Auditing: An International Approach Seventh Canadian Edition Solution Manual
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 1 - 1 Solutions Manual CHAPTER 1 Introduction to Auditing SOLUTIONS FOR REVIEW CHECKPOINTS ESSENTIALS 1 - 1. In this example of a three - party accountability structure, the owner is the '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 economic interests, but has to rely on the actions and information provided by the hired manager, who may have shorter term 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 of compensating his/her efforts and successes appropriately. The manager is accountable for giving reliable and fair reports of the business profit performance to the owner. Give the potential conflicts between the interests of the first and third parties, there is information risk - the risk that the financial statement information will not be a full and fair representation of the transactions and events that really occurred, and will not be reliable for economic decisions that the owner may base upon it. The auditor is accountable for objectively verifying the fairness and reliability of the information and providing an independent opinion on how well the information reflects the underlying 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 to trust the manager not to act against the owner's interests the owner will be more willing to share the profits with the manager (this is referred to as lowering "agency costs," which are charged by the owner/principal and incurred by the manager/agent if the owner does not trust the manager). For the auditor's opinion to have value in giving the owner some comfort (i.e. , " assurance") that the manager's information can be relied on, the auditor must have no 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 conclusions drawn from audit examination findings. Based on the examination, if the auditor comes to believe the financial statements are reliable and fair to the interests of third party users, this belief forms the basis of the opinion the auditor will communicate to financial statement users in the Auditor's Report. An 'audit opinion' provides a high level of assurance to the user that the auditor believes that the information risk is low, and has evidence to support that belief. TEXT 1 - 3 Auditors add credibility to financial information provided by the accountable party such as management (i.e. auditors make the financial or other information more likely to be true or representationally faithful ). Other common ways of characterizing this property of audited numbers is that the numbers are more accurate, have higher assurance, or are more reliable. These relate to different dimension of truthfulness, as we discuss later in the text. 1 - 4 By obtaining more accurate or reliable information about the company, Aunt Zhang can obtain a more accurate valuation of the company. This more accurate valuation gives Aunt Zhang more confidence that she will get her money’s worth in the investment. The preceding assumes Aunt Zhang is risk averse — a common assumption about economic behavior. 1 - 5 Auditing is the verification of numbers provided by others. To attest means to lend credibility or to vouch for the truth or accuracy of the statements that one party makes to another. The attest function is a term often applied to
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 1 - 2 Solutions Manual the activities of independent PAs when acting as auditors of financial statements. Since financial statements are prepared by managers of an entity who have authority and responsibility for financial success or failure, an outsider may be skeptical that the statements are objective, free from bias, fully informative, and free from material error -- intentional or inadvertent. The audit opinion of an independent - PA auditor helps resolve those doubts because the auditor's success depends upon his independent, objective, and competent assessment of the conformity of the financial statements with GAAP. The auditor's role is to lend credibility to the statements, hence the outsider will likely seek his independent audit opinion. 1 - 6 Client: the company, board of directors, agency, or some other person or group who retains (hires) the auditor. Usually the party who pays the fee. Auditee: the entity (e.g., business firm, hospital, city government) whose financial information is under audit. Auditors: report to the client on the auditee's financial or control information. Three party accountability consists of the auditor, the accountable party of the auditee such as management of the auditee, and the users. Users include the client as defined above. Traditionally management hired the auditor so that there was some confusion as to who was the true client. New corporate governance concepts in part attempt to clarify this three party accountability. 1 - 7 Auditors 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 expense in financial statements. Accountants produce the financial statements, auditors audit them. 1 - 8 The conditions of complexity, remoteness and consequences produce demands by outside users for financial reports. They cannot produce the reports for themselves because of these conditions. Company managers and accountant produce them. 1 - 9 Students can refer to the AAA and CAS 200 (CPA Canada ) definitions in Chapter 1. Some instructors may want to extend the consideration of definitions to include the internal and governmental definitions. In response to "what do auditors do," students can refer to Exhibit 1 - 2 and respond in terms of: (1) obtain and evaluate evidence about assertions management makes about economic actions and events, (2) ascertains the degree of correspondence between the assertions and GAAP, and (3) gives an audit report (opinion). Students can also respond more generally in terms of "lending credibility" to financial statements presented by management (attestation). 1 - 10 The essence of the risk reduction theory is that audits of financial statements reduce the information risk (probability of materially misleading statements) to users to a socially acceptable level. These various users cannot take it upon themselves to determine whether financial reports are reliable, therefore low in the information risk scale. They do not have the expertise, resources, or time to enter thousands of companies 1 - 11 Forensic accounting is the broader term that includes fraud auditing. Forensic accounting is the use of accounting for legal or investigative purposes. Fraud auditing is the use of forensic accounting in criminal investigations involving allegations of fraud. Frauds that PAs are most interested in are misappropriation of assets and fraudulent financial reporting (misreporting). 1 - 12 Fraud is intentional deception resulting in a loss to the deceived party . Frauds that PAs are most interested in are
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 1 - 3 Solutions Manual misappropriation of assets and fraudulent financial reporting (misreporting). 1 - 13 Operational auditing is the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies. CPA Canada views operational auditing as a type of management advisory service offered by public accounting firms. 1 - 14 The elements of comprehensive auditing include: (1) financial and compliance audits, (2) economy and efficiency audits, and (3) program results or effectiveness audits. Public sector is the part of the economy represented by all levels of government. Public companies are companies whose shares are traded on the stock markets. 1 - 15 A compliance audit involves a study of an organization's policies, procedures, and performance in following laws, rules, and regulations. An example is a company’s compliance with environmental laws. 1 - 16 Other kinds of auditors: Revenue Canada agents/auditors, provincial and federal bank examiners, provincial insurance commissioner auditors. 1 - 17 Yes, to a reasonable degree. Financial statement audits are intended to provide assurance there are no significant intentional or unintentional misstatements. 1 - 19 IAASB stands for International Auditing and Assurance Standards Board. Its ISAs are the basis for Canada’s CASs used throughout this text. The IFAC site is at www.ifac.org and click on “standards and guidance.” SOLUTIONS FOR MULTIPLE CHOICE QUESTIONS MC 1 - 1 LO 1 When people speak of the assurance function, they are referring to the work of auditors in a . lending credibility to a client’s financial statements. b . detecting fraud and embezzlement 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 LO 1 Company A hired Sampson & Delila, C P As, to audit the financial statements of Company B and deliver the audit report to Megabank. Which is the client? a . Megabank b . Sampson & Delila c . Company A d . Company B MC 1 - 3 LO 1 According to the CPA Canada , the objective of an audit of - financial statements is a . an expression of opinion on the fairness with which they present financial position, results of operations, and cash 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 cash flows 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 cash flows in conformity with accounting standards promulgated by the CPA C anada Accounting Standards Committee. d . to obtain systematic and objective evidence about - financial assertions and report the results to interested users. MC 1 - 4 LO 4 Bankers who are processing loan applications from companies seeking large loans will probably ask for financial statements audited by an independent PA because a . financial statements are too complex for them to analyze themselves.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 1 - 4 Solutions Manual b . 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 their needs for reliable financial statements. MC 1 - 5 LO 4 Operational audits of a company’s efficiency and economy of managing projects and of the results of programs are conducted by whom? a . Financial statement auditors b . The company’s internal auditors c . Tax auditors employed by the federal government d . Fraud auditors MC 1 - 6 LO 3 Independent auditors of financial statements perform audits that reduce and control a . 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 LO 4 The primary objective of compliance auditing is to a . 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 PROBLEMS EP 1 - 1 When the PA is hired by Hughes Corporation, he can no longer be considered independent with respect to the annual audit. The annual audit may then be unnecessary in a short - run view and unnecessary to the extent of services exclusive of the attest opinion. It is true that the in - house PA can perform all the procedural analyses that would be required of an independent audit; however, it is extremely unlikely that he could inspire the confidence of users of financial statements outside the company. He cannot modify the perception of potential conflict of interest that creates demand for the independent audit. As a matter of ethics rules, this PA would be prohibited from signing the standard unqualified attest opinion. EP 1 - 2 You should point out that you will be unable to replace the independent audit with your own communication output as controller. Make the point that you can conduct an effect ive internal audit function and be of considerable service to management and can even assist the independent auditors with preparation of schedules and general cooperation (thus facilitating the independent audit). Nevertheless, as a member of management, it would be impossible to be truly objective and unbiased about the financial results of management's decisions, hence the directors could not satisfy their obligations to the shareholders' interests. Neither could you issue an opinion to be used by outsiders. Lacking an opinion on the financial statements, the company could find itself in noncompliance with audit requirements of a stock exchange, a Provincial Securities Commission, or the U.S. Securities and Exchange Commission. EP 1 - 3 a. risk of litigation needs offsetting lower information risk (for example, litigation due to share practice decline or failure to meet a bond covenant). b. strength of internal controls (e.g., controls over financial instruments, controls over cash). c. financial health of client (industry factors, economic factors). d. management compensation system (management highly motivated to beat earnings targets, compensation
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 1 - 5 Solutions Manual tied to factors over which management has little control may motivate management to “manage earnings”). e. private vs. public company (publicly held company owners are more reliant on financial statements for information about their investment). EP 1 - 4 Financial statements are prepared on basis of GAAP. Knowledge of GAAP is thus indispensable for determining if the financial statements are in conformity with GAAP. For example lease accounting used to consist of some very specific rules (bright line rules) that the auditor effectively test ed compliance with. Unfortunately such detailed rule based accounting leads to what some refer to as a checklist mentality where the form is more important than the substance. Enron’s special purpose entity accounting also comes to mind. EP 1 - 5 Operational Auditing Bigdeal cannot hire the OAG. This government agency does not perform operational audits for private industry. One possibility is the management advisory services department of a large PA firm. The major advantage may be total objectivity. The PA firm has no stake in making a report reflect favorably or unfavorably on Smalltek (provided there are no prior relations of the PA firm with Bigdeal managers that may suggest a bias or with Smalltek). The possible disadvantage is that the PA firm may not possess the required expertise in Smalltek' type of business. Another possibility is the Bigdeal internal audit department. The major advantage may be a thorough appreciation of Bigdeal's managerial effectiveness and efficiency standards and a longstanding familiarity with Bigdeal's business. The possible disadvantage could be that the internal auditors may not be independent enough from internal management pressures for making or breaking the deal for reasons other than Smalltek's efficiency and effectiveness. Another possibility is a nonPA management consulting firm. The major advantage of objectivity would be similar to the PA firm, and such firms often have experts in manufacturing, sales, and research and development management. The major disadvantage could be a lack of appreciation and familiarity with Bigdeal's management standards (as possessed by the Bigdeal internal auditors). EP 1 - 6 The neighbor appears to be uninformed on the following points: 1. According to auditors' dogma, Price Waterhouse did not prepare the Dodge Corporation financial statements, and no auditor prepares a company's statements. Inform your neighbor that Dodge management is primarily responsible for preparing the financial statements and deciding upon the appropriate accounting principles. 2. An unqualified opinion does not mean an investment is safe . Tell your neighbor that the financial statements are history . The value of his investment depends on future events, including the many factors that affect market prices. Tell him the opinion only means that the statements conform to GAAP (and you can add that the auditor knows of no material fraud or error). EP 1 - 7 Identification of Audits and Auditors The responses to this matching type of question are ambiguous. The engagement examples are real examples of external, internal and governmental audit situations. You might point out to students that the distinctions among
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 1 - 6 Solutions Manual compliance, economy and efficiency and program results audits are not always clear. The "solution" is shown below in matrix form, showing some engagement numbers in two or three cells. The required schedule follows. Type of Audit Financial Economy, Program Kind of Auditor Statement Compliance Efficiency Results Independent PA 2, 10 Internal Auditor 6, 8 4, 8 Governmental ( auditors ) 3 1, 3, 9 1, 3 CRA Auditor X 5 X X Bank Examiner X 7 X X 1. FHA loan interest equity Economy and Efficiency or Program Results Governmental (AGC) 2. Advertising agency financial statements Financial statement Independent PAs 3. Dept. of Interior policies Compliance or Economy and Efficiency or Program Results Governmental (AGC) 4. Municipal services Economy and Efficiency Internal auditors 5. Tax shelters Compliance CRA auditors 6. Test pilot reporting Compliance Internal auditors 7. Bank solvency Compliance Bank examiners 8. Materials inspection by manufacturer Compliance or Economy and Efficiency Internal auditors 9. Drug enforcement vehicle seizures Economy and Efficiency Governmental (AGC) 10. Sports complex forecast Financial statement Independent PAs EP 1 - 8 Analysis and Judgment This problem is one of Robert Ashton's cases on judgment and decision making ( Accounting Review , January, 1984, pp. 78 - 97.) Ashton gives credit to Joyce and Biddle, "Anchoring and Adjustment in Probabilistic Inference in Auditing." Journal of Accounting Research , Spring, 1981, pp. 1 The case is set up to illustrate a person's tendency to anchor an estimate on some known information and adjust from that point in the course of performing analysis. This particular case set - up is intended to illustrate conjunctive and disjunctive events. Ashton's "answer key" explains in this manner: Ashton's Answer Key (abridged) This exercise focuses on probability estimates for two types of complex events called "conjunctive" and "disjunctive." The occurrence of a conjunctive event depends on the joint occurrence of all of a number of sub - events, each with a given probability of occurrence . An example is getting three 3's in a row when rolling a die. This is a conjunctive event with probability of 1/6 raised to the third power (1/6 x 1/6 x 1/6), or about 0.005. An example of a disjunctive event is getting at least one of a number of sub - events, such as one 3 in three rolls of the die. The probability of this disjunctive event is about 0.42
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 1 - 7 Solutions Manual If you are asked to estimate the probabilities of the conjunctive and disjunctive events of rolling the die, a natural starting place (anchor) would be to know that the probability of getting one three in one roll is 1/6, or 0.167. Then to estimate the harder conjunctive event (three 3's in a row), a downward adjustment would be required. Conversely, for the disjunctive event (one 3 in three rolls), an upward adjustment would be needed. However, since adjustments from an anchor are usually insufficient, the estimated probability of the conjunctive event will likely be too large, and that of the disjunctive event too small. Form A of the problem (the one in the textbook chapter) is a conjunctive statement of the problem, and it asks for an estimate of the probability of successful product introduction. With the five sub - events considered independent of each other, the best answer is 0.554 (.80 x .90 x .95 x .90 x .90). Students may anchor on the probabilities of the elementary sub - events and fail to adjust sufficiently downward, and their probability estimates will be higher than 0.554. Form B of the problem (reproduced below , not in the textbook) is a disjunctive statement of the same problem, and the best answer is still 0. 554. Form B, however, is stated in terms of failure in the chain of events. (Student responses must be subtracted from 1.000 to make them comparable to Form A.) If students anchor on the probabilities of the elementary disjunctive sub - events in Form B, their probability estimates (subtracted from 1.000) will probably be too low . As part of your regular year - end audit of a publicly - held client, you must make an estimate of the probability of success of its proposed new product line. The client has experienced financial difficulty during the last few years and -- in your judgment -- a successful introduction of the new product line is necessary for the client to remain a going concern. Any one of the following occurrences will prevent successful introduction of the new product line: (1) unsuccessful labor negotiations between the construction firms contracted to build the necessary addition to the present plant and the building trades unions; (2) unsuccessful defense of patent rights; (3) failure to obtain product approval by the 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 the past. The labor relations expert estimates that there is a 20 percent chance that labor negotiations will not be successfully resolved before the strike deadline. Legal counsel advises that there is a 10 percent chance that the patent rights defense will not be successful. The expert on FDA product approvals estimates the probability of failing to obtain approval at five percent. The experts in the two remaining areas estimate the probabilities of failing 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 five steps are independent of each other.) NOTE TO INSTRUCTORS: You may want to reproduce Form B and give both the textbook problem (conjunctive) and the Form B alternative (disjunctive) to different groups of students to illustrate the anchoring and adjustment behavioral phenomenon. You may also want to give students a response scale to make your classroom discussion easier. Ask them to circle one:
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 1 - 8 Solutions Manual .00 .10 .20 .30 .40 .50 .60 .70 .80 .90 1.00 EP 1 - 9 Information 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: a company that will fail in the next 3 months records all assets and liabilities assuming that the going concern assumption is true, impaired goodwill is not written down, the allowance for doubtful accounts has not been adjusted for changed economic circumstances, and the fair value assets have not been updated for changes in future cash flows. Accounting misstatements relate to future events whereas audit misstatements relate to facts about the present or past events. EP 1 - 10 The audit society. An example from the Auditor General of Ontario is given in the text. There was extensive coverage in Globe and Mail, Toronto Star, and local TV news coverage. EP 1 - 11 The audit society A recent controversy is the Canadian government’s proposed acquisition of a fleet of 65 single engine F35 fighter jets for $46 billion. See http://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 , 7 th Edition Page 2 - 1 Solutions Manual © 2016, McGraw - Hill Education. All Rights Reserved. CHAPTER 2 Auditors’ Professional Roles and Responsibilities SOLUTIONS FOR REVIEW CHECKPOINTS ESSENTIALS 2 - 1. Since auditing is a critical function in the economy, it is extensively regulated to ensure it remains effective. In Canada, the regulation of professional accountants and auditors is a provincial responsibility, and varies somewhat depending on the legislation in different provinces. The profession also has a national umbrella organization that all provincial organizations are associated with. At the time of writing, the profession is being streamlined at both the national and provincial levels by uniting three formerly separate accounting designations (CA, CGA, CMA ) into a single designation for Canadian professional accountants, the “CPA” (Chartered Professional Accountant). The national 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 not produce information that the general public will use and possibly rely on, such as bookkeeping and financial statement and tax preparation for individuals or private companies. Since a person from the general public may not be able to assess whether an accountant is properly qualified and regulated to act in their best interest, to practice public accounting a person will meet higher standards than are required to do other types of non - public accounting 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 - traded companies' financial statements, securities laws require the public accounting firm to be registered with the Canadian Public Accountability Board (CPAB). CPAB will inspect their financial statement audit work on public companies annually to provide the highest level of public protection, since these companies can sell their securities directly to the public. 2 - 3. Members of a CPA association are required to comply with the professional ethics code of their provincial association. Every ethics code has five similar components, requiring the member: to act with integrity; to remain objective; 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 behave professionally 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 any potentially conflicting interests, which includes being independent in fact and also independent as it would appear to an outsider. 2 - 5. Independence in fact means the auditor maintains an objective perspective in doing his or her work - this frame of mind is essential to performing an assurance role effectively, however it is not visible (or provable) to outsiders. The auditor's independence must also be apparent to outsiders for them to believe the auditor's opinion is in fact independent. Outsiders must see evidence that the CPA has no financial or other interest that would cause them to 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 accountability relationship 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 still just 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 , 7 th Edition Page 2 - 2 Solutions 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 they might be failing to remain impartial. A self - review threat means the auditor is checking his/her own work; in this case 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 best interest - in that case his/her opinion will not meet the user's needs. With an advocacy threat, the auditor has taken a personal stand in support of the first party's positions, so they are invested in that and will have a hard time seeing objectively whether the position they publicly supported is wrong - again the auditor is not free to act in the user's best interest. With a familiarity threat, the auditor is too friendly and close to the first party and that makes 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 facing personal risk and naturally must put their own critical interests first, before they can meet their professional responsibilities . In an intimidation threat situation, an auditor would need to seek legal advice on how best to protect him/herself without violating their professional duties. 2 - 7. Financial statement audits are required in various laws. Corporation laws require companies to produce audited annual financial statements (though private and smaller companies sometimes can waive this requirement), and securities 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 with these standards the bottom - line professional responsibility of professional accountants. CPA members meet the ethical requirements of professional competency and due care in performance their work by complying with requirements 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 the Audit in Accordance with Canadian Auditing Standards” CAS states a financial statement auditor's overall objectives are: (a) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and (b) To report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings. CAS 200 also sets out principles and fundamental concepts that underlie the auditing function. 2 - 1 0 . Self - regulation refers to the powers a professional group has in regulating its affairs without intervention by a government or a government established external regulator. These affairs include setting of standards, codes of conduct, education requirements, certification, and disciplining of members. Since the failure of Enron in 2001, there has been increased involvement by outside agencies in the monitoring of the audit function. Auditing is increasingly viewed as a key pillar in capital markets, along with regulators and good governance practices. As a result external regulation of the profession has been increasing. In Canada, this has taken the form of increased monitoring of auditors of publ ic companies via CPAB. CPAB however does not have the power to create audit and ethics standards as does the PCAOB in the U.S. Nevertheless, both CPAB and PCAOB are increasingly assertive monitoring the quality of audit practice and sanctioning auditors who do not meet their expectations . A major focus of inspections by CPAB and PCAOB is the quality of the audit. Quality generally refers to degree of conformity with standards and nature of procedures performed and their documentation. "Procedures" relate to acts to be performed. "Standards" deal with measures of the quality of performance of those acts and the objectives to be attained by the use of procedures. The standards are less subject to change. The standards provide the criteria for rejecting, accepting, or modifying a procedure in a given circumstance. An example of the relative stability of standards and procedures is found in the change from non - EDP to EDP systems. New procedures were required to audit EDP systems, but auditing standards remained unchanged and were the criteria for determining the adequacy of the new procedures.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 3 Solutions 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 procedures and the relative seriousness of their omission. The importance of any "omitted procedure," however, is the evidence the auditors failed to obtain. Merely omitting technical procedures is only a superficial analysis of an audit problem; the substance is the evidence not obtained. The standard for due audit care is the care which would be exercised by the prudent auditor . The prudent auditor is one who exercises reasonable judgment, who is not expected to be omniscient, who is presumed to have knowledge special to his profession, who is expected to be aware of his own ignorance, who is expected to possess the skills of his profession whether he is a beginner or a veteran. 2 - 1 1 . The Can adian board (CPAB) is more self - regulatory in that the profession has more influence through having a higher percentage of board membership, the monitoring process is less public and more designed to help firms improve their practices. The CICA continues to set audit standards. The PCAOB, on the other hand, not only sets standards but also has a more confrontational and public approach in its monitoring process. The most important difference is that PCAOB actually sets auditing and professional ethics standards for public company audits in the U.S. In Canada, audit standards are set by the CPA C anada while professional ethics standards are set by the provincial institutes/societies of CGAs, CMAs, and CAs. PCAOB reports are much more detailed disclosing the results of each inspection by firm, whereas CPAB reports are more generic providing an overall evaluation of the state of public company audits in Canada. Students generally find the PCAOB reports more interesting because they learn about problems identified for the firms they have accepted positions in. The CPAB report issued on April 3, 2012 on 2011 inspections was disappointed with the state of audits in Canada, particularly the implementation of audits in higher risk areas. “The Big 4 firms, which audit 94% of reporting issuers by market capitalization, had a GAAS deficiency rate of 20 - 26% on files inspected by CPAB.” Other audit firms had a 47% GAAS deficiency rate. CPAB found these results consistent with other regulators. This is not just a Canadian problem. 2 - 1 2 . CA’s, CGA’s, and CMA’s are the old terms. They are all now CPAs and belong to CPA Canada and related provincial associations such as CPA Ontario . 2 - 1 3 . Examples of other assurance services rendered on representations other than financial statements are on issues such as the effectiveness of internal controls, vote counts at the Academy Awards, forecasts of financial information, efficiency of public sector activities. • Vote counts (Academy Awards) • Amount of prizes claimed to have been given in sweepstakes advertisements • Investment performance statistics • Characteristics claimed for computer software programs • Also see the list of value for money audit engagements in chapter 1. 2 - 1 4 . The three major areas of public accounting services: Accounting and auditing Taxation Management advisory services (consulting) 2 - 1 5 . The SEC site is more comprehensive but covers only the Canadian companies cross listed on U.S. exchanges. 2 - 1 6 . "Procedures" relate to acts to be performed. "Standards" deal with measures of the quality of performance of those acts and the objectives to be attained by the use of procedures. The standards are less subject to change. The standards provide the criteria for rejecting, accepting, or modifying a procedure in a given circumstance. An example of the relative stability of standards and procedures is found in the change from non - EDP to EDP systems. New procedures were required to audit EDP systems, but auditin g standards remained unchanged and were the
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 4 Solutions 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 procedures and the relative seriousness of their omission. The importance of any "omitted procedure," however, is the evidence the auditors failed to obtain. Merely omitting technical procedures is only a superficial analysis of an audit problem; the substance is the evidence not obtained. 2 - 17 . The standard for due audit care is the care which would be exercised by the prudent auditor . The prudent auditor is one who exercises reasonable judgment, who is not expected to be omniscient, who is presumed to have knowledge special to his profession, who is expected to be aware of his own ignorance, who is expected to possess the skills of his profession whether he is a beginner or a veteran. 2 - 18 . Three elements of planning and supervision considered essential in audit practice are: 1. A written audit program. 2 . An understanding of the client's (auditee's) business. PA firm procedures to allow an audit team member to document disagreements with accounting or auditing conclusions and disassociate himself or herself from the matter. 3. Ensuring that staff have appropriate training and competence to perform the audit. 2 - 19 . The timing of the auditor's appointment matters because the auditor needs time to plan the audit properly and perform the work without undue pressure from too - short deadlines. 2 - 2 0 . An auditor obtains an understanding of a client's internal control s ystem as a part of the control risk assessment process primarily in order to plan the nature, timing and extent of subsequent substantive audit procedures. Understanding of internal control allows an auditor to gain a measure of comfort as to how much to rely on the information generated by the auditee’s accounting system. A secondary purpose (not covered in Chapter 2) is to obtain information about reportable conditions (control deficiencies) to report to the client . 2 - 2 1 . CAS 500.5( c) defines audit evidence as “Information used by the auditor in arriving at conclusions on which the auditor’s opinion is based. Audit evidence includes both information contained in the accounting records underlying the financial statements and other information.” Audit evidence is (and includes) all the influences on the mind of an auditor which affect decisions about the fair presentation of propositions (financial or otherwise) submitted for audit. Evidence may be quantified or qualified; it may be objective to a greater or lesser degree; it may be absolutely compelling or only mildly persuasive to a decision. 2 - 2 2 . The ten important elements of the standard un modified audit report. 1. Title. The title should contain the word independent, as in independent auditor or independent accountant. 2 - Address. The report shall be addressed to the client, which occasionally may be different from the auditee. 3. Notice of Audit. A sentence should identify the financial statements and declare that they were audited. This appears in the introduction paragraph . 4. Responsibilities. The report should state management's responsibility for the financial statements and the auditor's responsibility for the audit report. These statements are also in the last paragraph . 5. Description of the Audit. The auditor responsibilities and basis for opinion paragraph s ( scope paragraph s should declare that the audit was conducted in accordance with generally accepted auditing standards and describe the principal characteristics of an audit, including a statement of belief that the audit provided a reasonable basis for the opinion. 6. Opinion. The report shall contain an opinion ( opinion paragraph ) regarding conformity with generally accepted accounting principles. 7. Signature. The auditor shall sign the report, manually or otherwise. 8. Date. The report shall be dated with the date when all significant field work was completed.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 5 Solutions Manual © 2016, McGraw - Hill Education. All Rights Reserved. 9. Key audit matters paragraph indicate significant judgments or uncertainties in the audit 10. Address 2 - 2 3 . CPA C anada Handbook Recommendations are the highest level of authoritative support for GAAP. Textbooks and journal articles are the lowest level. In between are regulatory requirements emerging issues task force guides , Handbook Guidelines and the Conceptual Framework . Some would argue that an appropriate conceptual framework should be the highest set of principles. 2 - 2 4 . Yes. The un modified opinion sentence contains in the audit report implies, among other things, that the accounting principles used by the company are appropriate in the circumstances. 2 - 2 5 . Four types of opinions and their messages: Type Message Un modified opinion Financial statements are presented in conformity with GAAP. Adverse opinion Financial statements are not presented in conformity with GAAP. Qualified opinion Financial statements are presented in conformity with GAAP, except for one or more departures. Disclaimer of opinion Auditor's declaration that no opinion is given. 2 - 2 6 . 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 the areas of practitioner competence, internal control, reporting, and suitability criteria. GAAS presume knowledge of accounting and require training and proficiency as an auditor (meaning an auditor of financial statements. The assurance standards are more general, requiring training and proficiency in the "assurance function" and knowledge of the "subject matter of the assertions." The assurance standards have no requirement regarding an understanding of the internal control structure for an information system. Considerations of internal control are implicit in the task of obtaining sufficient evidence. Anyway, some kinds of attested information may not have an underlying information control system in the same sense as a financial accounting and reporting system. Reporting is different because assurance on nonfinancial information do not depend upon generally accepted accounting principles. The assurance standards speak of "evaluation suitable criteria," and "conformity with established or stated criteria" and leave the door open for assurance on a wide variety of informational assertions. 2 - 28 An assurance engagement is: An engagement in which a practitioner is engaged to issue or does issue a written communication that expresses a conclusion concerning a subject matter for which the accountable party in an accountability relationship is responsible. 2 - 29 The theoretical essence of an assurance engagement is an person's ability to recognize the information being asserted, determine the evidence relevant to the assertions, and make decisions about the correspondence of the information asserted with suitable criteria. 2 - 30 The assertion is that amateur golfers can drive Wilson golf balls farther than competing brands. The Wilson company is the asserter (2 nd party), the PA firm is the assurer (1 st party), and the amateur golfer is the 3 rd party owed accountability. The criterion is the average drive by the average amateur golfer. This criterion allows objective verification with sufficient numbers of representative amateurs at high (audit) level of assurance. Critical
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 6 Solutions 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 of amateur golfers? What are representative golfing conditions? What is a sufficient sample size to determine the average drive with audit level assurance so that the auditor does not commit the logical fallacy of “hasty generalization”? SOLUTIONS TO MULTIPLE - CHOICE QUESTIONS MC 2 - 1 LO 3 It is always a good idea for auditors to begin an audit with professional skepticism characterized by the assumption that a . a potential conflict of interest always exists between the auditor and the management of the enterprise under audit. b . in audits of financial statements, the auditor acts exclusively in the capacity of an auditor. c . the professional status of the independent auditor imposes commensurate professional obligations. d . financial statements and financial data are verifiable. MC 2 - 2 LO 3 When Auditee Company prohibits auditors from visiting selected branch offices of the business, this is an example of interference with a . reporting independence. b . investigative independence. c . auditors’ training and proficiency. d . audit planning and supervision. MC 2 - 3 LO 4 After the auditors learned of Auditee Company’s failure to record an expense for obsolete inventory, they agreed to a small adjustment to the financial statements because the Auditee president told them the company would violate its debt agreements if the full amount were recorded. This is an example of a lack of a . auditors’ training and proficiency. b . planning and supervision. c . audit investigative independence. d . audit reporting independence. MC 2 - 4 LO 3 The primary purpose for obtaining an understanding of the company’s internal controls in a financial statement audit is to a . 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 the financial statements. d . determine whether the company has changed any accounting principles. MC 2 - 5 LO 4 W hich of these generally accepted auditing standards are not affected by the auditee’s utilization of a computerized 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 planned and 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 regarding the financial statements under audit. d. The audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor. MC 2 - 6 LO 2 Which of the following is not found in the standard unqualified audit report on financial statements? a. An identification of the financial statements that were audited b. A general description of an audit c. An opinion that the financial statements present financial position in conformity with GAAP d. An emphasis paragraph commenting on the effect of economic conditions on the company MC 2 - 7 LO 4 A ssurance standards do not contain a requirement that auditors obtain a. adequate knowledge in the subject matter of the assertions being examined.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 7 Solutions 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 LO 3 Auditor Jones is studying a company’s accounting treatment of a series of complicated transactions in exotic financial instruments. She should look for the highest level of authoritative support for proper accounting in a. provincial securities commissions’ staff position statements. b. CPA C anada industry audit and accounting guides. c. CPA C anada recommendations in the Handbook . d. Emerging Issues Committee consensus statements. MC 2 - 9 LO 5 Which of the following is not an example of a quality control procedure likely to be used by a public accounting firm to meet its professional responsibilities to auditees? a. Completion of independence questionnaires by all partners and employees b. Review and approval of audit plan by the partner in charge of the engagement just prior to signing the auditor’s report c. Evaluating professional staff after the conclusion of each engagement d. Evaluating the integrity of management for each new audit client MC 2 - 10 LO 3 Which of the following concepts is not included in the wording of the auditor’s standard report? a. Management’s responsibility for the financial statements b. Auditor’s responsibility to assess significant estimates made by management c. Extent of auditor’s reliance on the auditee’s internal controls d. Examination of evidence on a test basis MC 2 - 11 LO 3 Which of the following is not mandatory when performing an audit in accordance with GAAS? a. Proper supervision of assistants b. Efficient performance of audit procedures c. Understanding the auditee’s system of internal controls d. Adequate planning of work to be performed SOLUTIONS FOR EXERCISES AND PROBLEMS EP2 - 1 a. PAs should not follow clients' suggestions about the conduct of an audit unless the suggestions clearly do not conflict with his professional competence, judgment, honesty, independence, or ethical standards. Where there is no disagreement about the results to be accomplished and the client's suggestion represents a good idea a PA can accept it. Within professional bounds, mutual agreement with the client is all right. The PA must never agree to any arrangement which violates generally accepted auditing standards or the Code of Professional Conduct. b. The reasons against dividing the assignment of audit work solely according to assets, liabilities and income and expenses include the following: 1. Work should be assigned to staff members by considering the degree of difficulty in relation to the technical competence and experience of individual staff members. 2. Sequence of work performed on an examination should be in accordance with an overall audit plan. 3. It is impossible to segregate work areas by major captions because often a close relationship exists among a number of accounts in more than one category, as for example where income is based on assets or expense is based on liabilities. 4. Often a single audit work paper is desirable to substantiate balances in accounts of various types, such as an insurance analysis supporting premium disbursements, the expense portion and the prepaid balance. 5. Duplication of staff effort would be more likely to occur if assignments were made on such a basis.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 8 Solutions Manual © 2016, McGraw - Hill Education. All Rights Reserved. 6. Frequently, the scope of work regarding a single account requires simultaneous participation by the staff, such as in the observation of inventories. 7. Many audit operations are not susceptible to division by category, as for example investigating internal control, testing transactions and writing the report. c. The staff member whose uncle owns the advertising agency should not be assigned to examine the advertising account, even if this is the staff member that has the most detailed, in - depth knowledge of this account. The firm is responsible for avoiding any relationships which might even suggest a conflict of interest. Even if this staff member could show independence and not be biased, it still could seem as if there'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, any situation where a bias might exist, that situation should be avoided. EP2 - 2 From a theoretical viewpoint (and, i n fact, from a practical viewpoint as well) such short notice of a request for an audit causes difficulties with planning the audit work, with staffing, and with reviewing the work -- all of these features being elements of the exercise of due audit care. The December 26 - January 20 period is a serious time constraint for a first audit. The greatest difficulties involve the third general standard (due audit care) and the three field standards. In view of the short notice and the time constraint, there may be some question as to whether a sufficient first audit could be completed by January 20. EP2 - 3 You must determine whether an unqualified opinion satisfies the GAAS reporting standard, in particular: a. Determine whether the financial statements are presented in conformity with GAAP. 1. Read the footnote description of accounting policies. 2. Use a GAAP checklist. 3. Review the working papers for any indication of accounting policies not described in the footnote or ones apparently not in conformity with GAAP. 4. Refer to GAAP criteria concerning the "meaning of present fairly" such as (i) The accounting principles are generally acceptable, having authoritative support. (ii) The accounting principles are appropriate in the circumstances. (iii) The financial statements are informative. (iv) The information is reasonably summarized. (v) Material adjustments have not been waived without good reasons. b. Determine whether any accounting changes have been made and whether accounting principles have been applied consistently. c. Determine whether the footnote disclosures are adequate to inform users of any material information evident in the working papers. EP2 - 4 GAAS in a Computer Environment In an audit of a computer - based system, adequate training and experience must be directly related to EDP. In particular, the auditor should be knowledgeable of what computer systems do, how to test the operations of an EDP system, and how to use EDP - unique documentation. The training and proficiency standard contributes to satisfaction of the independence standard by enabling the auditor to make his own decisions and judgments. Otherwise, he might tend to subordinate his judgment to other persons, possibly to client personnel. When the auditor lacks training and proficiency, it is virtually impossible to maintain an operational independence over audit decisions. An independence of mental attitude is futile if actual decisions are subordinated to others. The exercise of due audit care requires a critical review at every level of audit supervision of the work done and the decisions made by auditors Lacking the requisite skills and lacking independent decisions, the due care expected of an auditor at operational, supervisor, and review levels cannot be delivered.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 9 Solutions Manual © 2016, McGraw - Hill Education. All Rights Reserved. The first field work standard requires adequate planning and supervision of assistants. Training and proficiency in computer systems auditing is necessary in order to plan access to computerized records, programs, and to obtain machine time for conducting audit procedures. The planning should provide for an early examination of the computer system so that further procedures involving non - computer control and accounting features may be planned should they depend upon computer control procedures. Training and proficiency are very important for being able to obtain an understanding of the internal control structure in a computer system. Client personnel will expect audit personnel to be capable of working with a computer system. The third standard of field work requires the auditor to obtain sufficient competent evidential matter to provide a basis for an opinion on financial statements. Documentary evidence relating to a computer system includes program flow charts, logic diagrams, and decision tables that are not normally used in non - computer systems. Since these types of documentation are a part of the evidence, they must be understood by the auditor, and understanding of them comes through training and proficiency in their use. EP2 - 5 Audit Report Language a. The auditor is reporting to the body that has engaged the auditing services. While the report may be read and used by others who are indirect beneficiaries of the audit, current custom is not to address the report to the unknown class of users. b. The scope paragraph should specifically identify the audited statements by name so that there can be no mistake about the subject of the report. The alternative language is not as precise. c. The standard language effectively bases the audit on an extensive body of written auditing standards that are known to others and can be cited in case of controversy. The alternative language, on the other hand, seems to break loose from profession - wide quality norms and make the audit quality depend more on "the circumstances," which introduces an element of mystery and lack of definition into the report. d. The alternative wording is similar to the typical British audit report, and they seem to be able to live with it, but Canadian auditors believe that "opinion" connotes belief or judgment stronger than impression but less strong than positive knowledge. Canadian auditors do not wish to appear to have full, positive knowledge about the statements on the grounds that it's not feasible to know all there is to know about the financial statements. Also, the standard language leans heavily on GAAP as the criteria for fair presentation whereas the alternative language contains no reference to authoritative accounting criteria. EP2 - 6 The question requires one to review and discuss the current regulatory development in the audit profession. Some points that can be discussed include: The public accountability boards are intended to provide an additional level of independence for the public accounting function. Public concerns arose that public accountants and auditors lack independence because they are hired by and paid by the Company managers whom they are supposed to be monitoring. Since Company managers are effectively providing their own report cards when they issue their financial statements, the audit role has value because it provides an independent assessment of the validity of the claims managers are making in their financial statements. This independent audit assessment is important to outsiders using the financial statements because it enhances the reliability of that information. Since outsiders may suspect that managers will issue biased information if left to their own de vices, they demand an independent assessment of the manager’s claims as this should detect any bias and require the manager to correct it. An effective independent audit function should also act as a deterrent against managers issuing biased reports in the first place. This function is referred to as monitoring. If outsiders question the independence of the auditor it cannot
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 10 Solutions Manual © 2016, McGraw - Hill Education. All Rights Reserved. provide this monitoring value. A concern raised by some is that, if auditors lack independence, they themselves require some monitoring. It is this" monitoring the monitor" function that the public accountability boards were established to perform. At this time, the procedures these boards will follow to monitor public accountants and auditors are still evolving . The boards may also become involved in establishing generally accepted auditing standards, quality control review standards, peer review requirements and other specific procedures that public accountants and auditors will be required to adhere to. EP2 - 7 The case involves identifying a situation in which the audit scope is limited. In situation a) the auditor has been unable to determine the impact of a contract that the client company has entered into. One means by which an auditor might determine the potential financial impact of contract would be to make inquiries of the Company's lawyer and obtain assertions from the lawyer that could be relie d on. If this is not possible, the auditor is not in a position to assess whether the contracts would have a material impact on the Company that should be included in the Company's financial statements. Here the auditor has a scope limitation that prevents providing an opinion on whether the financial statements are fairly stated as there is the possibility that the statements exclude a material liability that should either be accrued or disclosed. In this situation , the auditor has a responsibility to ensure that users are aware of the existence of the contract and the auditor's inability to assess the potential impact of contract or to obtain evidence from the Company or its lawyer regarding the potential impact. Users' decisions based on the financial statements may well be affected if they are aware that Company management is bound by a contract yet cannot provide a reasonable explanation of its impact. In situation b) the Company is subject to regulations that can have a financial impact if violated. Determining if a violation has occurred requires scientific information. In this situation , the auditor would be required to try to determine whether any violations had occurred. Appropriate evidence would require obtaining representations from people with scientific qualifications because experts must be qualified in order for auditors to rely on their representations as evidence. In this situation , it is possible that the auditor could obtain reasonable evidence from scientific experts so no scope limitation would arise. However , similar to situation a) if the auditor it is unable to obtain evidence that can confirm whether the financial impact of complying with the environmental regulation has been properly measured and reported, then the scope limitation exists and this should be noted in the audit report. Similar to situation a) , users ’ decisions may be affected by the fact that the company is not able to provide evidence to the auditor about whether or not it is violating governmental regulations. EP2 - 8 ITR's statements does not appear to be an assurance engagement, after considering the components of assurance engagements. The parties involved are ITR and Knovel. • These parties could be involved in an assurance engagement, with Knovel making in assertions regarding a subject matter and ITR providing assurance to third parties regarding that assertion. The subject matter is how long it takes to recover, or "payback", the investment in Knovel's new software product. • If the objective of the engagement is to provide assurance that this payback is three months, the assurance provider needs to obtain management's acknowledgment of responsibility for the subject matter as it relates to this objective. Since Knovel management cannot be responsible for how a purchaser of a software product implements that product to achieve operational savings and recover the investment in that product over a period such as three months , it would be difficult to identify generally accepted, appropriate criteria for assessing the subject matter in this case. This leads to the conclusion that this is not a subject matter on which an assurance can be provided in accordance with assurance standards set out by CPA Canada .
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 11 Solutions Manual © 2016, McGraw - Hill Education. All Rights Reserved. The accountability relationships would be between the Company and the assurance provider, and between each of these parties and third parties. The third parties would be potential customers that could be making decisions based on the assertion and on the assurance attached to that assertion. These accountability relationships could result in an assurance engagement. The nature of the report that could be issued, in accordance with CPA C anada assurance standards, would be as follows: • The report would need to identify to whom it is addressed, the objective of the assurance engagements, the entity and the subject matter covered by the engagement, management's assertion, the responsibilities of management and the assurance provider, the standards that were followed in conducting the engagement, the criteria against which subject matter was evaluated, a conclusion indicating the level of assurance being provided, the name of the assurance provider, the date and place where the assurance report was issued. The president may have wanted the ad stopped because, effectively, the ad is providing assurance related to the claim that the Knovel software will payback in three months. Since ITR has not performed an assurance engagement , it has no basis for providing such assurance. Thus it is not appropriate to publicize this claim in a way that implies ITR is providing assurance on it. EP2 - 9 The question involves the relation between GAAP and providing an audit opinion. One approach to this issue is as follows. a) When an auditor needs to assess whether C PA C an a da Handbook Recommendations have been followed but the Handbook is silent on a particular issue, auditors usually go down a hierarchy to find the next highest source of support for the client's accounting solution to a financial reporting problem. The auditor can refer to the positions taken on accounting matters by provincial securities commissions, to accounting pronouncements issued in other countries (for example, the US Financial Accounting Standards Board or the International Accounting Standards Board), industry accounting guidelines and practices followed in financial reports of other companies in the same industry, CPA C anada EIC consensus positions, accounting research reports, textbooks, etc. In using any of these supports, including the CPA C anada Handbook, to determine what is GAAP in a particular situation, the exercise of good professional judgment by the auditor is critical. In applying judgment , the auditor has to take into account the context of the situation, how the information will be used, who the users are and what their level of sophistication and access to other information is, the motives of the preparers of the accounting information, and any other relevant issues that in the auditor’s experience may shed light on the reliability and appropriateness of the reported information. Possible example s of accounting issues that may not be covered in CPA C anada Handbook Recommendations (current at time of writing, but note that CPA C anada Handbook Recommendations are updated frequently) - revenue recognition for complex software sales that combine software and future services such as maintenance - capitalization or expensing of environmental control equipment expenditures b) When the C PA C anada Handbook Recommendations allow for different choices of accounting methods , the auditor needs to consider whether the client's choice is appropriate in the circumstances. Again, the exercise of good professional judgment by the auditor is critical. In applying judgment , the auditor has to take into account the context of the situation, how the information will be used, who the users are and what their level of sophistication and access to other information is, the motives of the preparers of the accounting information, and any other relevant issues that in the auditor’s experience may shed light on the reliability and appropriateness of the reported information. Examples of accounting choices set out in CPA C anada Handbook Recommendations (current at time of writing, but note that CPA C anada Handbook Recommendations are updated frequently)
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 12 Solutions Manual © 2016, McGraw - Hill Education. All Rights Reserved. - revenue recognition - amortization method - inventory costs flow method EP2 - 1 0 (Some instructors may prefer to defer this question until after Chapter 14 is covered.) The case presents a scenario where events occurring subsequent to the year - end potentially have an impact on the information that should be reported in Bunting's year - end financial statements. One possible analysis follows. One issue that is raised is the timeliness of financial reporting. By fixing a set date as of which financial statements are prepared, financial statements can become out of date before they are even issued, especially when business and economic conditions are undergoing rapid change, as is the situation in this case. Another issue is the sensitivity of the Company's operations to information that might be reported in the financial statements. In this case, information regarding the launch of a competing product can have a harmful impact on sales contracts the company is in the process of negotiating. Here Company management is arguing that this is proprietary information and that it has to be kept private. On the other hand, the auditor believes this information has a material impact on the company’s financial position and therefore it must be reported to users. The auditor might also argue that this information exists so it is very likely that potential customers are also aware of it already. By not including the impact in financial statements that are currently being prepared, the company runs the risk of giving the impression that is trying to mislead these potential customers. This can be very damaging to the company's reputation, and have very significant negative impact on its future operations. This negative impression would be aggravated by a qualified audit report which indicates that, not only was management aware of this new development, but it also refused to disclose the information even though the company’s auditor was insisting on disclosure. A further issue is the reliability of estimating the potential impact of the new product on the Bunting's future earnings. As management points out, since the product is untried in the marketplace it may well not operate as advertise. So it is a conjecture to say that its impact on Bunting's operations can be known at this time. This is difficult trade - off for the auditor to make: how should information that is highly relevant to users and their decisions but very difficult to measure reliably the handled in audit engagement? This line of reasoning would suggest that the auditor's may have gone too far in including estimated amounts and their impact on financial statement items in their audit qualification. This may explain why Bunting's management refused to accept the auditor's approach, resulting the qualified audit report. Other valid issues based on the case facts can be identified, analyzed from different perspectives, and concluded on. EP2 - 1 1 (Some instructors may prefer to defer this question until after Chapter 4 is covered.) The following are some of the points that can be discussed. Professional skepticism is required to comply with the general standard of auditing and that requires the auditor to conduct the audit with due care. Accepting management representations as being truthful without attempting to verify them by gathering relevant appropriate audit evidence is not exercising the required level of care. The need for the auditor to rely on management representations at some point creates a conflict. Some representations are not amenable to verification using feasible audit procedures. A good example of this is the completeness representation. Management represents that it has presented complete information concerning its liabilities, its revenues, its commitments, etc. but to verify these claims is not feasible. For example, verifying completeness of liabilities would require the auditor to inquire of every possible creditor - this is impossible. In practice this conflict is resolved some extent through the requirements of generally accepted auditing standards. In general, any management claim that can be verified by reasonable audit procedures will be verified, subject to consideration of its materiality. Representations that cannot be verified by reasonable means are
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 13 Solutions Manual © 2016, McGraw - Hill Education. All Rights Reserved. documented in management’s "Letter of Representation". Further, management's responsibility for the financial statements is explained in the standard wording of the auditor's report. Also, many companies, especially public companies, include with the financial statements a "Statement of Management's Responsibility" to communicate to users management's role in preparing the financial statements and its responsibility for the assertions, accounting choices and estimates contained in those financial statements. To the extent that these conflicts cannot ever be completely resolved, this a limitation to the assurance that an audit can provide. Audits can never provide 100% assurance, and knowledgeable users are expected to be aware of the limitations of audits. EP2 - 1 2 (Some instructors may prefer to defer this question until after Chapter 17 is covered.) The question requires the application of basis assurance principles to a unique setting, United Nations weapons in Iraq. One possible response is as follows. The subject matter is the existence of chemical, biological and nuclear weapons in Iraq. Using the analogy of auditing for missing liabilities in a company, the Iraqi government ("management") represents that there are no hidden weapons (" unrecorded liabilities") . An approach for the assessing risks and probabilities of weapons existing. Given the concerns of the UN about the harm that might arise from the Iraqi government possessing weapons of mass destruction, the inspectors would want to reduce the risk of missing hidde n weapons to very low level. T o parallel this to an audit of financial statements, this would be like setting the acceptable audit risk very low, which the auditor will do when the consequences to the auditor of missing a misstatement in the financial statements can be very costly (for example, an audit of a public company or a financial institution). The probabilities of weapons existing is comparable to the assessment of inherent risk in a financial statement audit. Based on their resources devoted to the weapons inspection exercise and a heightened attention focused on the inspectors work and findings, it seems the UN assessed the inherent risk that weapons exist as being very high. This may have been based on internal investigations, intelligence reports or other information available to the inspectors but not public knowledge. To implement the inspection, the inspectors would have to follow a systematic process similar to that followed by financial statement auditors. The inspectors would need to obtain a knowledge of the types of weapons and weapon manufacturing equipment that may exist, where such weapons could be concealed, the process involved in creating such weapons and transporting them. This could be paralleled to the "knowledge of business" that the financial statement auditor requires in order to plan and execute the audit. This knowledge would inform the inspectors of the kinds of places that they need to visit and the kinds of evidence that may exist to indicate that weapons have been created or transported to a particular location. Any internal reports or other intelligence that exists concerning the use of public buildings for storing concealed weapons would also be relevant to determining the probabilities that weapons are concealed in particular locations. A planning procedure would need to be followed to scope out the extent of the territory and existing structures and facilities that will need to be inspected and the staff required. This will determine the number of inspectors that need to be employed, the types of qualifications they require, the specific procedures they will have to perform and to estimate the time required to complete the inspection. EP2 - 1 3 Ac c ording to some recent CPAB reports PA firms seem to have most problems with meeting the independence requirements and the quality of documentation in their audit files. These problems have been ongoing for the first 10 years of the CPAB’s monitoring. In part t his may be why the Handbook now has a special section dealing with standards for quality control for PA firms. CPAB findings seem to increasingly influence the CPA C anada and it , in
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 2 - 14 Solutions Manual © 2016, McGraw - Hill Education. All Rights Reserved. turn, is influencing IFAC. For example, the CPA C anada at the urging of CPAB has recently created three committees to look at research and professional literature related to 1. The audit report 2. Auditor independence, including mandatory rotation of audit firms 3. The role of audit committees. EP2 - 1 4 One major source of the expectations gap is the public’s expectations regarding auditor responsibilities to detect fraud. Discuss in class. The profession’s response is discussed in chapter 7. This is a complex problem. Some questions to consider in class. How much assurance can the auditor give that management (or anyone) is honest? Should auditors provide the same assurance for detecting management fraud as for detecting lower level employee fraud ? Should the auditor have responsibility only for fraud affecting the financial statements or for any fraud? Does fraud have to be a material amount, or is all fraud automatically material no matter how small the amount? It is also important to keep in mind that accusing somebody of committing fraud (or any criminal act) can lead to libel unless the accusation is proven in a court of law. In Canada’s legal system an individual is considered innocent until a criminal act is proven in a court of law. These are just some of the complications in trying to close the expectations gap. For now it is sufficient for the students to get a general idea of the complexities and this can be done best through class discussion. EP2 - 1 5 There definitely seems to be more of an expectations gap in the private sector. Chapter 1 illustrates that public sector auditors have some of the best reputations in Canada. You cannot say the same about partners in the private sector! Some might argue that is due to the fact public sector auditors arguably have more independence than private sector auditors. See application case discussion for chapters1 and 2. For example, when an auditor general decides which organization to audit and what type of audit (VFM? Compliance?) to perform, the auditee cannot say no! Public sector auditors have been very successful in rooting out corruption and waste and this appears to be closer to the public’s image about what all auditors should be doing. See discussion in EP15. Perhaps all audits should be more like VFM audits in meeting the public’s expectations. Again, surveying class attitudes at this point is a good way to get students thinking about what should be the role of auditors and comparing that to what standards actually require. EP2 - 1 6 Most students find that the ir non - accounting friends or relatives have only a vague understanding of what auditors do. Having them read the audit report does not seem to have improved matters. See discussion of answer to EP 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 , 7 th Edition Page 3 - 1 Solutions Manual © 201 6 , McGraw - Hill Education . All Rights Reserved . CHAPTER 3 AUDITORS ’ ETHICAL AND LEGAL RESPONSIBILITIES SOLUTIONS FOR REVIEW CHECKPOINTS ESSENTIALS 3 - 1. The essential role and responsibility of an auditor is to establish and communicate assurance to users that the financial statements are ‘ fairly presented ’ , which implies that unethical reporting has not occurred. Unethical reporting means the accountable party has prepared the financial statements in a biased way that either conceals fraud 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 the possibility, and address any suspicions, that the reporting has be en done unethically. 3 - 2. To say financial statements are ‘ fairly presented ’ implies that unethical reporting has not occurred. It means the financial statements meet the qualitative characteristics set out in the conceptual framework of accounting, the most relevant of which is ‘ representational faithfulness ’ . This quality means that information presented in an entity ’ 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 that outside 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 when management decides to incur lavish travel expenses which are not directly leading to increased profits and hence not in the long term interest of shareholders. A conflict between auditors and management can arise when management want use an aggressive revenue recognition policy, or a valuation model that underestimates its bad debt provision, and auditors contend these policies are not appropriate. A conflict could arise between the auditors and the shareholders if the auditors gave a clean opinion and the company later had to restate its profits to a much lower amount . T he shareholders would probably think the auditors had done a poor job, or perhaps they 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 very fond of some of the people in the accounting function there. This can happen through many shared experiences working together on the challenges of completing the audit that build up good memories. In this case it requires strong will on the part of the auditor to recognize and act appropriately, in an unbiased way , if a situation should arise where the someone in the accounting staff is doing something that impairs the auditors ability to get the evidence they need to comply with GAAS, or takes a decision that result in the financial statements not being fairly presented. 3 - 5. Professional skepticism means that an auditor neither trusts nor distrusts claims made by management of the enterprise being audit ed. The auditor always wants to question the se claims and therefore seeks independent, corroborating evidence. The auditor has a duty to corroborate management ’ s claims and assertions - this is what the 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 that support a particular claim. Auditors must gather their own evidence on the financial statements and disclosures to reach reasonable and supportable decision to provide assurance on the truthfulness of management ’ s financial statements, 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 , 7 th Edition Page 3 - 2 Solutions Manual © 201 6 , McGraw - Hill Education . All Rights Reserved . provided by auditing, accounting and ethical standards, to make informed decisions about the most appropriate action to take in the circumstances of an audit engagement. Professional judgment in auditing requires critical thinking on accounting issues and the evidence related to them. A critical - thinking framework can be used for deciding 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 the context provided by auditing, accounting and ethical standards, to make informed decisions about the most appropriate action to take in the circumstances of an audit engagement. Experience is required to develop good judgment because most important lessons are learned by trying something new and making mistakes. To allow professionals to develop good judgment, auditing work is typically organized so that more junior auditors work under the supervision of more experienced ones. 3 - 9. A strong argument can be made that it can not. Being independent and objective, taking a skeptical attitude, and thinking carefully and critically, are an individual responsibility. But people may also find it challenging to ‘ think for themselves ’ . It may seem difficult to go against the views of more experienced people, or the views of the majority. But if an individual ’ s own critical reasoning leads to the conclusion that some action or decision is unethical, 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 always detect 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 even if auditors have performed well, the users may expect them to have done more to warn of the future business failure. If an audit fails to detect unethical reporting, and the third party believes that auditors have not met their professional 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) must prove 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. The auditor's defense 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 of penalties auditors can be charged if they are liable. In common law, auditor liability principles and penalties are set by judges , who refer to basic principles of fairness and to the past decisions of courts of law to support their judgments. The development of statute - based regulation of auditors reflects that governments no longer rely on the audit profession to self - regulate, as historically was the case. TEXT 3 - 13 This arises from the three party accountability discussed in chapter 1. The auditor is hired because users expect there may be such a conflict. If users completely trusted management there would be no need to have an auditor. This is the only way to detect fraudulent or misleading reporting. The goal is to reduce this potential to an acceptable level of risk. If the auditor assumed this risk was zero to start with the auditor would not need to provide evidence that the possibility is low, and that contradicts the reason users demand an audit. 3 - 14 No, the auditor cannot detect deception without being skeptical. A non - skeptical auditor on finding evidence of fraud may not treat it with the significance it deserves. The rule that suspicious transactions or evidence of management deceit should automatically be considered material, even when the absolute amounts involved may be very small or insignificant, is an example of skeptical logic in action. Since three party accountability implies some degree of mistrust of management by users, the auditor must incorporate skepticism in his or her reasoning process when management makes assertions about the financial statements it has prepared.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 3 - 3 Solutions Manual © 201 6 , McGraw - Hill Education . All Rights Reserved . 3 - 15 A professional accountant must be prepared to be agent, spectator, advisor, instructor, judge, and critic . 3 - 16 In ethical philosophy, the word “ conscience ” is used to describe the “ undefinable mental process that yields moral decisions. ” A close kin in the political science terms would be “ anarchy. ” Conscience might not be a sufficient guide for personal ethics decisions because the individual ’ s undefinable mental processes may be based on caprice, immaturity, ignorance, stubbornness, or misunderstanding. Conscience may fail to show the consistency, clarity, practicability, impartiality, and adequacy preferred in ethical standards and behavior. Exactly the same can be said about professional ethics decisions because a nonhypocritical individual can no more split his behavior between personal life and professional life than he can voluntarily split his own personality. 3 - 17 The rule “ Failure to tell the whole truth is wrong ” would (a) require that you not serve as a bank director when a conflict of interest might arise, (b) tell the employer what you know about the forgeries. This rule may be called imperative because it requires the truth regardless of what you might personally feel about the consequences. Strict duty based or imperative theor ies (e.g., Kant) excuses the individual from undesirable consequences as long as his decisions do not cause other people to be used as means. 3 - 18 Utilitarian ethics theory requires that a decision maker recognizes value attributes of the consequences of ethical choice alternatives (good v. evil), somehow measure or weigh these, and then decide on the basis of the greater good (or the lesser evil). Duty based ethics does not require that consequences be considered. 3 - 19 Mon i stic theories are based on idealizations or simplifications of the real world. The real world is “ messy ” with the context of a situation, such as whether there is three party or two party accountability, having a major impact on the proper role of an individual. Everyone has multiple social roles in life and it is the conflicts in these multiple roles that seem to cause the most problems for mon i stic theories. 3 - 20 In the current audit environment, PAs are expected to better justify their decisions. This need for justification, including the consideration of ethical issues, i ncreas es the importance of critical thinking. 3 - 21 Three specific aspects of on - the - job independence 1. Programming independence 2. Investigative independence 3 - Reporting independence 3 - 22 In a class action lawsuit, a few aggrieved persons with small losses can bring suit on behalf of a large group of similar persons, collectively having large losses (as in a securities offering). Large lawsuits often result in large damage awards, and many lawyers are willing to take such plaintiffs on a contingency fee bas i s. Such fees are very lucrative for lawyers, and probably less lucrative for their clients. Anyway, the losses loom large for PAs and their insurance companies. 3 - 23 Some causes are as follows: • Failure to report known departures from accounting principles, including misinterpretation of accounting principles. • Failure to conduct audits properly, including (a) misinterpretation of auditing standards, and (b) faulty implementation of auditing procedures. • Failure to detect management fraud, fraudulent financial reporting. • Actual involvement in fraud. • Also, business failure by clients after rendering an unqualified audit report. 3 - 24 Lawsuits related to tax practice, about 60 percent.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 3 - 4 Solutions Manual © 201 6 , McGraw - Hill Education . All Rights Reserved . SOLUTIONS FOR MULTIPLE CHOICE QUESTIONS MC 3 - 1 LO 5 Auditors are interested in having independence in appearance because a . they want to impress the public with their independence in fact. b . they want 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 LO 1 If a PA says she always follows the rule that requires adherence to CPA C anada pronouncements in order to give a standard unqualified audit report, she is following a philosophy characterized by a . 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 LO 4 Which of the following “ committees ” have been authorized to discipline members in violation of the rules of professional conduct? a . CPA C anda Committee on Professional Ethics b . Appeals Committee c. Discipline Committee d . Professional Conduct Committee MC 3 - 4 LO 4 Which of the following bodies does not have any power to punish individual members for violations of the rules of professional conduct? a . CPA C anada b . Canada Revenue Agency c . OSC d . CPA Ontario MC 3 - 5 LO 4 Phil Greb has a thriving practice in which he assists lawyers in preparing litigation dealing with accounting and auditing matters. Phil is “ practicing public accounting ” if he a . uses his PA designation on his letterhead and business card. b . is in partnership with another PA. c . practices in a limited partnership with other PAs. d . never lets his clients know that he is a PA. MC 3 - 6 LO 4 CPA Ontario should remove its general prohibition against PAs taking commissions and contingent fees because a . C P As 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 LO 5 PA Smith is the auditor of Ajax Corporation. Her audit independence will not be considered impaired if she a . 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 ’ s ownership of 40 percent of Pericles ’ s shares, and Pericles contributes 3 percent of the total assets and income in Ajax ’ s financial statements.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 3 - 5 Solutions Manual © 201 6 , McGraw - Hill Education . All Rights Reserved . MC 3 - 8 LO 4 When a client ’ s financial statements contain a material departure from a CPA C anada Handbook Accounting Recommendation and the PA believes that disclosure is necessary to make the statements not misleading, the PA a . 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 audit report. c . must give an adverse audit report. d . can give the standard unqualified audit report with an unqualified opinion paragraph. MC 3 - 9 LO 4 Which of the following would not be considered confidential information obtained in the course of an engagement 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 time b . The actuarial assumptions used by a tax client in calculating pension expense c . Management ’ s strategic plan for next year ’ s labour negotiations d . Information about material contingent liabilities relevant for audited financial statements MC 3 - 10 LO 4 Which of the following would probably not be considered an “ act discreditable to the profession ” ? a . Numerous moving traffic violations b . Failing to file the PA ’ s own tax return c . Filing a fraudulent tax return for a client in a severe financial difficulty d . Refusing to hire Asian Canadians in an accounting practice MC 3 - 11 LO 4 A group of investors sued Anderson, Olds & Watershed, PAs, for alleged damages suffered when the company they held common shares in went bankrupt. In order to avoid liability under the common law, AOW must prove 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 professional care. MC 3 - 12 LO 6 A PA ’ s legal licence to practice public accounting can be revoked by which organization? a . the CPA C anada b . provincial body of PAs c . Auditing Standards Board d . provincial securities commissions MC 3 - 13 LO 5 A PA ’ s independence would not be considered impaired if he had a . 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 the company became a client. d . performed the bookkeeping and financial statement preparation for the company, which had no accounting personnel, and a president with no understanding of accounting principles. MC 3 - 14 LO 4 When a PA knows that a tax client has skimmed cash receipts and not reported the income o n his federal income tax return, but he signs the return as a PA who prepared the return, that PA has violated which rule of professional conduct? a . Confidential Client Information b . Integrity and Objectivity c . Independence d . Accounting Principles MC 3 - 15 LO 6 Under the Foreign Corrupt Practices Act , a . companies must refrain from bribing foreign politicians for commercial advantage. b . independent auditors must audit all elements of a company ’ s internal control system. c . independent auditors must establish control systems to keep books, records, and accounts properly.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 3 - 6 Solutions Manual © 201 6 , McGraw - Hill Education . All Rights Reserved . d . independent auditors must establish control systems to keep books, records, and accounts properly. MC 3 - 16 LO 7 The management accountants employed by Robbins, Inc., wrongfully charged executives ’ personal expenses to the overhead on a government contract. Their activities can be characterized as a . 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 PROBLEMS EP3 - 1 Independence, Integrity, and Objectivity Cases a. Interpretation -- Honorary Directorships and Trusteeships. The PA will be considered independent provided : 1. the position is in fact purely honorary, and 2. listings of directors show she is an honorary director and 3. she restricts participation strictly to the use of her name, and 4. she does not vote or participate in management functions. b. Interpretation -- Retired Partners and Firm Independence. Since the PA is still active with the firm as an ex - officio member of the income tax advisory committee, meeting monthly, his situation would impair the appearance of the firm ’ s independence . The CPA should either resign from the Palmer board or cease his association with the accounting firm. Another ethics issue arises over Wolfe ’ s ability to hear about tax problems of other clients, and his directorship with Palmer would raise appearance questions about confidential information (Rule 208 ). c. Interpretation -- Accounting Services. The PA must be careful to know whether outsiders would perceive relationships that would indicate status as an employee, hence impairing the appearance of independence. In particular, the PA must. 1. Not have any business connection with Harper Corp. or with Marvin Harper that would in fact impair independence, objectivity and integrity, and 2. Impress Marvin Harper (and the board of directors) that they must be able and willing to accept primary responsibility for the financial statements as their own, and 3. Not take managerial responsibility for conducting operations of the Harper Corp. (although the PA ’ s supervision of the bookkeeper seems to have this characteristic), and 4. Conduct the audit in conformity with GAAS and not fail to audit records simply because they were processed under the PA ’ s supervision. This case assumes Harper Corp. is not a reporting entity , in which case the PA ’ s audit independence would certainly be impaired as a result of participating in the bookkeeping work. d. Interpretation of -- Effect of Family Relationships on Independence The PA ’ s wife ’ s interest is attributed to him, and he would not be independent. The financial interest is considered direct. e. Interpretation The PA is still not independent, so long as the daughter is a dependent child. The financial interest is considered direct . f. Interpretation
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 3 - 7 Solutions Manual © 201 6 , McGraw - Hill Education . All Rights Reserved . Still not enough. The grandfather (either the PA ’ s father or his father - in - law) is considered a nondependent close relative, but the appearance of independence is impaired. The grandfather ’ s investment is material (50 percent) in relation to his net financial resources. g. Interpretation The remote kin (uncle) who is geographically separated and in infrequent contact is far enough removed. h. Interpretation -- Meaning of Certain Independence Terminology The firm ’ s independence is not impaired by the attributable managerial relationship so long as the PA is not connected with the ATC audit. i. The PA ’ s promotion changes the situation. When he becomes a partner, a stricter standard will apply and his firm ’ s independence will be considered impaired even if he does not work on the ATC audit. Such occurrences are not really too rare in practice, affecting family relationships other than husband and wife. PA firms ’ resolutions are that one must forgo partnership or the other must give up his or her job with a client. j. Interpretation Such loans would impair independence. EP3 - 2 Independence, Integrity, and Objectivity Cases (a, b, c, d, e, f) Interpretation -- Effect of Actual or Threatened Litigation on Independence. In general, when the present management of a client company commences or expresses an intention to commence legal actions against the auditor, the auditor and the client management may be placed in adversary positions in which the management ’ s willingness to make complete disclosures and the auditor ’ s objectivity may be affected by self - interest. Independence may be impaired whenever the auditor and his client company or its management are in positions of material adverse interest by reason of actual or threatened litigation. Various situations are hard to generalize, and the responses offered below are guidelines expressed in AICPA Ethics Interpretations 101 - 6 (Effect of Litigation). SEC Accounting Series Release No. 234 (December 1977) expresses similar guidelines. a. An expressed intention by the client company to begin litigation alleging deficiencies in audit work is considered to impair independence if the auditor concluded that there is a strong possibility that such a claim will actually be filed. b. The commencement of litigation alleging deficiencies in audit work would be considered to impair independence. c. The commencement of litigation by the auditor alleging management fraud or deceit would be considered to impair independence. d. The claim under subrogation by the insurance company would not “ normally ” affect the auditor ’ s independence. In this case, the client company and members of management are not the nominal plaintiffs . However, the idea of “ normally ” needs to be evaluated. If members of Contrary management are going to testify on behalf of the insurance company ’ s interest and thus act in an adversary relation to the auditor, independence would seem to be impaired. The substance of the situation is essentially the same as if Contrary Corporation was the named plaintiff. e. Litigation not related to the audit work, whether threatened or actual, for an amount that is not material to the audit fi rm or to the financial statements of the client company would not usually be considered to affect the PA - client relationship in such a way as to impair independence. According to the SEC, this situation might impair independence.
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Smieliauskas & Bewley, Auditing: An International Approach , 7 th Edition Page 3 - 8 Solutions Manual © 201 6 , McGraw - Hill Education . All Rights Reserved . f. The class action lawsuit against both auditor and company in itself would not alter fundamental relationships between the company management and directors and the auditor and therefore would not be considered to have an adverse impact on the auditor ’ s independence. These situations, however, should be examined carefully. Actions to be taken When independence is considered impaired, the auditor should (a) withdraw from the audit engagement in order to avoid the appearance that his self - interest would affect his objectivity or (b) issue an opinion denial because of lack of independence. g. Interpretation -- Effect on Independence of Financial Interests in Non - clients Having Investor or Investee Relationships with a Member ’ s Client The PA ’ s financial interest in Dove Corp. (investor) is sufficiently large to allow him to influence the actions of Dove, and the PA ’ s (and the PA firm ’ s) independence would be considered impaired . The PA ’ s ability to influence Dove Corp. could permit him to exercise a degree of control over Tale Company (the investee, a client) that would place the PA in a capacity equivalent to that of a member of management . h.i. Interpretation Assuming that the North Country is a profit - seeking enterprise, the independence of the auditors is not impaired by the association of the two individuals who served both as members of the auditing firm and as directors for the client during the period examined as long as they have ended all ties with the bank and are not involved in the audit. j. The auditor ’ s services may consist of advice and technical services, but he must not make management decisions or take positions which might impair his objectivity. The independence of the auditing firm would be compromised by any partner making a decision on loan approvals and the minimum balance checking account policy, but normally not by his performing a computer feasibility study. If the former controller ’ s participation in the feasibility study was objective and advisory, and his advice was subject to effective client review and decision, the firm ’ s independence has not been compromised. It is desirable, however, that the former controller not participate in the audit of the North Country ’ s financial statements. (AICPA Adapted) k. The acceptance by the PA of the unsecured interest - bearing notes in payment of unpaid fees would not be construed as discrediting the PA ’ s independence in his relations with his client because the notes are merely a substitution for an open account payable. The rule of professional conduct that prohibits a PA from having any financial interest in a client does not extend to the liability for the PA ’ s fee. If liability for the PA ’ s fee was considered to be financial interest in a client, the present form of the PA - client relationship would not be permitted to continue because often (frequently in engagements for continuing audits) the client ’ s statements being audited include a liability for the CPA ’ s services. Under SEC rules, however, a definite arrangement for paying the notes must be stated by the client. However, the acceptance of two shares of common stock (or prior commitment to accept stock) would be a violation of Rule 204. Any direct financial interest such as common stock holdings are construed as discrediting the PA ’ s independence. (AICPA adapted) l. Interpretation 204 -- Acceptance of a Gift. The rules apply to Johnny if he ’ s a student member of the provincial body . The ruling applies to the independence of a firm if an employee accepts a gift that is more than token. Independence is impaired because a member cannot permit his employees to break rules he himself is obligated to observe. m. Member as Bank Stockholder.
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