Solution Manual For Auditing: A Practical Approach with Data Analytics, 1st Edition

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1CHAPTER 1Introduction and Overview ofAuditAssuranceLearning Objectives1.Differentiate among assurance, attestation, and audit services.2.Describe thedifferent types of assurance services.3.Explainthe demand for audit andassurance services.4.Discussthe different roles of the financial statement preparer and the auditor.5.Identifythe roles of different regulators and organizations that affect the audit profession.6.Explain theconcepts of reasonable assurance, materiality, and the nature of anunqualified/unmodified report on the audit of financial statements.7.Explain the concept of reasonable assurance and the nature of an unqualified report on internalcontrols over financial reporting.8.Discuss the audit expectation gap.ANSWERS TO MULTIPLE-CHOICE QUESTIONS1.CLO 1, BT:C, Difficulty:Easy, TOT:2min., AACSB:None, AICPAAC:Risk Assessment, Analysis and Management, Section:Assurance, Attestation, and AuditServices2.ALO2, BT:C, Difficulty:Easy, TOT:2min., AACSB:None, AICPAAC:Risk Assessment, Analysis and Management, Section:Different Assurance Services3.BLO2, BT:C, Difficulty:Easy, TOT:2min., AACSB:None, AICPAAC:Risk Assessment, Analysis andManagement, Section:Different Assurance Services4.CLO2, BT:C, Difficulty:Medium, TOT:2min., AACSB:None, AICPAAC:Risk Assessment, Analysis and Management, Section:Different Assurance Services5. CLO3, BT:C, Difficulty:Medium, TOT:2min., AACSB:None, AICPAAC:Risk Assessment, Analysis and Management, Section:Demand for Audit and AssuranceServices6.BLO4, BT:C, Difficulty:Easy,TOT:2min., AACSB:None, AICPAAC:Risk Assessment, Analysis and Management, Section:Preparers and Auditors7.ALO5, BT:C, Difficulty:Easy, TOT:2min., AACSB:None, AICPAAC:Reporting,Section:The Role of Regulators and Regulations8.DLO5, BT:C, Difficulty:Easy, TOT:2min., AACSB:None, AICPABC:GovernancePerspective, Section:The Role of Regulators and Regulations

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29.DLO6, BT:C, Difficulty:Easy, TOT:2min., AACSB:None, AICPAAC:Risk Assessment, Analysis and Management, Section:AuditReport on Financial Statements10.CLO6, BT:C, Difficulty: Easy, TOT:2min., AACSB:None, AICPAAC:Reporting, Section:Audit Report on the Financial Statements11.BLO7, BT:C, Difficulty: Easy, TOT:2min., AACSB:None, AICPAAC:Reporting, Section:AuditReport on Internal Controls overFinancial Reporting12. BLO8, BT:C, Difficulty:Medium, TOT:2min., AACSB:None, AICPAPC:Professional Behavior, Section:The Audit Expectation GapANSWERS TO REVIEW QUESTIONS1.1An assuranceserviceis any serviceprovided byanindependent practitionerthat improves the qualityof informationthat was prepared by someone else.An independent practitioner can verify that theinformation meets relevant criteria, which provides assurance to users who intend to use the informationfor decision making.An assurance engagement has three parties: the assurance provider(auditor/practitioner), the party responsible for providing the information (client), and the intended usersof the information(investors/lenders/others who rely on theinformation).LO1, BT:C, Difficulty:Easy, TOT:5min., AACSB:None, AICPAAC:Risk Assessment, Analysis and Management, Section:Assurance, Attestation, and AuditServices1.2 The criterionused in a financial statement audit to measure and evaluate subject matter is theapplicable financialreporting framework used by the client. The most common framework used in theU.S. is GAAP.LO 1, BT:C, Difficulty: Easy, TOT:5min., AACSB:None, AICPAAC:MeasurementAnalysis and Interpretation, Section:Assurance, Attestation, and AuditServices1.3Financial statements are not guaranteed to be free from error or fraud due to several limitations. Theselimitations include the nature of financial reporting, the nature of audit procedures and the need for theaudit to be conducted within a reasonable period of time and within a reasonable budget. The nature offinancial reporting causes limitations because it includes management’s judgment when applyingaccounting standards and estimates. The nature of the audit proceduresisa limitation because the auditorshave to rely on management to provide all the necessary documentation needed for the audit. The auditormay arrive at an inappropriate conclusion if information is tampered with or excluded. The last limitationrefers to the limited resources of timeand money for an audit engagement. It would be impractical forauditors to examine every transaction. Therefore, auditors rely on sampling measures to provide anaccurate representation of the population,andsamplingcannot provide absolute assurance.LO2, BT:C, Difficulty:Medium, TOT: 15 min., AACSB:None, AICPAAC:Risk Assessment, Analysis and Management, Section:Different Assurance Services1.4Management and those charged with governance can request an operational audit to help improve theefficiency and effectiveness of a company’s operations. An organization’s internal audit departmenttypically conducts operational audits.LO2, BT:C, Difficulty: Easy, TOT:5min., AACSB:None, AICPABC:Governance Perspective, Section:Different Assurance Services1.5Investors are interested in the information that financial statements can provide about theirinvestment. This includes, but is not limited to, information regarding the profitability of the company,return on investment, going concern/continuity of operations, and dividend distributions. Anindependentaudit helps to ensure that the information in the financial statements is credibleand of high quality.LO3, BT:C, Difficulty:Easy, TOT: 10min., AACSB:None, AICPABC:Governance Perspective, Section:Demand for Audit and Assurance Services

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31.6Both the preparer and the auditor haveresponsibilitiesregarding the company’s financial statements.Management (the preparer) is in charge of preparing the financial statements. This includes ensuringtheinformation is presented fairly and in compliance with GAAP, or other applicable financial reportingframework. Management is responsible for designing, implementing, and maintaining internal controlover financial reporting, as well as providing auditors with all the necessary documentation and personnelneeded to complete the audit. Auditors are responsible forproviding an opinionon whetherthe financialstatementsare presentedfairly and in accordance with the applicable financial reporting framework. Thethree responsibilities of auditors are toconduct the audit in accordance with the appropriateauditstandards, plan and perform the audit with professional skepticism, andexerciseprofessional judgment.LO4, BT:C, Difficulty:Medium, TOT:15min., AACSB:None, AICPAAC:Reporting, Section:Preparers and Auditors1.7The SOX Act of 2002, which emphasized a need for better governance over financial reporting,created the Public Accounting Oversight Board (PCAOB). The PCAOB is a non-profit corporationestablished to oversee the audits of public companies. The SECis a federal government agencywhoserole is to enforce and interpret securities laws. The SECapproves each new auditing standard establishedby the PCAOB beforeit canbe implemented. The SEC and PCAOB work closely together to ensurestandards are in place forbothpubliccompanies and auditors to safeguard investors.LO5, BT:C, Difficulty:Medium, TOT: 10min., AACSB:None, AICPAAC:Reporting, Section:The Role of Regulators and Regulations1.8Some functions of the state boards of accountancy include issuing CPA licenses, adopting andenforcing professional conduct rules for CPAs, enforcing continuing professional education requirements,and administering disciplinary actions. NASBA is a professional organization that works to unite theinterests of the 55 jurisdictions of state boards with regulative and legislative bodies.LO5, BT: AP, Difficulty:Easy, TOT: 10min., AACSB:Analytic, AICPAPC:Professional Behavior, Section:The Role of Regulators and Regulations1.9The principles of GAAS start with the purpose of an audit, which is to provide an opinion on whethera company’s financial statements are presented fairly and in accordance with GAAP. The next principledescribes the premise upon which an audit is conducted. This outlines management’s responsibility toprepare the financial statements in accordance with the applicable framework, manage and maintaininternal controls over financial reporting, and provide the auditor with access to all documentationrelevant to conduct the audit. The next principle outlines the responsibilities of the auditor, whichexplicitly states auditors have to be competent, comply with auditing standards, maintain professionalskepticism and exercise professional judgment during anaudit. While performing an audit, an auditormust obtain reasonable assurance that the financial statements are freefrommaterial misstatement, butalso recognize it is not an absolute assurance due to several limitations. The last principle states thatauditors must report the results of the audit in a formalized written report.LO5, BT:C, Difficulty: Easy, TOT: 10min., AACSB:None, AICPAAC:Reporting, Section:The Role of Regulators and Regulations1.10Audit reports for private and public companies are very similar in content. Both reports contain theessential components: a title with the word “independent,” an address to the shareholders/ownersandboard, identification of which financial statements were audited, a description of the responsibilities of theparties involved,a description of the conduct of an audit,an opinion on the outcome, a signature with thefirm’s name and a date indicating the end of fieldwork. However, there are a few differences between thetwo. The title for an audit report of a public company includes the term “registered” indicating the firm isregistered with the PCAOB. Audit reports for public companiesstate the auditor is required to beindependent from the company in accordance with U.S. federal securities laws and with regulations of theSEC and PCAOB.One of the biggest differences between the reports is that public companies include aparagraph referencing the audit of the firm’s internal controls over financial reporting.Public companiesare required to have two audits, one for financial statements and the other for ICFR; whereas, privatecompanies are not required to have an audit of ICFR.Also, auditors must provide a statement aboutauditor tenure at the bottom of the audit report public companies.Finally, the order of the paragraphs in

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4the two reports is different. The audit report for a public company begins with the auditor’s opinion in thefirst paragraph.In the audit report for a private company, the opinion is given in the last paragraph.LO6, BT:AN, Difficulty:Medium, TOT:15min., AACSB:Analytic, AICPAAC:Reporting, Section:Audit Report on Financial Statements1.11 The components of an auditor’s report on internal controls over financial reporting include the title,address, opinion, reference to the financial statement audit, basis for opinion paragraph, scope paragraph,definition and limitations paragraph, signature and date. The title must include two important terms—“independent” and “registered”—signifying the auditor’s independence and that the firm is registeredwith the PCAOB. The report is addressed to the board and shareholders of the company. The opinionparagraph states that an audit of the company’s internal controls was conducted using the COSOInternalControl-Integrated Frameworkas the criteria, and then states whether or not the company maintainedeffective internal control. The next paragraph references the audit of the company’s financial statementssince public companies require two audits. The basis for opinion paragraph briefly describes theresponsibilities of management and the auditor and mentions that auditors are required to be independentfrom the company. The scope paragraph briefly describes how an audit of ICFR is conducted. Thedefinition and inherent limitations paragraph definesICFR for users unfamiliar with the terminology andemphasizes that internal controls will not be able to prevent or detect all misstatements or errors. Thereport is signed by the firm and dated to represent the end of the fieldwork.LO7, BT:C, Difficulty:Medium, TOT: 15 min., AACSB:None, AICPAAC:Reporting, Section:Audit Report on Internal Controls over Financial Reporting1.12 The audit expectation gap occurs when the auditor’s professional responsibilities do not align withthe financial statement users’ beliefs. This gap is created when the user has unrealistic expectations forthe audit. Some examples of unrealistic expectations are as follows:the user may believe the auditor is providingabsoluteassurance instead of reasonable assurance,the user may believe the auditor is guaranteeing future viability of the company,the user may believe a favorable audit conclusion indicates complete accuracy instead of nomaterial misstatements,the user may believe the auditor will find any and all fraud when that is simply impossible, andthe user may believe the auditor has tested every transaction instead of a sample.It is impossible forprofessional auditing standardsto give users what they want because of inherentlimitations with the conduct of an audit.Auditors sometimes do not meet professional standards because of time constraints in completing theaudit(possibly being short staffed), not exercising enough professional skepticism,and not maintainingprofessional competence through continuing professional education.LO8, BT:AN, Difficulty:Medium, TOT: 10min., AACSB:Analytic, AICPAAC:RiskAssessment, Analysis and Management, Section:TheAudit Expectation GapSOLUTIONS TO ANALYSIS PROBLEMSAP1.1Although internal and external audit are different professional fields, they share some similarresponsibilities. Both fields follow rules and regulations made by their respective professionalorganizations, the Institute of Internal Auditors (IIA) and theAmerican Institute of Certified PublicAccountants (AICPA). Additionally, external auditors of public companies must adhere to regulations setforth by the PCAOB and SEC. Internal auditors are typically employees of the organization and therefore

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5cannot have the same level of independence from the organization as an external auditor can.Nevertheless, internal auditors are required to maintain independence from management to ensureobjectivity and an unbiased attitude. External auditors cannot be employees of the audit client, and theymust adhere to strict independence guidelines to ensure there are no conflicts of interest in performing theaudit engagement.The most common role for internal auditors is to monitor internal controls and improve theeffectiveness of controls, governance, and risk management strategies. Internal auditors report theirresults to those charged with governance and typically do notreport findings to the public. The role ofthe external auditors is to express an opinion on the fair presentation of the client’s financial statements inaccordance with the applicable financial reporting framework. Forcertainpublic company clients,external auditors also provide an opinion on the effectiveness of the client’s internal controls overfinancial reporting. The external auditors report their opinion(s) to those charged with governance, andfor public company clients, to interested usersoutside of the client.LO 1,2BT: AN, Difficulty: Easy, TOT: 15 min., AACSB:Analytic,Technology, AICPAAC:Research, Section:Assurance, Attestation, and Audit Services,Different Assurance ServicesAP1.2 Users demand audited financial statements for various reasons.If the accounting firm performingthe audit is perceived as incompetent, not independent, or unethical, then the value of theaudit service islost. Users will not be confident that the information managementispresents in the financial statementsis unbiased and reliable. If users think the financial statements are unreliable, then they may not invest inthe company, do business with the company, or lend money to the company. Therefore, a company doesnot wantto be associated with an accountingfirm that has a poor reputation or that is in violation ofprofessional standards.That is why clients dropped Arthur Andersen after charges were brought againstthe firm.LO3, BT:AP, Difficulty:Hard, TOT:15 min., AACSB:Analytic, AICPAPC:Professional Behavior, Section:Demand for Audit and Assurance ServicesAP1.3The solution will depend on the accounting firm chosen and the date of the analysis. However, theanswers should show for the Big 4:greater geographic coverage, larger numbers of staff and broader rangeof skills offered, greater claims to specialization and industry coverage, more publications available(particularly from the international offices), more consistent and sophisticated marketing.LO3,4,BT:AN, Difficulty:Medium, TOT:20min., AACSB:Analytic,Technology, AICPAAC:Research, Section:Demand for Audit and Assurance Services,Preparers and AuditorsAP1.4a.Financialstatementaudits are mandatory forpubliccompanies, so overall demand is largely fixed ordetermined by economic conditions affecting the number of companies. However, for organizations thatare not required by legislation to have an audit, there are two opposing pressures in times of economicrecession. First, cost-cutting would result in fewer audits. Second, organizations with less credible financialstatementswill facethemost difficulty in borrowing during a credit squeeze. This suggests that demand forauditing will increase in difficult times, because an audit will increase the credibility of thefinancialstatementsand thus increase access to external finance.b. Shifting from a mid-tier auditor to a Big 4 auditor would increase both costs and financialstatementcredibility for a company. Therefore, it can be argued thatcompanieswith greater need to reduce costs willshift“down”from Big 4 auditors to mid-tier auditors, butcompanieswith greater need for credibility (andfinancial advice) will shift“up”from mid-tier auditors to Big 4 auditors.LO3,4BT: AP, Difficulty:Hard, TOT: 15 min., AACSB:Analytic, AICPABC:Customer Perspective, Section:Demand for Audit and Assurance Services,Preparers and AuditorsAP1.5The solution will vary based on the states selected by the student to research. In general, most statesrequire a bachelor’s degree and relevant accounting and business courses. Some states, such as Texas andColorado, require an ethics course. Some states allow candidates to sit for the CPA exam after completinga bachelor’s degree with the relevantaccounting courses, but a total of 150 hours of college credits are

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6required to be licensed as a CPA.In addition to passing the CPA exam and meeting the educationrequirements, most states require 1-2 years of work experience in public accounting to be licensed.LO5, BT: AN, Difficulty:Basic, TOT:20min., AACSB:Technology, AICPAAC:Research, Section:The Role of Regulators and RegulationsAP1.6To be registered with the PCAOB, a firm must complete a 27-page application (Form 1) and paythe required fees. The purpose of Form 1 is to capture information about the firm including contactinformation, number of employees, types of clients serviced bythe firm, any on-going or pendingcriminal or civil actions against the firm, quality control procedures, and names of issuers that the firmexpects to provide audit services to in the current year. Form 1 is signed by a partner or authorizedofficer ofthe firm. The application fee is $500 for a firm that audits less than 50 issuers, $3,000 for afirm that audits 50-100 issuers, $29,000 for a firm that audits 101-1000 issuers, and $390,000 for a firmthat audits 1001 or more issuers.Once a firm isregistered, annual fees are $100,000 for firms with more than 500 issuer auditclients and more than 10,0000 personnel,$25,000 for firms with more than 200 issuer clients and morethan 1,000 personnel, and $500 for all other firms.Registered firms have to file an annual report with thePCAOB on Form 2. Form 2 captures any updated information related to the firm and its audit clients,affiliations with other firms, and on-going or pending criminal or civil actions against the firm.Registered firms must abide by PCAOB regulations andconsent tobe inspected on a regularbasis.Firms that audit 100 or more issuers per year are inspected annually. Firms that audit less than 100issuers per year are inspected once every three years.LO5, BT:C, Difficulty:Basic, TOT:20min., AACSB:Technology, AICPAAC:Research, Section:The Role of Regulators and RegulationsAP1.7a. Answers may vary depending on which year is accessed to review the audit reports of TheBoeingCompany and Starbucks. Most likely both companies will have unqualified opinions on both the financialstatements and internal controls.b. All accounting firms follow the standard audit report formatsprovided by the ASB (for private companyaudits) and the PCAOB (for public company audits). Having a uniform report format promotes consistencyin the profession and is easier for financial statement users to understand.LO6,7, BT: AN, Difficulty: Easy, TOT:20min., AACSB:Analytic,Technology, AICPAAC:Research,Reporting,Section:Audit Report on Financial Statements,Audit Report on Internal Controls over Financial ReportingAP1.8Dear Kim,I enjoyed eating dinner with you the other night, old friend. I am writing to you because you had adifficult time understanding the audit profession and a few of its important aspects. I will describe to youthe concept of“reasonable assurance”and how it is determined, the “professional skepticism” that allauditors must practice, and why your perceptions are a great example of what is called the “expectationsgap.”As auditorsof acompany, we are required to give our opinion on the level of confidence we have in thereliability thatthefinancial statements are free of material misstatement. This confidence level is called“reasonable assurance.”It is determinedbyusing our professional judgment andbyacquiring asignificant amount of evidence to support this assurance. We cannot offer absolute assurance becausethere are several factors that make it impossible for us to detect every misstatement.First, we havealimited time to conduct the audit, therefore we cannot audit everything. We focus our time on the mostimpactful, or material, items on the financial statements. Second, there is a risk that management cancollude to hideinformationor provide false information to us, but fraud is not a common occurrence.

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7Finally, some items on the financial statements are subjective and can be very complex to audit. Wecannot provide absolute assurance on an item that is subjective.“Professional skepticism” is a concept that means auditors must have a state of awareness about thefactors that could lead to material misstatement, be critical of the evidence and documents they receivefrom an organization’s management, and have a questioning attitude overall. Although we are skeptical ofmanagement, this does not mean that we believe they are constantly trying to deceive us. There aremanysituations where we must rely on the information provided to us by the client’s management team.Theperceptions that you had during dinner about the audit profession are a perfect example of the“expectations gap.”We define the expectations gap as the difference between what the public believesauditors are providing and what the auditing profession is actually capable of doing.Now that you haveread my explanations of reasonable assurance and professional skepticism, I hope I have provided youwith a more realistic impression of my profession. Hope we can get together fordinner again soon!Sincerely,LO4,6, 8BT:S, Difficulty: Medium, TOT: 30min., AACSB:Analytic,Communication, AICPAPC:Communication, Section:Prepares and Auditors, Audit Reporton Financial Statements, The Audit Expectations GapAP1.9a.An auditis limited due to several factors. The nature of financial reportingcausesalimitation oftheaudit. This refers to the subjectivity involved when a company is deciding which accounting methods orestimates to use.It can be difficult to audit an item that has been created based on judgment.Anotherlimitationis the nature of audit procedures.Auditors select audit procedures that will detectmaterialmisstatements, as it is too costly to try and detect all misstatements.Also, auditors use samplingtechniques when gathering evidence related to some financial statement items. A limitation of samplingis that the sample may not be representative of the population and the auditor will draw an incorrectconclusion.Finally, one of the bigger limitations auditorsface is that of time. There is a need for an auditto be conducted within a reasonable period of time and at a reasonable cost. This time constraint on theaudit can cause auditorsto perhaps rush their work and not be as diligent as they would be otherwise.b.When looking at the reports in figures 1.6, 1.7, and 1.9 in Chapter 1, you can see these limitationsreferenced. The reports mention the reasonableness of accounting estimates, which refers to thesubjectivity limitation. Also, you see the word “material”in all three of these audit reports. Auditors areonly concerned with material misstatements that could affect the decisions of financial statement users.Reasonable assurance is mentioned in every report. It is because of these limitations that auditors provideonly reasonable assurance. Defined as a high, but not absolute, level of assurance, reasonable assurancemeans the auditor does not “guarantee” that the financial statements are 100% accurate. Finally, the auditreport for a public company inIllustration 1.7 includes the phrase “procedures included examining, on atest basis,” which refers to the limitation of using sampling. The auditor does not test all information,;therefore, sampling risk exists.LO2,4,6, 7, 8BT: AN, Difficulty:Hard, TOT:30min., AACSB:Analytic, AICPAAC:Risk Assessment, Analysis and Management,Reporting,Section:DifferentAssurance Services, Preparers and Auditors, Audit Report on FinancialStatements, Audit Report on Internal Controls over Financial Reporting, The AuditExpectation GapAP1.10a. The auditors for GSK are PricewaterhouseCoopers (for the 12/31/17 audit).b. The UK auditor’s report model has some similarities to the US report model, but also some significantdifferences. Some similarities include:-a title that includes the word “independent”-the opinion is stated in the first sentence of the first paragraph

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8-a basis for opinion paragraph that states the audit standards that were followed and that audit evidenceobtained is sufficient and appropriate to provide a basis for the opinion-discussion of both management and auditor responsibilities-disclosure of auditor tenureSome differences of the UKauditor’s report are:-the title also includes the addressee-the report references the IFRS standards (GAAP is referenced in the US report) and UK laws andregulations-includesexpanded discussion of the auditor’s independence-states themateriality amount used for the audit and how it was calculated, and specific areas of audit focus-includes expanded discussion of the scope of the audit-defines “key audit matters,” which are comparable to “critical audit matters” in the US-listed seven keyaudit matters and how they were addressed in the audit (for the 12/31/17 audit)-includes expanded discussion of going concern and how auditors addressed it-includes a discussion ofreporting on other information-includes a section titled “use of this report”c. Student answers will vary based on preference. But a notable issue that students will probably recognizeis the difference in the length of the UK report. The report for the 12/31/17 audit of GSK is eight pages inlength. The US report is onepage;however, that will change once the requirement to report CAMs goesinto effect in the US.Would all types of users prefer the UK report? It depends on the sophistication of the user. Lenders andinvestment analysts, who are knowledgeable about financial statements,mostlikely prefer the UK reportbecause there is more detail provided about key areas addressed during the audit.Preparers of financialstatements (management) and auditors might prefer the shorter US report. Management and auditors maynot feel comfortable disclosing so much detailed information about the audit, especially since it requiresprofessional judgment to determine what is a CAM. Auditors have also feared increased litigation basedon what will be disclosed as a CAM in the auditor’s report.LO6, BT: AN, Difficulty:Hard, TOT:45min., AACSB:Analytic,Technology, AICPAAC:Reporting, Section:AuditReport on Financial StatementsCloud 9a.A financial statement audit only focuses on determining if the financial statements are preparedaccording to the applicable financial reporting framework. A financial statement audit must be performedby an independent accounting firmunder the supervision of a CPA. A compliance audit is performed todetermine if an entity hasfollowed rules, laws, or regulations with which it is required to conform. Acompliance audit does not have tobeperformed by a CPA, but it must be performed by someonedesignated or approved by the body that enforces the rules, laws, or regulations. An operational auditfocuses on the efficiency and effectiveness of an entity’s activities. Typically, an operational audit isperformed by employees of the company, but it can be outsourced.The individual(s) performing theaudit does not have to be independent and does not have to be a CPA.b. Reasonable assurance is a high level of assurance, but it is not absolute assurance. Absolute assuranceimplies a level of service that is akin to a guarantee or a certification. Because of the limitations of anaudit (time constraints, subjectivity,and the nature of audit procedures), auditors can only providereasonable assurance.c.An audit is more in depth and broader in scopethan a review. An audit also provides a higher level ofassurance, reasonable assurance, than a review,which only provides limited assurance. Since Chip is

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9considering purchasing McLellan’s shoes, he requires more assurance that the financial statements arefairly presentedand the information in the financial statements is reliable.d. Ron should consider the reputation of the firm and whether the firm has the expertise to conduct anaudit of a company in the sports footwear industry. Since Ron’s company is small, he would most likelyconsider using a regional or mid-tier firm because their work is tailored to companies of his size.LO 1, 2, 3, 4, 6, BT: AN, Difficulty: Medium, TOT: 30 min., AACSB:Analytic, AICPAAC: Reporting, Section:Assurance, Attestation, and Audit Services,Different Assurance Services,Demand for Audit and Assurance Services, Preparers and Auditors,Audit Report on Financial Statements

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Before You Go On SolutionsCHAPTER 1Introduction and Overview of Audit Assurance1.1The intended users of assurance services are decision makers, such as investors, creditors, andregulators.1.2Within the context of assurance services,“independent” means that the person performing the serviceis not involved with the creation of the information and is objective in the evaluation of theinformation.1.3Examples of “applicable financial reporting frameworks” are GAAP, IFRS, and a federal income taxbasis of accounting.2.1Theobjectiveof a financial statement audit is to provide financial statement users with an opinion bythe auditor on whether the financial statements are presented fairly in accordance with an applicablefinancial reporting framework.2.2An inherentlimitationof a financial statement audit is the nature of financial reporting wherebyauditors use judgment when preparing financial statements due to the subjectivity required whenarriving at accounting estimates. Another inherentlimitationis the nature of audit procedures whichrefers to the reliance on evidence provided by the client and its management. Also, auditors often usesampling techniques rather than auditing an entire population of items, therefore there is a risk ofarriving at an incorrect conclusion. The final inherentlimitationis the need for the audit to beconducted within a reasonable period of time at a reasonable cost.2.3The three elements of operational audits are economy, efficiency, and effectiveness of anorganization’s activities.2.4The most common functions of internal auditors areevaluating and improving risk management,internal control procedures, and elements of the governance process.3.1The main users of company financial statements are current and potential investors, suppliers,customers, lenders, employees, governments, and the general public.3.2Financial statement users demand an audit because of remoteness of the company, complexity offinancial statements, competing incentivesamong management and users, and reliability ofinformation.3.3Auditors are the appropriate professionals to conduct an audit because they have the knowledge andexpertise to assess the fairness of the information being presented by the preparers. They have accessto company records, so they are not remote. Auditors have little incentive to aid the company inpresenting the results in the best possible light because their work is regularly reviewed by regulators.4.1Management is responsible for ensuring the information included in the financial statements ispresented fairly and complies with the applicable financial reporting framework. Management is alsoresponsible for designing, implementing, and maintaining internal control relevant to the preparationand fair presentation of the financial statements. Management provides the auditors with access to all

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records, documentation, and personnel relevant to the preparation and fair presentation of financialstatements and any additional information the auditors may consider relevant to complete the audit.4.2Professional skepticism is an attitude adopted by auditors when conducting an audit that includes aquestioning mind, being alert to conditions that may indicate possible misstatement due to fraud orerror, and a critical assessment of audit evidence.4.3 Non-audit services arenotassurance services, therefore, the CPA does not need to be independent.Examples include management consulting, business valuation, mergers and acquisitions, tax, andaccounting.5.1The SECis a federal government agency whose mission is to protect investors, maintain fair andefficient markets, and facilitate capital formation. The SEC enforces and interprets securities laws.5.2 The PCAOB is the organization that sets standards for the audits of public companies.The ASB setsthe standards for the audits of private companies.5.3 The main functions of the state board of accountancy are issuing CPA licenses to individuals whomeet all the requirements, adopting and enforcing rules of professional conduct for CPAs, adopting andenforcing rules regarding continuing professional education requirements, investigating complaintsagainst CPAs,conducting hearings,and takingappropriate disciplinary actions, such as suspension orrevocation of the CPA license.6.1Auditors provide reasonable assurance because they give their opinions on whether the financialstatements are presented fairly. An opinion is defined as a judgment about matters that are subjective.Also, an audit could not be completed in a reasonable amount of time if auditors had to provide absoluteassurance.6.2 Materiality is an aspect of a financial statement that is significant enough to influence or make adifference in the judgment of consequential activities of a financial statement user. Materiality relates toreasonable assurance because auditors design an audit to provide reasonable assurance that the financialstatements are free of material misstatement.6.3 The term unqualifiedis usedin the context of an audit reportfor a public company client. It means inthe auditor’s opinion, the financial statements are presented fairly, in all material respects, in accordancewith theapplicable financial reporting framework. The term unqualified is equivalent to the termunmodifiedwhich isused for the private companyauditreport.7.1Havingeffectiveinternal controls over financial reporting provides reasonable assurancethat thefinancial statements will be reliableand free of material misstatement.An effective internal controlsystem may not prevent all misstatements, therefore, it can only provide reasonable assurance. Similar toan audit of the financial statements, auditors can only provide reasonable assurance that a company’sinternal controlsare effective.

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7.2 According to the audit report on the effectiveness of internal controls,management is responsible formaintaining effective internalcontrolover financial reporting and for its assessment of the effectivenessof internal control over financial reporting.7.3 The date used on the audit report on the effectiveness of internal controls represents the end offieldwork. The date represents the conclusion of gathering and evaluating evidence for the auditand itshould be the same date as the audit report on the financial statements.8.1 The audit expectation gap occurs when there is a difference between the expectations of auditors, asdictated by auditing standards,and financial statement users. The performance gap is the differencebetween auditor performance and auditing standards and regulations.8.2The audit expectation gap is caused by unrealistic user expectations such as:Auditor is providing absolute assurance.Auditor is guaranteeing future viability of the entity.An unmodified opinion is an indicator of complete accuracy of financial statements.Auditor will definitely find fraud.Auditor has checked all transactions.In reality, the auditor does not fulfill these unrealistic user expectations.8.3 The audit expectation gap can be reduced by:Auditing standards being reviewed and updated on a regular basis to enhance the work beingdone by auditors.Education of users as to theresponsibilities of preparers and auditors of financial statements.The performance gap can be reduced by:Auditors performing their duties appropriately and complying with auditing standards.Inspections of audits to ensure that auditing standards have been correctly applied.Assurance providers reporting accurately the level of assurance being provided.

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1CHAPTER2Professionalism and Professional ResponsibilitiesLearning Objectives1.Explain what it means to be a professional and howthese traits apply to auditors2.Explain the structure of the AICPACode of Professional Conduct.3.Applytheconceptual framework approach to ethical decision making for members in publicpractice4.Evaluate the ethical behavior needed to comply with rules of conduct on integrity and objectivity5.Evaluate the ethical behavior needed to comply with rules of conduct on independence6.Evaluate the ethical behavior needed to comply with rules of conduct on general standards7.Evaluate the ethical behavior needed to comply with other rules of conduct for members in publicpractice8.Evaluate an auditor’s legal liability under common law9.Evaluate an auditor’s legal liability under statutory lawANSWERS TO MULTIPLE-CHOICE QUESTIONS1.BLO 1, BT:C, Difficulty:Medium, TOT: 2 min., AACSB:Ethics,AICPA PC: Ethics2.DLO 2, BT: C, Difficulty: Easy, TOT: 2 min., AACSB:Ethics,AICPA PC: Ethics3.ALO3, BT: C, Difficulty:Easy, TOT: 2 min., AACSB:Ethics,AICPA PC: Ethics4.DLO4, BT: C, Difficulty: Easy, TOT: 2 min., AACSB:Ethics,AICPA PC: Ethics5.ALO5, BT:E, Difficulty:Medium, TOT: 2 min., AACSB:Ethics,AICPA PC: Ethics, Decision Making6.CLO5, BT:E, Difficulty:Medium, TOT: 2 min., AACSB:Ethics,AICPA PC: Ethics, Decision Making7.D

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2LO 5, BT:C, Difficulty:Easy, TOT: 2 min., AACSB:Ethics,AICPA PC: Ethics8.CLO 5, BT:C, Difficulty:Medium, TOT: 2 min., AACSB:Ethics,AICPA PC: Ethics9.DLO6, BT:C, Difficulty:Easy, TOT: 2 min., AACSB:Ethics,AICPA PC: Ethics10.BLO7, BT:C, Difficulty: Easy, TOT: 2 min., AACSB:Ethics,AICPA PC:Professional Behavior11.DLO8, BT:C, Difficulty: Easy, TOT: 2 min., AACSB: None,AICPA PC:Professional Behavior12.CLO 8, BT:AP, Difficulty:Medium, TOT: 2 min., AACSB: NoneAICPA PC:Professional Behavior13. BLO9, BT: C, Difficulty: Medium, TOT: 2 min., AACSB: None,AICPA PC:Professional Behavior14. ALO9, BT: C, Difficulty: Medium, TOT: 2 min., AACSB: None,AICPA PC:Professional BehaviorANSWERS TO REVIEW QUESTIONSR2.1AnAuditor’s concern for the public interestcomes from the work that practitioners perform and therecognition by practitioners of an obligation tosociety. Upon becoming licensed as a CPA,individuals also agree to accept the responsibility to follow professional standards (e.g., accountingand auditing standards), and a code of professional conduct (usually written into state rules or law). Itis also important for auditors to be independent of management when serving the public interest. Thepublicexpects auditor toprovide reasonable assurance that financial statements are free of materialmisstatement.LO 1, BT:C, Difficulty:Medium, TOT: 10min., AACSB:Ethics,AICPA PC: EthicsR2.2The question is answered in the table below:

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3ArchitecturePublic AccountingRecognized by aspecialized body ofknowledgeKnowledge of building codes andhow to build structuresAuditing or Tax knowledgeA formal educationprocessTo become a licensed architect acandidate must graduate from anaccredited architecture program (orits equivalent)To become a CPA a candidate mustcompleted150 semester hours ofeducation including requirements inaccounting and businessStandards governingadmission to theprofessionTo become a licensed architect acandidate mustcomplete aneducation requirement, pass aprofessional exam, and completean experience requirementTo become a licensed CPA acandidate must complete the state’seducation requirement, pass the CPAexam, and complete an experiencerequirementAdherence to a codeof ethicsArchitects must follow the Code ofEthics and Professional Conduct ofthe American Institute ofArchitectsCPAs must follow the Code of Ethicsof the state where they are licensed.AICPA membersmust also follow theAICPACode of ProfessionalConduct.Recognized statusindicated by alicenseState governments (through stateboards of architect examiner) granta license to practice architectureState governments (through stateboards of accountancy) grant a CPAlicense practice public accountingA public interest inthe work thatpractitionersperformThe public interest in the work ofarchitectsrelates to building safetyThe public interest in the work ofauditors relates to the public’sreliance on the opinion of auditorabout the fair presentation of financialinformation. Tax accountants have aduty to the public regardingcompliance with tax laws.Recognition bypractitioners of anobligation to societyArchitects recognizean obligationto follow building codes and attimes put the public safety aheadof the wishes of their clientsAccountants have an obligation to fairpresentation in financial statementsthat supersedes their obligation totheir clients. The same is true forcompliance with tax laws.LO 1,BT:S, Difficulty:Difficult, TOT:20 min., AACSB:Ethics,AICPA PC: EthicsR2.3The AICPA’sCode of Professional Conduct(the Code) provides guidance to all members of theAICPA with respect to performance of their responsibilities. The Code consists of principles, rules,interpretations, and other guidance for AICPA members.

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