.EP1-11The audit societyA recent controversy is the Canadian government’s proposed acquisition of a fleet of 65 single engine F35 fighter jets for$46 billion.Seehttp://www.thestar.com/news/canada/2012/04/03/auditor_general_slams_canadas_plan_to_buy_f35_jets.html

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-1Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.CHAPTER 2Auditors’ Professional Roles and ResponsibilitiesSOLUTIONS FOR REVIEW CHECKPOINTSESSENTIALS2-1.Sinceauditingis a critical function in the economy, it is extensively regulatedto ensure it remains effective. InCanada, the regulation of professional accountants and auditors is a provincial responsibility, and varies somewhatdepending on the legislation in different provinces. The profession also has a national umbrella organization thatall provincial organizations are associated with. At the time of writing, the profession is being streamlined at boththe national and provincial levels by uniting three formerly separate accounting designations (CA, CGA, CMA) intoasingle designation for Canadian professional accountants, the “CPA” (Chartered Professional Accountant). Thenational umbrella organization is CPA-Canada, and there are counterpart CPA associations in each province (e.g.,CPA-Saskatchewan)and territory.2-2.When an accountant provides auditing and assurance services for use by the general public, this is referred to as‘public accounting’. Public accounting is distinct from many other types of accounting-related work that do notproduce information that the general public will use and possibly rely on, such as bookkeeping and financialstatement and tax preparation for individuals or private companies. Since a person from the general public maynot be able to assess whether an accountant is properly qualified and regulated to act in their best interest, topractice public accounting a person will meet higher standards than are required to do other types of non-publicaccounting work. Generally, a public accountant in Canada must have a CPA designation, and in many (most)provinces of Canada must obtain further qualification and licensing (e.g.,in Ontario,from the Public Accountants’Council of Ontario). In the case of public accounting that involves auditing publicly-tradedcompanies' financialstatements, securities laws require the public accounting firm to be registered with the Canadian PublicAccountability Board (CPAB). CPAB will inspect their financial statement audit work on public companies annuallyto provide the highest level of public protection, since these companies can sell their securities directly to thepublic.2-3.Members of a CPA association are required to comply with the professional ethics code of their provincialassociation. Every ethics code has five similar components, requiring the member: to act with integrity; to remainobjective; to maintain the professional competencies their work requires and to do their work with appropriate‘due’ care; to keep confidential all information they acquire through their professional work, and; to behaveprofessionally in a way that befits a well-respected profession.2-4.In public accounting engagements, CPAs must demonstrate they can be objective by remaining independent of anypotentially conflicting interests, which includes being independent in fact and also independent as it would appearto an outsider.2-5.Independence in fact means the auditor maintains an objective perspective in doing his or her work-this frame ofmind is essential to performing an assurance role effectively, however it is not visible (or provable) to outsiders.Theauditor's independence must also be apparent to outsiders for them to believe the auditor's opinion is in factindependent. Outsiders must see evidence that the CPA has no financial or other interest that would cause themto act in a biased way, rather than in the outside user’s best interest.2-6.The professional ethics codes for accountants identify five situations that can arise in a three-party accountabilityrelationship and, if they exist, can threaten an auditor’s independence: self-review, self-interest, advocacy,familiarity and intimidation. An important theme here is that even in their public interest role, an auditor is stilljust a human being, and vulnerable to the usual human weaknesses and failings. The independence guidance

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-2Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.attempts to bring these potential weaknesses to light, so auditors will have a better chance of seeing when theymight be failing to remain impartial. A self-review threat means the auditor is checking his/her own work; in thiscase s/he cannot provide the critical, independent perspective that a user (third party) would expect. With a self-interest threat, the auditor has something personal to gain and so is not free to do what is in the user's bestinterest-in that case his/her opinion will not meet the user's needs. With an advocacy threat, the auditor hastaken a personal stand in support of the first party's positions, so they are invested in that and will have a hardtime seeing objectively whether the position they publicly supported is wrong-again the auditor is not free to actin the user's best interest. With a familiarity threat, the auditor is too friendly and close to the firstparty andthatmakes it more difficult for the auditor to suspect or believe that this well-known person would do anything wrong,or act against the best interests of the third party. In the case of an intimidation threat, the auditor is facingpersonal risk and naturally must put their own critical interests first, before they can meet their professionalresponsibilities. In an intimidation threat situation, an auditor would need to seek legal advice on how best toprotect him/herself without violating their professional duties.2-7.Financial statement audits are required in various laws. Corporation laws require companies to produce auditedannual financial statements (though private and smaller companies sometimes can waive this requirement), andsecurities laws require public companies to file audited financial statements within 90 days of their year end.2-8.The professional ethics codes incorporate professional accounting and auditing standards, making compliance withthese standards the bottom-line professional responsibility of professional accountants. CPA members meet theethical requirements of professional competency and due care in performance their work by complying withrequirements of the CPA-Canada standards for accounting (generally accepted accounting principles, GAAP, e.g.,ASPE or IFRS) and auditing (generally accepted auditing standards, GAAS: CAS).2-9.The overall objectives of a financial statement audit are stated in Canadian Auditing Standards (CAS) in the CPA-Canada Assurance Handbook, in CAS 200, “Overall Objective of the Independent Auditor, and the Conduct of theAudit in Accordance with Canadian Auditing Standards” CAS states a financial statement auditor's overallobjectives are: (a) To obtain reasonable assurance about whether the financial statements as a whole are freefrom material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion onwhether the financial statements are prepared, in all material respects, in accordance with an applicable financialreporting framework; and (b) To report on the financial statements, and communicate as required by the ISAs, inaccordance with the auditor’s findings.CAS 200 also sets out principles and fundamental concepts that underliethe auditing function.2-10.Self-regulation refers to the powers a professional group has in regulating its affairs without intervention byagovernment oragovernment established external regulator. These affairs include setting of standards, codes ofconduct, 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 ofthe audit function. Auditing is increasingly viewed as a key pillar in capital markets, along with regulators and goodgovernance practices. As a result external regulation of the profession has been increasing. In Canada, this hastaken the form of increased monitoring of auditors of public companies via CPAB. CPAB however does not havethe power to create audit and ethics standards as does the PCAOB in the U.S. Nevertheless, both CPAB and PCAOBare increasinglyassertive monitoring the quality of audit practice and sanctioning auditors who do not meet theirexpectations. A major focus of inspections by CPAB and PCAOB is the quality of the audit. Quality generally refersto 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 ofthose 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. Anexample 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 thecriteria for determining the adequacy of the new procedures.

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-3Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.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 proceduresand the relative seriousness of their omission. The importance of any "omitted procedure," however, is theevidence the auditors failed to obtain. Merely omitting technical procedures is only a superficial analysis of anaudit problem; the substance is the evidence not obtained.The standard for due audit care is the care which would be exercised by theprudent auditor. The prudent auditoris one who exercises reasonable judgment, who is not expected to be omniscient, who is presumed to haveknowledge special to his profession, who is expected to be aware of his own ignorance, who is expected to possessthe skills of his profession whether he is a beginner or a veteran.2-11.The Canadian board (CPAB) is more self-regulatory in that the profession has more influence through having ahigher percentage of board membership,the monitoringprocess is less public and more designed to help firmsimprove their practices. The CICA continues to set audit standards. The PCAOB, on theother hand, not only setsstandards 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 publiccompany audits in the U.S. In Canada, audit standards are set by theCPACanadawhile professional ethicsstandards are set by the provincial institutes/societies of CGAs, CMAs, and CAs. PCAOB reports are much moredetaileddisclosing the results of each inspection by firm, whereas CPAB reports are more generic providing anoverall evaluation of the state of public company audits in Canada.Students generally find the PCAOB reportsmore interesting because they learn about problems identified for the firms they have accepted positions in. TheCPAB 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 issuersby market capitalization, had a GAAS deficiency rate of 20-26% on files inspected by CPAB.” Other audit firms had a47% GAAS deficiency rate. CPAB found these results consistent with other regulators. This is not just a Canadianproblem.2-12.CA’s, CGA’s, and CMA’sare the old terms. They are all now CPAs and belong to CPA Canada and related provincialassociations such as CPA Ontario.2-13.Examples of otherassurance services rendered onrepresentationsother than financial statementsare onissuessuch asthe effectiveness of internal controls, vote counts at the Academy Awards, forecasts of financialinformation, 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 1.2-14.The three major areas of publicaccounting services:Accounting and auditingTaxationManagement advisory services (consulting)2-15.The SEC site is more comprehensive but covers only the Canadian companies crosslisted on U.S. exchanges.2-16."Procedures" relate to acts to be performed. "Standards" deal with measures of the quality of performance ofthose 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. Anexample 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

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-4Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.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 proceduresand the relative seriousness of their omission. The importance of any "omitted procedure," however, is theevidence the auditors failed to obtain. Merely omitting technical procedures is only a superficial analysis of anaudit problem; the substance is the evidence not obtained.2-17.The standard for due audit care is the care which would be exercised by theprudent auditor. The prudent auditoris one who exercises reasonable judgment, who is not expected to be omniscient, who is presumed to haveknowledge special to his profession, who is expected to be aware of his own ignorance, who is expected to possessthe skills of his profession whether he is a beginner or a veteran.2-18.Three elements of planning and supervision considered essential in audit practice are:1. Awritten 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 orauditing conclusions and disassociate himself or herself from the matter.3. Ensuring that staff have appropriate training and competence to perform the audit.2-19.The timing of the auditor's appointment matters because the auditor needs time to plan the audit properly andperform the work without undue pressure from too-short deadlines.2-20.An auditor obtains an understanding of a client's internal control systemas a part of the control risk assessmentprocess 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 theinformation generated by theauditee’s accountingsystem.A secondary purpose (not covered in Chapter 2) is toobtain information about reportable conditions (control deficiencies) to report to the client.2-21.CAS 500.5(c) definesaudit evidence as “Information used by the auditor in arriving at conclusions on which theauditor’s opinion is based. Audit evidence includes both information contained in the accounting recordsunderlying the financial statements and other information.”Audit evidence is (and includes) all the influences onthe 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; itmay be absolutely compelling or only mildly persuasive to a decision.2-22.Thetenimportant elements of the standard unmodifiedaudit 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 theintroduction paragraph.4.Responsibilities. The report should state management's responsibility for the financial statements and theauditor's responsibility for the audit report. These statements are also in thelastparagraph.5.Description of the Audit. Theauditor responsibilities and basis for opinionparagraphs(scope paragraphsshould declare that the audit was conducted in accordance with generally accepted auditing standards anddescribe the principal characteristics of an audit, including a statement of belief that the audit provided areasonable basis for the opinion.6.Opinion. The report shall contain an opinion (opinion paragraph) regarding conformity with generallyaccepted 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.

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-5Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.9.Key audit matters paragraph indicate significant judgments or uncertainties in the audit10.Address2-23.CPACanadaHandbook Recommendations are the highest level of authoritative support for GAAP.Textbooksandjournal articles are the lowest level. In between are regulatory requirements emerging issues task force guides,HandbookGuidelinesand the Conceptual Framework.Some would argue that an appropriate conceptualframework should be the highest set of principles.2-24.Yes.The unmodifiedopinion sentence contains in the audit report implies, among other things, that the accountingprinciples used by the company are appropriate in the circumstances.2-25.Four types of opinions and their messages:TypeMessageUnmodifiedopinionFinancial statements are presented in conformity with GAAP.Adverse opinionFinancial statements are not presented in conformity with GAAP.Qualified opinionFinancial statements are presented in conformity with GAAP, exceptfor one or more departures.Disclaimer of opinionAuditor's declaration that no opinion is given.2-26.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.2-27.The major differences between assurance standards and generally accepted auditing standards(GAAS)lie in theareas 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 offinancial 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 aninformation 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 samesense as a financial accounting and reporting system.Reporting is different because assurance on nonfinancial information do not depend upon generally acceptedaccounting principles. The assurance standards speak of "evaluation suitable criteria," and "conformity withestablished or stated criteria" and leave the door open for assurance on a wide variety of informational assertions.2-28Anassurance engagement is: An engagement in which a practitioner is engaged to issue or does issue a writtencommunication that expresses a conclusion concerning a subject matter for which the accountable party in anaccountability relationship is responsible.2-29The theoretical essence of an assurance engagement is an person's ability to recognize the information beingasserted, determine the evidence relevant to the assertions, and make decisions about the correspondence of theinformation asserted with suitable criteria.2-30The assertion is that amateur golfers can drive Wilson golf balls farther than competing brands. The Wilsoncompany is the asserter (2ndparty), the PA firm is the assurer (1stparty), and the amateur golfer is the 3rdpartyowed accountability. The criterion is the average drive by the average amateur golfer. This criterion allowsobjective verification with sufficient numbers of representative amateurs at high (audit) level of assurance. Critical

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-6Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.issues: how to define amateur golfer and the population it represents? How to obtain a representative sample ofamateur golfers? What are representative golfing conditions? What is a sufficient sample size to determine theaverage drive with audit level assurance so that the auditor does not commit the logical fallacy of “hastygeneralization”?SOLUTIONSTOMULTIPLE-CHOICE QUESTIONSMC 2-1 LO3It is always a good idea for auditors to begin an audit with professional skepticism characterized by theassumption thata.apotential conflict of interest always exists between the auditor and the management of the enterprise underaudit.b.in audits of financial statements, the auditor acts exclusively in the capacity of an auditor.c.the professional status of theindependent auditor imposes commensurate professional obligations.d.financial statements and financial data are verifiable.MC 2-2 LO3When Auditee Company prohibits auditors from visiting selected branch offices of the business, this is anexample of interference witha.reporting independence.b.investigative independence.c.auditors’ training and proficiency.d.audit planning and supervision.MC 2-3 LO4After the auditors learned of Auditee Company’s failure to record an expense for obsolete inventory, theyagreed to a small adjustment to the financial statements because the Auditee president told them the companywould violate its debt agreements if the full amount were recorded. This is an example of a lack ofa.auditors’ training and proficiency.b.planning and supervision.c.audit investigative independence.d.audit reporting independence.MC 2-4LO3Theprimary purpose for obtaining an understanding of the company’s internal controls in a financialstatement audit is toa.determine the nature, timing, and extent of auditing procedures to be performed.b.make consulting suggestions to the management.c.obtain direct, sufficient, and appropriate evidential matter to afford a reasonable basis for an opinion on thefinancial statements.d.determine whether the company has changed any accounting principles.MC 2-5LO4Which of these generally accepted auditing standards are not affected by the auditee’s utilization of acomputerized accounting system?a.The audit report shall state whether the financial statements are presented in accordance with GAAP.b.The work is to be adequately plannedand assistants, if any, are to be properly supervised.c.Sufficient appropriate evidential matter is to be obtained...to afford a reasonable basis for an opinion regardingthe financial statements under audit.d.The audit is to be performed by a person or persons having adequate technical training and proficiency as anauditor.MC 2-6 LO2Which of the following is not found in the standard unqualified audit report on financial statements?a.An identification of the financial statements that were auditedb.A general description of an auditc.An opinion that the financial statements present financial position in conformity with GAAPd.An emphasis paragraph commenting on the effect of economic conditions on the companyMC 2-7 LO4Assurance standards do not contain a requirement that auditors obtaina.adequate knowledge in the subject matter of the assertions being examined.

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-7Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.b.an understanding of the auditee’s internal control structure.c.sufficient evidence for the conclusions expressed in an attestation report.d.independence in mental attitude.MC 2-8 LO3Auditor Jones is studying a company’s accounting treatment of a series of complicated transactions inexotic financial instruments. She should look for the highest level of authoritative support for proper accounting ina.provincial securities commissions’ staff position statements.b.CPACanadaindustry audit and accounting guides.c.CPACanadarecommendations in theHandbook.d.Emerging Issues Committeeconsensus statements.MC 2-9 LO5Which of the following is not an example of a quality control procedure likely to be used by a publicaccounting firm to meet its professional responsibilities to auditees?a.Completion of independence questionnaires by all partners and employeesb.Review and approval of audit plan by the partner in charge of the engagement just prior to signing the auditor’sreportc.Evaluating professional staff after the conclusion of each engagementd.Evaluating theintegrity of management for each new audit clientMC 2-10 LO3Which of the following concepts is not included in the wording of the auditor’s standard report?a.Management’s responsibility for the financial statementsb.Auditor’s responsibility to assess significant estimates made by managementc.Extent of auditor’s reliance on the auditee’s internal controlsd.Examination of evidence on a test basisMC 2-11 LO3Which of the following is not mandatory when performing an audit in accordance with GAAS?a.Proper supervision of assistantsb.Efficient performance of audit proceduresc.Understanding the auditee’s system of internal controlsd.Adequate planning of work to be performedSOLUTIONS FOR EXERCISES AND PROBLEMSEP2-1a.PAs should not follow clients' suggestions about the conduct of an audit unless the suggestions clearly donot 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 suggestionrepresents a good idea a PA can accept it. Within professional bounds, mutual agreement with the client isall right. The PA must never agree to any arrangement which violates generally accepted auditing standardsor the Code of Professional Conduct.b.The reasons against dividing the assignment of audit work solely according to assets, liabilities and incomeand expenses include the following:1.Work should be assignedto staff members by considering the degree of difficulty in relation to thetechnical 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 existsamong a number of accounts in more than one category, as for example where income is based onassets 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 andtheprepaidbalance.5.Duplication of staff effort would be more likely to occur if assignments were made on such a basis.

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-8Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.6.Frequently, the scope of work regarding a single account requires simultaneous participation by thestaff, such as in the observation of inventories.7.Many audit operations are not susceptible to division by category, as for example investigatinginternal control, testing transactions and writing the report.c.The staff member whose uncle owns the advertising agency should not be assigned to examine theadvertising account, even if this is the staff member that has the most detailed, in-depth knowledge of thisaccount. The firm is responsible for avoiding any relationships which might even suggest a conflict ofinterest. Even if this staff member could show independence and not be biased, it still could seem as ifthere's a conflict of interest to outsiders. So to play it safe, it would be better to avoid this type of situation.If an issue came up down the road, it could potentially jeopardize the firm's position; therefore, anysituation where a bias might exist, that situation should be avoided.EP2-2From a theoretical viewpoint (and, infact, from a practical viewpoint as well) such short notice of a request for anaudit causes difficulties with planning the audit work, with staffing, and with reviewing the work--all of thesefeatures being elements of the exercise of due audit care. The December 26-January 20 period is a serious timeconstraint for a first audit. The greatest difficulties involve the third general standard (due audit care) and thethree field standards. In view of the short notice and the time constraint, there may be some question as towhether a sufficient first audit could be completed by January 20.EP2-3You must determine whether an unqualified opinion satisfies the GAAS reportingstandard, 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 orones 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 beenapplied consistently.c.Determine whether the footnote disclosures are adequate to inform users of any material informationevident in the working papers.EP2-4GAAS in aComputer EnvironmentIn an audit of a computer-based system, adequate training and experience must be directly related to EDP. Inparticular, the auditor should be knowledgeable of what computer systems do, how to test the operations of anEDP system, and how to use EDP-unique documentation.The training and proficiency standard contributes to satisfaction of the independence standard by enabling theauditor to make his own decisions and judgments. Otherwise, he might tend to subordinate his judgment to otherpersons, possibly to client personnel. When the auditor lacks training and proficiency, it is virtually impossible tomaintain an operational independence over audit decisions. An independence of mental attitude is futile if actualdecisions are subordinated to others.The exercise of due audit care requires a critical review at every level of audit supervision of the work done andthe decisions made by auditors Lacking the requisite skills and lacking independent decisions, the due careexpected of an auditor at operational, supervisor, and review levels cannot be delivered.

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-9Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.The first field work standard requires adequate planning and supervision of assistants. Training and proficiency incomputer systems auditing is necessary in order to plan access to computerized records, programs, and to obtainmachine time for conducting audit procedures. The planning should provide for an early examination of thecomputer system so that further procedures involving non-computer control and accounting features may beplanned should they depend upon computer control procedures.Training and proficiency are very important for being able to obtain an understanding of the internal controlstructure in a computer system. Client personnel will expect audit personnel to be capable of working with acomputer system.The third standard of field work requires the auditor to obtain sufficient competent evidential matter to provide abasis for an opinion on financial statements. Documentary evidence relating to a computer system includesprogram 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, andunderstanding of them comes through training and proficiency in their use.EP2-5Audit Report Languagea.The auditor is reporting to the body that has engaged the auditing services. While the report may be readand used by others who are indirect beneficiaries of the audit, current custom is not to address the reportto the unknown class of users.b.The scope paragraph should specifically identify the audited statements by name so that there can be nomistake 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 thatare 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 "thecircumstances," 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 lessstrong than positive knowledge. Canadian auditors do not wish to appear to have full, positive knowledgeabout the statements on the grounds that it's not feasible to know all there is to know about the financialstatements. Also, the standard language leans heavily on GAAP as the criteria for fair presentation whereasthe alternative language contains no reference to authoritative accounting criteria.EP2-6The question requires one to review and discussthe currentregulatory development in the audit profession. Somepoints that can be discussed include:The public accountability boards are intendedto provide an additional level of independence for the publicaccounting function. Public concerns arose that public accountants and auditors lack independence because theyare 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 financialstatements, the audit role has value because it provides an independent assessment of the validity of the claimsmanagers are making in their financial statements. This independent audit assessment is important to outsidersusing the financial statements because it enhances the reliability of that information. Since outsiders may suspectthat managers will issue biased information if left to their own devices, they demand an independent assessmentof the manager’s claims as this should detect any bias and require the manager to correct it. An effectiveindependent audit function should also act as a deterrent against managers issuing biased reports in the firstplace. This function is referred to as monitoring. If outsiders question the independence of the auditor it cannot

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-10Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.provide this monitoring value.A concern raised bysomeis that, if auditors lack independence, they themselvesrequire some monitoring. It isthis" 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 arestill evolving.The boards may also become involved in establishing generally accepted auditing standards, quality control reviewstandards, peer review requirements and other specific procedures that public accountants and auditors will berequired to adhere to.EP2-7The 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 hasentered into. One means by which an auditor might determine the potential financial impact of contract would beto 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 impacton the Company that should be included in the Company's financial statements. Here the auditor has a scopelimitation that prevents providing an opinion on whether the financial statements are fairly stated as there is thepossibility that the statements exclude a material liability that should either be accrued or disclosed. In thissituation,the auditor has a responsibility to ensure that users are aware of the existence of the contract and theauditor's inability to assess the potential impact of contract or to obtain evidence from the Company or its lawyerregarding the potential impact. Users' decisions based on the financial statements may well be affected if they areaware that Company management is bound by a contract yet cannot provide a reasonable explanation of itsimpact.In situation b) the Company is subjecttoregulations that can have a financial impact if violated. Determining if aviolation has occurred requires scientific information. In this situation,the auditor would be required to try todetermine whether any violations had occurred. Appropriate evidence would require obtaining representationsfrom people with scientific qualifications because experts must be qualified in order for auditors to rely on theirrepresentations as evidence. In this situation,it is possible that the auditor could obtain reasonable evidence fromscientific experts so no scope limitation would arise. However,similar to situation a) if the auditor it is unable toobtain evidence that can confirm whether the financial impact of complying with the environmental regulation hasbeen properly measured and reported, then the scope limitation exists and this should be noted in the auditreport. Similar to situation a),users’decisions may be affected by the fact that the company is not able to provideevidence to the auditor about whether or not it is violating governmental regulations.EP2-8ITR's statements does not appear to be an assurance engagement, after considering the components of assuranceengagements.Theparties involvedare ITR and Knovel.•These parties could be involved in an assurance engagement, with Knovel making in assertions regarding asubject matter and ITR providing assurance to third parties regarding that assertion.Thesubject matteris 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 assuranceprovider needs to obtain management's acknowledgment of responsibility for the subject matter as it relatesto this objective. Since Knovel management cannot be responsible for how a purchaser of a software productimplements that product to achieve operational savings and recover the investment in that product over aperiod such as three months, itwould be difficult to identify generally accepted, appropriate criteria forassessing the subject matter in this case. This leads to the conclusion that this is not a subject matter on whichan assurance can be provided in accordance with assurance standards set out byCPA Canada.

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-11Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.Theaccountability relationshipswould be between the Company and the assurance provider, and between each ofthese parties and third parties. The third parties would be potential customers that could be making decisionsbased on the assertion and on the assurance attached to that assertion.These accountability relationships couldresult in an assurance engagement.Thenature of the reportthat could be issued, in accordance withCPACanadaassurance standards, would be asfollows:•The report would need to identify to whom it is addressed, the objective of the assurance engagements, theentity and the subject matter covered by the engagement, management's assertion, the responsibilities ofmanagement and theassurance 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 beingprovided, 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 theclaim that the Knovel software will payback in three months. Since ITR has not performed an assuranceengagement,it has no basis for providing such assurance. Thus it is not appropriate to publicize this claim in a waythat implies ITR is providing assurance on it.EP2-9The question involves the relation between GAAP and providing an audit opinion. One approach to this issue is asfollows.a)When an auditor needs to assess whether CPACanadaHandbook Recommendationshave been followedbut theHandbookis silent on a particular issue, auditors usually go down a hierarchy to find the nexthighest source of support for the client's accounting solution to a financial reporting problem. Theauditor can refer to the positions taken on accounting matters by provincial securities commissions, toaccounting pronouncements issued in other countries (for example, the US Financial AccountingStandards Board or the International Accounting Standards Board), industry accounting guidelines andpractices followed in financial reports of other companies in the same industry,CPACanadaEIC consensuspositions, accounting research reports, textbooks, etc.In using any of these supports, including theCPACanadaHandbook,to determine what is GAAP in aparticular situation, the exercise of good professional judgment by the auditor is critical. In applyingjudgment,the auditor has to take into account the context of the situation, how the information will beused,who theusersareand what their level of sophistication and access to other information is, themotives of the preparers of the accounting information, and any other relevant issues that in the auditor’sexperience may shed light on the reliability and appropriateness of the reported information.Possibleexamplesof accounting issues that may not be covered inCPACanadaHandbookRecommendations(current at time of writing, but note thatCPACanadaHandbook Recommendationsareupdated frequently)-revenuerecognition for complex software sales that combine software and future services such asmaintenance-capitalization or expensing of environmental control equipment expendituresb)When the CPACanadaHandbook Recommendationsallow for different choices of accounting methods,the auditor needs to consider whether the client's choice is appropriate inthecircumstances. Again, theexercise of good professional judgment by the auditor is critical. In applying judgment,the auditor has totake into account the context of the situation, how the information will be used, whotheusersareandwhat their level of sophistication and access to other information is, the motives of the preparers of theaccounting information, and any other relevant issues that in the auditor’s experience may shed light onthe reliability and appropriateness of the reported information.Examples of accounting choices set outin CPACanadaHandbook Recommendations(current at time ofwriting, but note thatCPACanadaHandbook Recommendationsare updated frequently)

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-12Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.-revenue recognition-amortization method-inventory costs flow methodEP2-10(Some instructors may prefer to defer this question until after Chapter 14 is covered.)The case presents a scenario where events occurring subsequent to theyear-endpotentially have an impact on theinformation 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 statementsare prepared, financial statements can become out of date before they are even issued, especially when businessand 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 financialstatements. In this case, information regarding the launch of a competing product can have a harmful impact onsales contracts the company is in the process of negotiating. Here Company management is arguing that this isproprietary information and that it has to be kept private. On the other hand, the auditor believes this informationhas a material impact on the company’s financial position and therefore it must be reported to users. The auditormight 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 ofgiving the impression that is trying to mislead these potential customers. This can be very damaging to thecompany's reputation, and have very significant negative impact on its future operations. This negative impressionwould be aggravated by a qualified audit report which indicates that, not only was management aware of this newdevelopment, but it also refused to disclose the information even though the company’s auditor was insisting ondisclosure.A further issue is the reliability of estimating the potential impact of the new product on the Bunting's futureearnings. As management points out, since the product is untried in the marketplace it may well not operate asadvertise. So it is a conjecture to say that its impact on Bunting's operations can be known at this time. This isdifficult trade-off for the auditor to make: how should information that is highly relevant to users and theirdecisions but very difficult to measure reliably the handled in audit engagement? This line of reasoning wouldsuggest that the auditor's may have gone too far in including estimated amounts and their impact on financialstatement items in their audit qualification. This may explain why Bunting's management refused to accept theauditor's approach, resulting the qualified audit report.Other valid issues based on the case facts can be identified, analyzed from different perspectives, and concludedon.EP2-11(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 toconduct the audit with due care. Accepting management representations as being truthful without attempting toverify 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. Somerepresentations are not amenable to verification using feasible audit procedures. A good example of this is thecompleteness representation. Management represents that it has presented complete information concerning itsliabilities, its revenues, its commitments, etc.but to verify these claims is not feasible. For example, verifyingcompleteness 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 auditingstandards. 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

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-13Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.documented in management’s "Letter of Representation". Further, management's responsibility for the financialstatements is explained in the standard wording of the auditor's report. Also, many companies, especially publiccompanies, include with the financial statements a "Statement of Management's Responsibility" to communicateto 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 anaudit can provide. Audits can never provide 100% assurance, and knowledgeable users are expected to be awareof the limitations of audits.EP2-12(Some instructors may prefer to defer this question until after Chapter17is covered.)The question requires the application of basis assurance principles to a uniquesetting,United Nations weapons inIraq. 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") representsthatthere 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 ofmass destruction, the inspectors would want to reduce the risk of missing hidden weapons to very low level. Toparallel this to an audit of financial statements, this would be like setting the acceptable audit risk very low, whichthe auditor will do when the consequences to the auditor of missing a misstatement in the financial statementscan 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 statementaudit. Based on their resources devoted to the weapons inspection exercise and a heightened attention focusedon theinspectors work and findings, it seems the UN assessed the inherent risk that weapons exist as being veryhigh. This may have been based on internal investigations, intelligence reports or other information available tothe inspectors but not public knowledge.To implement the inspection, the inspectors would have to follow a systematic process similar to that followed byfinancial statement auditors.The inspectors would need to obtain a knowledge of the types of weapons and weapon manufacturing equipmentthat may exist, where such weapons could be concealed, the process involved in creating such weapons andtransporting them. This could be paralleled to the "knowledge of business" that the financial statement auditorrequires in order to plan and execute the audit. This knowledge would inform the inspectors of the kinds of placesthat they need to visit and the kinds of evidence that may exist to indicate that weapons have been created ortransported to a particular location. Any internal reports or other intelligence that exists concerning the use ofpublic buildings for storing concealed weapons would also be relevant to determining the probabilities thatweapons are concealed in particular locations.A planning procedure would need to be followed to scope out the extent of the territory and existing structuresand facilities that will need to be inspectedandthe staff required. This will determine the number of inspectorsthat need to be employed, the types of qualifications they require, the specific procedures they will have toperform and to estimate the time required to complete the inspection.EP2-13According tosome recentCPAB reports PA firms seem to have most problems with meeting the independencerequirements and the quality of documentation in their audit files. These problems have been ongoing for the first10years of the CPAB’s monitoring. In partthis may be why the Handbook now has a special section dealing withstandards for quality control for PA firms.CPAB findings seem to increasingly influence theCPACanadaandit, in

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Smieliauskas & Bewley,Auditing: An International Approach, 7thEditionPage 2-14Solutions Manual© 2016, McGraw-Hill Education. All Rights Reserved.turn, is influencing IFAC. For example, theCPACanadaat the urging of CPAB has recently created threecommittees 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.EP2-14One major source of the expectations gap is the public’s expectationsregarding auditor responsibilities to detectfraud. Discuss in class. The profession’s response is discussed in chapter 7. This is a complex problem.Somequestions 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 levelemployee fraud?Should the auditor have responsibility only for fraud affecting the financial statements or for anyfraud? Does fraud have to be a material amount, or is all fraud automatically material no matter how small theamount?It is also important to keep in mindthat accusing somebody of committing fraud (or any criminal act) canlead to libelunless the accusation is proven in a court of law. In Canada’s legal system an individual is consideredinnocent until a criminal act is proven in a court of law. These are just some of the complications in trying to closethe expectations gap. For now it is sufficient for the students to get a general idea of the complexities and this canbe done best through class discussion.EP2-15There definitely seems to be more of an expectations gap in the private sector. Chapter 1 illustrates that publicsector auditors have some of the best reputations in Canada.You cannot say the same about partners in theprivate sector! Some might argue that is due to the fact public sector auditors arguably have more independencethan private sector auditors.See application case discussion for chapters1 and 2.For example, when an auditorgeneral decides which organization to audit and what type of audit (VFM? Compliance?)to perform, the auditeecannot say no! Public sector auditors have been very successful in rooting out corruption and waste and thisappears to be closer to the public’s image about what all auditors should be doing. See discussion in EP15. Perhapsall audits should be more like VFM audits in meeting the public’s expectations.Again, surveying class attitudes atthis point is a good way to get students thinking about what should be the role of auditors and comparing that towhat standards actually require.EP2-16Most students find that theirnon-accounting friends or relatives have only a vague understanding of what auditorsdo.Having them read the audit report does not seem to have improved matters.See discussion ofanswer toEP 2-15. Perhaps a more valid question is whether more sophisticated users have a better understanding.

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 3-1Solutions Manual© 2016, McGraw-HillEducation. All Rights Reserved.CHAPTER3AUDITORS’ETHICAL AND LEGAL RESPONSIBILITIESSOLUTIONS FOR REVIEW CHECKPOINTSESSENTIALS3-1.The essential role and responsibility of an auditor is to establish and communicate assurance to users that thefinancialstatements are‘fairly presented’, which implies that unethical reporting has not occurred. Unethicalreporting means the accountable party has prepared the financial statements in a biased way thateitherconcealsfraud or provides a deceptive and misleading impression of the financial performance and condition of a company.Unethical reporting is an aspect of information risk. To reduce the information risk, the auditor must consider thepossibility, and address any suspicions, that the reporting has beendone unethically.3-2.Tosay financialstatements are‘fairly presented’implies that unethical reporting has not occurred. It means thefinancial statements meet the qualitative characteristics set out in the conceptual framework of accounting, themost relevant of which is‘representational faithfulness’. This quality means that information presented in anentity’s financial statements closely corresponds to the actual underlying transactions and events affecting it,conveying their economic substance rather than simply their legal form. Informally, fair presentation means thatoutside users have a fair shot at making reasonable decisions based on the information in the financial statements.3-3.An example of a potential conflict between a manager and shareholders of a company would be whenmanagement decides to incur lavish travel expenses which are not directly leading to increased profits and hencenot in the long term interest of shareholders. A conflict between auditors and management can arise whenmanagement want use an aggressive revenue recognition policy, or a valuation model that underestimates its baddebt provision, and auditors contend these policies are not appropriate. A conflict could arise between theauditors and the shareholders if the auditors gave a clean opinion and the company later had to restate its profitsto a much lower amount.The shareholders would probably think the auditors had done a poor job, or perhapsthey even were complicit with management and not acting in the shareholders’best interest.3-4.An example would be when an auditor has been auditing the same company for many years and becomes veryfond of some of the people in the accounting function there.Thiscan happen through many shared experiencesworking together on the challenges of completing theaudit thatbuild up good memories. In this case it requiresstrong will on the part of the auditor to recognize and act appropriately, in an unbiased way, ifa situation shouldarise where the someone inthe accountingstaff is doing something that impairs the auditors ability to get theevidence they need to comply with GAAS, or takes a decision that result in the financial statements not being fairlypresented.3-5.Professional skepticism means that an auditorneither trusts nor distrusts claims made by managementof theenterprisebeingaudited. The auditoralways wants to question theseclaims andtherefore seeksindependent,corroborating evidence. The auditor has a duty to corroborate management’s claims and assertions-this is whatthe ethics code refers to as using‘due care’. A practical approach to being skeptical is to always be thinking about‘what could go wrong here?’3-6.Critical thinking is a process of reasoning logically to assess whether evidence provides reliable reasons thatsupport a particular claim. Auditors must gather their own evidence on the financial statements and disclosures toreach reasonable and supportable decision to provide assurance on the truthfulness of management’s financialstatements, and use critical thinking to reach their conclusions.3-7.Professional judgment refers to an auditor applying relevant training, knowledge and experience, in the context

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 3-2Solutions Manual© 2016, McGraw-HillEducation. All Rights Reserved.provided by auditing, accounting and ethical standards, to make informed decisions about the most appropriateaction to take in the circumstances of an audit engagement. Professional judgment in auditing requires criticalthinking on accounting issues and the evidence related to them. A critical-thinking framework can be used fordeciding when an audit conclusion is sufficiently justified, giving consideration to possible conflicts of interest.3-8.Good professional judgment in auditing involves applying relevant training, knowledge and experience, in thecontext provided by auditing, accounting and ethical standards, to make informed decisions about the mostappropriate action to take in the circumstances of an audit engagement. Experience is required to develop goodjudgmentbecause most important lessons are learned by trying something new and making mistakes. To allowprofessionals to develop good judgment, auditing work is typically organized so that more junior auditors workunder the supervision of more experienced ones.3-9.A strong argument can be made that itcannot. Being independent and objective, taking a skeptical attitude, andthinking carefully and critically, are an individual responsibility. But people may also find it challenging to‘think forthemselves’. It may seem difficult to go against the views of more experienced people, or the views of themajority. But if an individual’s own critical reasoning leads to the conclusion that some action or decision isunethical, it is still unethical even if more experienced people support it, or‘everyone is doing it’.3-10.‘The expectation gap’refers to a difference between what users of audit reports expect-that auditors will alwaysdetect errors, fraud, theft, and illegal acts and report them publicly, and what auditors take responsibility for-detecting material misstatements. This gap can lead to lawsuits, particularly if a business fails. That is because evenif auditors have performed well, the users may expect them to have done more to warn of the future businessfailure. Ifan auditfails to detect unethical reporting, and the third party believes that auditors have not met theirprofessional responsibilities, auditors can face legal liability.3-11.To establish auditor liability under common law, the plaintiff (the party who claims to have been wronged) mustprove four elements of negligence:1. There was a legal duty of care to the plaintiff;2. There was a breach of that duty;3. There is proof that damages to the plaintiff resulted from the breach;4. There is a reasonable connection between the breach and the damages.Theauditor'sdefense in a liability law suit is to show that any of the elements is not proven.3-12.Statutory liability is written into law statutes which specify when auditors can be found liable and the ranges ofpenalties auditors can be charged if they are liable. In common law, auditor liability principles and penalties are setby judges, who refertobasic principles of fairness and to the past decisions of courts of law to support theirjudgments. The development of statute-based regulation of auditors reflects that governments no longer rely onthe audit profession to self-regulate, as historically was the case.TEXT3-13Thisarises from the three party accountability discussed in chapter 1. The auditor is hired because users expectthere 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. Thegoalis to reduce this potential to anacceptable level of risk. If the auditor assumed this risk was zero to start with the auditor would not need toprovide evidence that the possibility is low, and that contradicts the reason users demand an audit.3-14No, the auditor cannot detect deception without being skeptical.Anon-skeptical auditor on finding evidence offraud may not treat it with the significance it deserves. The rule that suspicious transactions or evidence ofmanagement deceit should automatically be considered material, even when the absolute amounts involved maybe very small or insignificant, is an example of skeptical logic in action. Since three party accountability impliessome degree of mistrust of management by users, the auditor must incorporate skepticism in his or her reasoningprocess when management makes assertions about the financial statements it has prepared.

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 3-3Solutions Manual© 2016, McGraw-HillEducation. All Rights Reserved.3-15A professional accountant must be prepared to be agent, spectator, advisor, instructor, judge,and critic.3-16Inethical philosophy, the word“conscience”is used to describe the“undefinable mental process that yields moraldecisions.”A close kin in the political science terms would be“anarchy.”Consciencemight notbe a sufficient guide for personal ethics decisions because the individual’s undefinablemental 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 ethicalstandards and behavior. Exactly the same can be said about professional ethics decisions because anonhypocritical individual can no more split his behavior between personal life and professional life than he canvoluntarily split his own personality.3-17The rule“Failure to tell thewholetruth is wrong”would (a) require that you not serve as a bank director when aconflict of interest might arise, (b) tell the employer what you know about the forgeries. This rule may be calledimperativebecause it requires the truth regardless of what you might personally feel about the consequences.Strictduty based orimperative theories(e.g., Kant) excuses the individual from undesirable consequences as longas his decisions do not cause other people to be used as means.3-18Utilitarian ethics theory requires that a decision maker recognizes value attributes of the consequences of ethicalchoice alternatives (good v. evil), somehow measure or weigh these, and then decide on the basis of the greatergood (or the lesser evil).Duty based ethicsdoes not require that consequences be considered.3-19Monistic theories are based on idealizations or simplifications of the real world. The real world is“messy”with thecontext of a situation, such as whether there is three party or two party accountability, having a major impact onthe proper role of an individual. Everyone has multiple social roles in life and it is the conflicts in these multipleroles that seem to cause the most problems for monistic theories.3-20In thecurrent auditenvironment, PAs are expected to better justify their decisions. This need for justification,including the consideration of ethical issues,increasesthe importance of critical thinking.3-21Three specific aspects of on-the-job independence1.Programming independence2.Investigative independence3-Reporting independence3-22Ina class action lawsuit, a few aggrieved persons with small losses can bring suit on behalf of a large group ofsimilar persons, collectively having large losses (as in a securities offering). Large lawsuits often result in largedamage awards, and many lawyers are willing to takesuchplaintiffs on a contingency fee basis. Such fees are verylucrative for lawyers, and probably less lucrative for their clients. Anyway, the losses loom large for PAs and theirinsurance companies.3-23Somecauses are as follows:•Failure to report known departures from accounting principles, including misinterpretation of accountingprinciples.•Failure to conduct audits properly, including (a) misinterpretation of auditingstandards, and (b) faultyimplementation 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.3-24Lawsuits related to tax practice, about60percent.

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 3-4Solutions Manual© 2016, McGraw-HillEducation. All Rights Reserved.SOLUTIONS FORMULTIPLE CHOICE QUESTIONSMC 3-1 LO5Auditors are interested in having independence in appearance becausea.they want to impress the public with their independence in fact.b.theywant the public at large to have confidence in the profession.c.they need to comply with the standards of field work of GAAS.d.audits should be planned, and assistants, if any, need to be properly supervised.MC 3-2 LO1If a PA says she always follows the rule that requires adherence toCPACanadapronouncements in orderto give a standard unqualified audit report, she is following a philosophy characterized bya.the imperative principle in ethics.b.the utilitarian principle in ethics.c.the generalization principle in ethics.d.reliance on one’s inner conscience.MC 3-3 LO4Which of the following“committees”have been authorized to discipline members in violation of the rulesof professional conduct?a.CPACandaCommittee on Professional Ethicsb.Appeals Committeec.Discipline Committeed.Professional Conduct CommitteeMC 3-4LO4Which of the following bodies does not have any power to punish individual members for violations ofthe rules of professional conduct?a.CPACanadab.Canada Revenue Agencyc.OSCd.CPAOntarioMC 3-5 LO4Phil Grebhas a thriving practice in which he assists lawyers in preparing litigation dealing with accountingand auditing matters. Phil is“practicingpublic accounting”if hea.uses his PA designation on his letterhead and business card.b.is inpartnership with another PA.c.practicesin a limited partnership with other PAs.d.never lets his clients know that he is a PA.MC 3-6 LO4CPA Ontario should remove its general prohibition against PAs taking commissions and contingent feesbecausea.CPAs prefer more price competition to less.b.commissions and contingent fees enhance audit independence.c.the Charter of Rights will force the change anyway.d.objectivity is not always necessary in accounting and auditing services.MC 3-7 LO5PA Smith is the auditor of Ajax Corporation. Her audit independence will not be considered impaired ifshea.owns $1,000 worth of Ajax shares.b.has a husband who owns $2,000 worth of Ajax shares.c.has a sister who is the financial vice-president of Ajax.d.owns $1,000 worth of the shares of Pericles Corporation, which is controlled by Ajax as a result of Ajax’sownership of 40 percent of Pericles’s shares, and Pericles contributes 3 percent of the total assets and incomein Ajax’s financial statements.

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 3-5Solutions Manual© 2016, McGraw-HillEducation. All Rights Reserved.MC 3-8 LO4When a client’s financial statements contain a material departure from aCPACanadaHandbookAccounting Recommendation and the PA believes that disclosure is necessary to make the statements notmisleading, the PAa.must qualify the audit report for a departure from GAAP.b.can explain why the departure is necessary, and then give an unqualified opinion paragraph in the auditreport.c.must give an adverse audit report.d.can give the standard unqualified audit report with an unqualified opinion paragraph.MC 3-9 LO4Which of the following would not be considered confidential information obtained in the course of anengagement for which the client’s consent would be needed for disclosure?a.Information about whether a consulting client has paid the PA’s fees on timeb.The actuarial assumptions used by a tax client in calculating pension expensec.Management’s strategic plan for next year’s labour negotiationsd.Information about material contingent liabilities relevant for audited financial statementsMC 3-10 LO4Whichof the following would probably not be considered an“act discreditable to the profession”?a.Numerous moving traffic violationsb.Failing to file the PA’s own tax returnc.Filing a fraudulent tax return for a client in a severe financial difficultyd.Refusing to hire Asian Canadians in an accounting practiceMC 3-11 LO4A group of investors sued Anderson, Olds & Watershed, PAs, for alleged damages suffered when thecompany they held common shares in went bankrupt. In order to avoid liability under the common law, AOW mustprove which of the following?a.The investors actually suffered a loss.b.The investors relied on the financial statements audited by AOW.c.The investors’loss was a direct result of their reliance on the audited financial statements.d.The audit was conducted in accordance with generally accepted auditing standards and with due professionalcare.MC 3-12 LO6A PA’s legal licenceto practice public accounting can be revoked by which organization?a.theCPACanadab.provincialbodyof PAsc.Auditing Standards Boardd.provincial securities commissionsMC 3-13 LO5A PA’s independence would not be considered impaired if he hada.owned common shares of the audit client but sold them before the company became a client.b.sold short his common shares of an audit client while working on the audit engagement.c.served as the company’s treasurer for six months during the year covered by the audit but resigned before thecompany became a client.d.performed the bookkeeping and financial statement preparation for the company, which had no accountingpersonnel, and a president with no understanding of accounting principles.MC 3-14 LO4When a PA knows that a tax client has skimmed cash receipts and not reported the incomeonhisfederalincome tax return, but he signs the return as a PA who prepared the return, that PA has violated which rule ofprofessional conduct?a.Confidential Client Informationb.Integrity and Objectivityc.Independenced.Accounting PrinciplesMC 3-15 LO6Under theForeign Corrupt Practices Act,a.companies must refrain from bribing foreign politicians for commercial advantage.b.independentauditors must audit all elements of a company’s internal control system.c.independent auditorsmust establish control systems to keep books, records, and accounts properly.

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 3-6Solutions Manual© 2016, McGraw-HillEducation. All Rights Reserved.d.independent auditors must establish control systems to keep books,records, and accounts properly.MC 3-16 LO7The management accountants employed by Robbins, Inc., wrongfully charged executives’personalexpenses to the overhead on a government contract. Their activities can be characterized asa.errors in the application of accounting principles.b.irregularities of the type independent auditors should plan an audit to detect.c.irregularities of the type independent auditors have no responsibility to plan an audit to detect.d.illegal acts of a type independent auditors should be aware might occur in government contract business.SOLUTIONS FOR EXERCISES AND PROBLEMSEP3-1Independence, Integrity, and Objectivity Casesa.Interpretation--Honorary Directorships and Trusteeships. The PA will be considered independentprovided:1.the position is in fact purely honorary, and2.listings of directors show she is anhonorarydirector and3.she restricts participation strictly to the use of her name, and4.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 situationwould impair theappearance of the firm’s independence. The CPA should either resign from the Palmer board or cease hisassociation with the accounting firm.Another ethics issue arises overWolfe’sability to hear about tax problems of other clients, and hisdirectorship with Palmer would raise appearance questions about confidential information (Rule208).c.Interpretation--Accounting Services.The PA must be careful to know whether outsiders would perceive relationships that would indicatestatus 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 wouldin factimpair independence, objectivity and integrity, and2.Impress Marvin Harper (and the board of directors) that they must be able andwilling to acceptprimary responsibility for the financial statements as their own, and3.Not take managerial responsibility for conducting operations of the Harper Corp. (although thePA’s supervision of the bookkeeper seems to have this characteristic), and4.Conduct the audit in conformity with GAAS and not fail to audit records simply because theywere processed under the PA’s supervision.This case assumes Harper Corp. is notareportingentity, in which case the PA’s audit independence wouldcertainly be impaired as a result of participating in the bookkeeping work.d.Interpretation of--Effect of Family Relationships on IndependenceThe PA’s wife’s interest is attributed to him, and he would not be independent. The financial interest isconsidered direct.e.InterpretationThe PA is still not independent, so long as the daughter is a dependent child. The financial interest isconsidereddirect.f.Interpretation

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 3-7Solutions Manual© 2016, McGraw-HillEducation. All Rights Reserved.Still not enough. The grandfather (either the PA’s father or his father-in-law) is considered anondependent close relative, but the appearance of independence is impaired. The grandfather’sinvestment is material (50 percent) in relation to his net financial resources.g.InterpretationTheremote kin(uncle) who isgeographically separatedand ininfrequent contactis far enough removed.h.Interpretation--Meaning of Certain Independence TerminologyThe firm’s independence is not impaired by the attributable managerial relationship so long as the PA isnot connected with the ATC audit.i.The PA’s promotion changes the situation. When he becomes a partner, a stricter standard will apply andhis firm’s independence will be considered impaired even if he does not work on the ATC audit. Suchoccurrences 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 aclient.j.InterpretationSuch loans would impair independence.EP3-2Independence, Integrity, andObjectivity 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 tocommence legal actions against the auditor, the auditor and the client management may be placed in adversarypositions in which the management’s willingness to make complete disclosures and the auditor’s objectivity maybe affected by self-interest. Independence may be impaired whenever the auditor and his client company or itsmanagement are in positions of material adverse interest by reason of actual or threatened litigation. Varioussituations are hard to generalize, and the responses offered below are guidelines expressed in AICPA EthicsInterpretations 101-6 (Effect of Litigation). SEC Accounting Series Release No. 234 (December 1977) expressessimilar guidelines.a.An expressed intention by the client company to begin litigation alleging deficiencies in audit work isconsidered to impair independence if the auditor concluded that there is a strong possibility that such aclaim will actually be filed.b.The commencement of litigation alleging deficiencies in audit work would be considered to impairindependence.c.The commencement of litigation by the auditor alleging management fraud or deceit would be consideredto impair independence.d.The claim under subrogation by the insurance company would not“normally”affect the auditor’sindependence. In this case, the client company and members of management are not the nominalplaintiffs.However, the idea of“normally”needs to be evaluated. If members of Contrary managementare going to testify on behalf of the insurance company’s interest and thus act in an adversary relation tothe auditor, independence would seem to be impaired. The substance of the situation is essentially thesame as if Contrary Corporation was the named plaintiff.e.Litigation not related to the audit work, whether threatened or actual, for an amount thatis not materialto the audit firm or to the financial statements of the client company would not usually be considered toaffect the PA-client relationship in such a way as to impair independence. According to the SEC, thissituation might impair independence.

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Smieliauskas & Bewley,Auditing: An International Approach,7thEditionPage 3-8Solutions Manual© 2016, McGraw-HillEducation. All Rights Reserved.f.The class action lawsuit against both auditor and company in itself would not alter fundamentalrelationships between the company management and directors and the auditor and therefore would notbe considered to have an adverse impact on the auditor’s independence. These situations, however,should be examined carefully.Actions to be takenWhen independence is considered impaired, the auditor should (a) withdraw from the audit engagementin order to avoid the appearance that his self-interest would affect his objectivity or (b) issue an opiniondenial because of lack of independence.g.Interpretation--Effect on Independence of Financial Interests in Non-clients Having Investor or InvesteeRelationships with a Member’s ClientThe PA’s financial interest in Dove Corp. (investor) is sufficiently large to allow him to influence theactions of Dove, and the PA’s (and the PA firm’s)independence would be considered impaired. The PA’sability to influence Dove Corp. could permit him to exercise a degree of control over Tale Company (theinvestee, a client) that would place the PA in acapacity equivalent to that of a member of management.h.i.InterpretationAssuming that the North Country is a profit-seeking enterprise, the independence of the auditors is notimpaired by the association of the two individuals who served both as members of the auditing firm andas directors for the client during the period examined as long as they have ended all ties with the bankand are not involved in the audit.j.The auditor’s services may consist of advice and technical services, but he must not make managementdecisions or take positions which might impair his objectivity. The independence of the auditing firmwould be compromised by any partner making a decision on loan approvals and the minimum balancechecking account policy, but normally not by his performing a computer feasibility study.If the former controller’s participation in the feasibility study wasobjective and advisory, and his advicewas subject to effective client review and decision, the firm’s independence has not been compromised. Itis desirable, however, that the former controller not participate in the audit of the North Country’sfinancial statements. (AICPA Adapted)k.The acceptance by the PA of the unsecured interest-bearing notes in payment of unpaid fees would notbe construed as discrediting the PA’s independence in his relations with his client because the notes aremerely a substitution for an open account payable. The rule of professional conduct that prohibits a PAfrom having any financial interest in a client does not extend to the liability for the PA’s fee. If liability forthe PA’s fee was considered to be financialinterest in a client, the present form of the PA-clientrelationship would not be permitted to continue because often (frequently in engagements for continuingaudits) 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 bea violation of Rule 204.Any directfinancial interest such as common stock holdings are construed asdiscrediting 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 provincialbody.The ruling applies totheindependence of afirmif anemployeeaccepts a gift that is more than token. Independence is impairedbecause a member cannot permit his employees to break rules he himself is obligated to observe.m.Member as Bank Stockholder.

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