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Solution Manual for Auditing and Assurance Services, 16th Edition

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    1 - 1 Chapter 1 The Demand for Audit and Other Assurance Services  Concept Checks P. 8 1. To do an audit, there must be information in a verifiable form and some standards ( criteria ) by which the auditor can evaluate the information. Determining the degree of correspondence between information and established criteria is determining whether a given set of information is in accordance with the established criteria. For an audit of a company’s financial statements the criteria are U.S. generally accepted accounting principles o r International Financial Reporting Standards. 2. The four primary causes of information risk are remoteness of information, biases and motives of the provider, voluminous data, and the existence of complex exchange transactions. The three main ways to reduce information risk are: 1. User verifies the information. 2. User shares the information risk with management. 3. Audited financial statements are provided. P. 17 1. The three main types of audits are operational audits, compliance audits, and financial statement audits. The table below summarizes the purposes and nature of each type of audit. OPERATIONAL AUDITS COMPLIANCE AUDITS AUDITS OF FINANCIAL STATEMENTS PURPOSE To evaluate whether operating procedures are efficient and effective To determine whether the client is following specific procedures set by a higher authority To determine whether the overall financial statements are presented in accordance with specified criteria (usually GAAP)

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    1 - 2 Concept Checks (continued) OPERATIONAL AUDITS COMPLIANCE AUDITS AUDITS OF FINANCIAL STATEMENTS USERS OF AUDIT REPORT Management of organization Authority setting down procedures, internal or external Different groups for different purposes — many outside entities NATURE Highly nonstandard; often subjective Not standardized, but specific and usually objective Highly standardized PERFORMED BY: CPAs Frequently Occasionally Almost universally GAO AUDITORS Frequently Frequently Occasionally IRS AUDITORS Never Universally Never INTERNAL AUDITORS Frequently Frequently Frequently * * Internal auditors may assist CPAs in the audit of financial statements. Internal auditors may also audit internal financial statements for use by management. 2. The major differences in the scope of audit responsibilities for CPAs, GAO auditors, IRS agents, and internal auditors are: • CPAs perform audits of financial statements prepared using U.S. GAAP or IFRS in accordance with auditing standards . • GAO auditors perform compliance or operational audits in order to assure the Congress of the expenditure of public funds in accordance with its directives and the law. • IRS agents perform compliance audits to enforce the federal tax laws as defined by Congress, interpreted by the courts, and regulated by the IRS. • Internal auditors perform compliance or operational audits in order to assure management or the board of directors that controls and policies are properly and consistently developed, applied , and evaluated.

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    1 - 3  Review Questions 1 - 1 To do an audit, there must be information in a verifiable form and some standards ( criteria ) by which the auditor can evaluate the information. The information for Jones Company's tax return is the federal tax returns filed by the company. The established criteria are found in the Internal Revenue Code and all interpretations. For the audit of Jones Company's financial statements the information is the financial statements being audited and the established criteria are U.S. GAAP or IFRS . 1 - 2 This apparent paradox arises from the distinction between the function of auditing and the function of accounting. The accounting function is the recording, classifying , and summarizing of economic events to provide relevant information to decision makers. The rules of accounting are the criteria used by the auditor for evaluating the presentation of economic events for financial statements and he or she must therefore have an understanding of accounting standards, as well as auditing standards. The accountant need not, and frequently does not, understand what auditors do, unless he or she is involved in doing audits, or has been trained as an auditor. 1 - 3 An independent audit is a means of satisfying the need for reliable information on the part of decision makers. Recent changes in accounting and business operations include: 1. Increased global activities of many businesses a. Multiple product lines and transaction locations b. Foreign exchange affects transactions 2. Complex accounting and exchange transactions a. Increasing use of derivatives and hedging activities b. Increasingly complex accounting standards in areas such as revenue recognition 3. More complex information systems a. Possibly millions of transactions processed daily through on - line and traditional sales channels b. Voluminous data requires interpretation 1 - 4 1. Risk - free interest rate This is approximately the rate the bank could earn by investing in U.S. treasury notes for the same length of time as the business loan. 2. Business risk for the customer This risk reflects the possibility that the business will not be able to repay its loan because of economic or business conditions such as a recession, poor management decisions, or unexpected competition in the industry. 3. Information risk This risk reflects the possibility that the information upon which the business risk decision was made was inaccurate. A likely cause of the information risk is the possibility of inaccurate financial statements. Auditing has no effect on either the risk - free interest rate or business risk. However, auditing can significantly reduce information risk.

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    1 - 4 1 - 5 The three main ways to reduce information risk are: 1. User verifies the information. 2. User shares the information risk with management. 3. Audited financial statements are provided. The advantages and disadvantages of each are as follows: ADVANTAGES DISADVANTAGES USER VERIFIES INFORMATION 1. User obtains information desired. 2. User can be more confident of the qualifications and activities of the person getting the information. 1. High cost of obtaining information. 2. Inconvenience to the person providing the information because large number of users would be on premises. USER SHARES INFORMATION RISK WITH MANAGEMENT 1. No audit costs incurred. 1. User may not be able to collect on losses. AUDITED FINANCIAL STATEMENTS ARE PROVIDED 1. Multiple users obtain the information. 2. Information risk can usually be reduced sufficiently to satisfy users at reasonable cost. 3. Minimal inconvenience to management by having only one auditor. 1. May not meet needs of certain users. 2. Cost may be higher than the benefits in some situations, such as for a small company. 1 - 6 Information risk is the risk that information upon which a business decision is made is inaccurate. Fair value accounting is often based on estimates and requires judgment. Fair value can be estimated using multiple methods with some estimates being more subjective than others. Fair value estimates are made at a point in time, but can also change rapidly, depending on market conditions. All of these factors increase information risk. 1 - 7 An assurance service is an independent professional service to improve the quality of information for decision makers. An attestation service is a form of assurance service in which the CPA firm issues a report about the reliability of an assertion that is the responsibility of another party. Audit services are a form of attestation service in which the auditor expresses a written conclusion about the degree of correspondence between information and established criteria.

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    1 - 5 1 - 7 (continued) The most common form of audit service is an audit of historical financial statements, in which the auditor expresses a conclusion as to whether the financial statements are presented in accordance with an applicable financial reporting framework such as U.S. GAAP or IFRS. An example of an attestation service is a report on the effectiveness of an entity’s internal control over financial reporting. There are many possible forms of assurance services, including services related to business performance measurement, health care performance, and information system reliability. 1 - 8 The primary evidence the internal revenue agent will use in the audit of the Jones Company's tax return include all available documentation and other information available in Jones’ office or from other sources. For example, when the internal revenue agent audits taxable income, a major source of information will be bank statements, the cash receipts journal and deposit slips. The internal revenue agent is likely to emphasize unrecorded receipts and revenues. For expenses, major sources of evidence are likely to be cancelled checks and electronic funds transfers , vendors' invoices , and other supporting documentation. 1 - 9 Five examples of specific operational audits that could be conducted by an internal auditor in a manufacturing company are: 1. Examine employee time records and personnel records to determine if sufficient information is available to maximize the effective use of personnel. 2. Review the processing of sales invoices to determine if it could be done more efficiently. 3. Review the acquisitions of goods, including costs, to determine if they are being purchased at the lowest possible cost considering the quality needed. 4. Review and evaluate the efficiency of the manufacturing process. 5. Review the processing of cash receipts to determine if they are deposited as quickly as possible. 1 - 10 When auditing historical financial statements, an auditor must have a thorough understanding of the client and its environment. This knowledge should include the client’s regulatory and operating environment, business strategies and processes, and measurement indicators. Th is strategic understanding is also useful in other assurance or consulting engagements. For example, an auditor who is performing an assurance service on information technology would need to understand the client’s business strategies and processes related to information technology, including such things as purchases and sales via the Internet. Similarly, a practitioner performing a consulting engagement to evaluate the efficiency and effectiveness of a client’s manufacturing process would likely start with an analysis of various measurement indicators, including ratio analysis and benchmarking against key competitors.

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    1 - 6 1 - 1 1 The four parts of the Uniform CPA Examination are: Auditing and Attestation, Financial Accounting and Reporting, Regulation, and Business Environment and Concepts.  Multiple Choice Questions From CPA Examinations 1 - 1 2 a. (3) b . (2) c . ( 1 ) 1 - 1 3 a. (2) b . (4) c . ( 2 )  Multiple Choice Questions From Becker CPA Exam Review 1 - 14 a. (4) b. (1) c. (3)  Discussion Questions And Problems 1 - 1 5 a. Audit services are a form of attestation service, and attestation services are a form of assurance service. In a diagram, audit services are located within the attestation service area, and attestation services are located within the assurance service area. b. 1. ( 2 ) An attestation service other than an audit service 2. ( 1 ) An audit of historical financial statements 3. ( 3 ) An assurance or nonassurance service that is not an attest ation service 4. (2) An attestation service other than an audit service 5. (2) An attestation service other than an audit service 6. (2) An attestation service other than an audit service 7. (2) An attestation service other than an audit service 8. (2) An attestation service other than an audit service 9. (2) An attestation service other than an audit service (Review services are a form of attestation, but are performed according to Statements on Standards for Accounting and Review Services.) 10. (2) An a ttestation service other than an audit service 11. ( 3) An assurance or nonassurance service that is not an attestation service 1 - 1 6 a. The interest rate for the loan that requires a review report is lower than the loan that did not require a review because of lower information risk. A review report provides moderate assurance to financial statement users, which lowers information risk. An audit report provides further assurance and lower information risk. As a result of reduced information risk, the interest rate is lowest for the loan with the audit report.

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    1 - 7 1 - 16 (continued) b. Given these circumstances, Busch should select the loan from First City Bank that requires an annual audit. In this situation, the additional cost of the audit is less than the reduction in interest due to lower information risk. The following is the calculation of total costs for each loan: LENDER CPA SERVICE COST OF CPA SERVICES ANNUAL INTEREST ANNUAL LOAN COST Existing loan None 0 $ 360 , 0 00 $ 360 , 0 00 United National Bank Review $ 35 ,000 $ 300 , 0 00 $ 335 , 0 00 First City Bank Audit $ 60 ,000 $ 240 , 0 00 $ 300 , 0 00 c. Busch should select the loan from United National Bank due to the higher cost of the audit and the reduced interest rate for the loan from United National Bank. The following is the calculation of total costs for each loan: LENDER CPA SERVICE COST OF CPA SERVICES ANNUAL INTEREST ANNUAL LOAN COST Existing loan None 0 $ 360 , 0 00 $ 360 , 0 00 United National Bank Review $ 35 ,000 $ 270 ,000 $ 305 ,000 First City Bank Audit $ 80 ,000 $ 240 , 0 00 $ 320 , 0 00 d . Busch may desire to have an audit because of the many other benefits that an audit provides. The audit will provide Busch’s management with assurance about annual financial information used for decision - making purposes. The audit may detect errors or fraud, and provide management with information about the effectiveness of controls. In addition, the audit may result in recommendations to management that will improve efficiency or effectiveness. e . T he auditor must have a thorough understanding of the client and its environment, including the client’s e - commerce technologies, industry, regulatory and operating environment, suppliers, customers, creditors, and business strategies and processes. This thorough analysis helps the auditor identify risks associated with the client’s strategies that may affect whether the financial statements are fairly stated. This strategic knowledge of the client’s business often helps the auditor identify ways to help the client improve business operations, thereby providing added value to the audit function.

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    1 - 8 1 - 1 7 a. The services provided by Consumers Union are very similar to assurance services provided by CPA firms. The services provided by Consumers Union and assurance services provided by CPA firms are designed to improve the quality of information for decision makers. CPAs are valued for their independence, and the reports provided by Consumers Union are valued because Consumers Union is independent of the products tested. b. The concepts of information risk for the buyer of an automobile and for the user of financial statements are essentially the same. They are both concerned with the problem of unreliable information being provided. In the case of the auditor, the user is concerned about unreliable information being provided in the financial statements. The buyer of an automobile is likely to be concerned about the manufacturer or dealer providing unreliable information. c. The four causes of information risk are essentially the same for a buyer of an automobile and a user of financial statements: (1) Remoteness of information It is difficult for a user to obtain much information about either an automobile manufacturer or the automobile itself without incurring considerable cost. The automobile buyer does have the advantage of possibly knowing other users who are satisfied or dissatisfied with a similar automobile , and the ability to perform online research of new vehicles . (2) Biases and motives of provider There is a conflict between the automobile buyer and the manufacturer. The buyer wants to buy a high quality product at minimum cost whereas the seller wants to maximize the selling price and quantity sold. (3) Voluminous data There is a large amount of available information about automobiles that users might like to have in order to evaluate an automobile. Either that information is not available or too costly to obtain. (4) Complex exchange transactions The acquisition of an automobile is expensive and certainly a complex decision because of all the components that go into making a good automobile and choosing between a large number of alternatives.

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    1 - 9 1 - 17 (continued) d. The three ways users of financial statements and buyers of automobiles reduce information risk are also similar: (1) User verifies information him or herself That can be obtained by driving different automobiles, examining the specifications of the automobiles, talking to other users and doing research in various magazines. (2) User shares information risk with management The manufacturer of a product has a responsibility to meet its warranties and to provide a reasonable product. The buyer of an automobile can return the automobile for correction of defects. In some cases a refund may be obtained. (3) Examine the information prepared by Consumer Reports This is similar to an audit in the sense that independent information is provided by an independent party. The information provided by Consumer Reports is comparable to that provided by a CPA firm in an audit of financial statements. 1 - 1 8 a. The following parts of the definition of auditing are related to the narrative: (1) Altman is being asked to issue a report about qualitative and quantitative information for trucks. The trucks are therefore the information with which the auditor is concerned. (2) There are four established criteria which must be evaluated and reported by Altman : existence of the trucks on the night of June 30, 20 1 6 , ownership of each truck by Regional Delivery Service, physical condition of each truck and fair market value of each truck. (3) Samantha Altman will accumulate and evaluate four types of evidence : (a) Count the trucks to determine their existence. (b) Use registration documents held by Burrow for comparison to the serial number on each truck to determine ownership. (c) Examine the trucks to determine each truck's physical condition. (d) Examine the blue book to determine the fair market value of each truck. (4) Samantha Altman , CPA, appears qualified, as a competent, independent person . She is a CPA, and she spends most of her time auditing used automobile and truck dealerships and has extensive specialized knowledge about used trucks that is consistent with the nature of the engagement.

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    1 - 10 1 - 18 (continued) (5) The report results are to include: (a) which of the 25 trucks are parked in Regional's parking lot the night of June 30. (b) whether all of the trucks are owned by Regional Delivery Service. (c) the condition of each truck, using established guidelines. (d) fair market value of each truck using the current blue book for trucks. b. The only parts of the audit that will be difficult for Altman are: (1) Evaluating the condition, using the guidelines of poor, good, and excellent. It is highly subjective to do so. If she uses a different criterion than the "blue book," the fair market value will not be meaningful. Her experience will be essential in using this guideline. (2) Determining the fair market value, unless it is clearly defined in the blue book for each condition. 1 - 19 a. The major advantages and disadvantages of a career as an IRS agent, CPA, GAO auditor, or an internal auditor are: EMPLOYMENT ADVANTAGES DISADVANTAGES INTERNAL REVENUE AGENT 1. Extensive training in individual, corporate, gift, trust and other taxes is available with concentration in area chosen. 2. Hands - on experience with sophisticated selection techniques. 1. Experience limited to taxes. 2. No experience with operational or financial statement auditing. 3. Training is not extensive with any business enterprise. CPA 1. Extensive training in audit of financial statements, compliance auditing and operational auditing. 2. Opportunity for experience in auditing, tax consulting, and management consulting practices. 3. Experience in a diversity of enterprises and industries with the opportunity to specialize in a specific industry. 1. Exposure to taxes and to the business enterprise may not be as in - depth as the internal revenue agent or the internal auditor. 2. Likely to be less exposed to operational auditing than is likely for internal auditors.

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    1 - 11 1 - 19 (continued) EMPLOYMENT ADVANTAGES DISADVANTAGES INTERNAL AUDITOR 1. Extensive exposure to all segments of the enterprise with which employed. 2. Constant exposure to one industry presenting opportunity for expertise in that industry. 3. Likely to have exposure to compliance, financial , and operational auditing. 1. Little exposure to taxation and the audit of taxes. 2. Experience is limited to one enterprise, usually within one or a limited number of industries. GAO AUDITOR 1. Increasing opportunity for experience in operational auditing. 2. Exposure to highly sophisticated statistical sampling and computer auditing techniques. 1. Little exposure to diversity of enterprises and industries. 2. Bureaucracy of federal government. b. The two best choices for the senior interested in becoming a certified fraud examiner would be starting out as either a CPA or an internal auditor. A CPA gains experience with internal controls and has an understanding of incentives and opportunities to commit fraud. An internal auditor gains experience with internal controls and has an in - depth understanding of operations and the many facets of a business. IRS agents and GAO auditors would be in demand for fraud examinations relating specifically to tax fraud or governmental entities . c. Other auditing careers that are available are:  Auditors within many of the branches of the federal government (e.g., Department of Homeland Security )  Auditors for many state and local government units (e.g., state insurance or bank auditors)

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    1 - 12 1 - 2 0 The most likely type of auditor and the type of audit for each of the examples are: EXAMPLE a. TYPE OF AUDITOR b. TYPE OF AUDIT 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. IRS IRS Internal auditor or CPA CPA Internal auditor or CPA Internal auditor or CPA Internal auditor or CPA CPA or internal auditor GAO CPA GAO GAO Compliance Compliance Financial statements or operational Financial statements Compliance Compliance Operational Financial statements Operational Financial statements Financial statements Compliance 1 - 2 1 a. Financial statement audits reduce information risk, which lowers borrowing costs. An audit also provides assurances to management about information used for decision - making purposes, and may also provide recommendations to improve efficiency or effectiveness of operations. b. Czarnecki and Hogan likely provide tax services, accounting services, and management advisory services. They may also provide additional assurance and attestation services other than audits of financial statements. c. Student answers will vary. They may identify new types of information that require assurance, such as environmental or corpora te responsibility reporting. Students may also identify opportunities for consulting or management advisory services, such as assistance with the adoption of I nternational F inancial R eporting S tandards. 1 - 2 2 a. Assurance related to financial statements are the most likely forms of assurance that are likely to be provided only by public accounting firms. Examples include audits of historical financial statements, reviews of historical financial statements, audits of internal control over financial reporting, and compliance auditing such as that required by the Single Audit Act and OMB Circular A - 133 (although these audits may also be provided by government auditors).

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    1 - 13 1 - 22 (continued) b. There are many types of information that are assured by providers other than public accounting firms. Some of these assurance s are provided by government entities, such as food inspections, elevator inspections, and pumps at gasoline stations. Other assurance s are provided by nonprofit and for - profit assurance providers, such as ISO 9000 certifications. c. Table 1 - 1 on p. 11 includes some examples of assurance that may be provided by public accounting firms or other assurance providers. For example, assurance on corporate responsibility and sustainability may be provided by public accounting firms or other assurance provide r s . Other examples included assurance on Web site controls, and information such as Web site traffic or newspaper circulation. 1 - 23 a. The vision of the Global Reporting Initiative (GRI) is a sustainable global economy where organizations manage their economic, environmental, social and governance performance and impacts responsibly, and report transparently. Its mission is to make sustainability reporting standard practice by providing guidance and support to organizations. b. According to the GRI “A sustainability report is a report published by a company or organization about the economic, environmental , and social impacts caused by its everyday activities. A sustainability report also presents the organization's values and governance model, and demonstrates the link between its strategy and its commitment to a sustainable global economy .” In an integrated report, sustainability information is included along with financial information. These reports emphasize the links between financial and non - financial performance. An integrated report also presents the risks and opportunities the company faces, integrated with disclosure of environmental, social, and governance issues. c. GRI offers two “in accordance” reporting options, Core and Comprehensive. The Core report provides the essential element s of a sustainability report. The Comprehensive report includes additional d isclosures of the organization’s strategy and analysis, governance, and ethics and integrity. The GRI recommends external assurance, but it is not required for either type of “in accordance” report.

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    1 - 14 1 - 24 a. Answers will vary by state. Most states require 150 hours of education, with specific requirements for number of accounting hours and credit hours in other subject areas. b. Answers will vary by state. Many states require one or two years of work experience gained in public practice, or possibly government, academia or industry, depending on the state. In many states, experience in industry or internal audit is sufficient , depending on the type of work performed . c . Most states have frequently addressed questions. Many of these address education requirements, as well as information on how to prepare for the exam, as well as information on applying for licensure. d . The Elijah Watt Sells award program was established in 1923 by the American Institute of Certified Public Accountants (AICPA) to recognize outstanding performance on the Uniform CPA Examination. The award i s presented to candidates who obtained a cumulative average score above 95.50 across all four sections of the Uniform CPA Examination, completed testing during the previous calendar year, and passed all four sections of the Examination on their first attempt. e . Passing information is available on the CPA Examination portion of the AICPA web site. Recent passing rates have ranged from approximately 4 4 % to 5 9 % across the four sections .

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    2 - 1 Chapter 2 The CPA Profession  Concept Checks P. 28 1. The four major services that CPAs provide are: a. Audit and assurance services Assurance services are independent professional services that improve the quality of information for decision makers. Assurance services include attestation services, which are any services in which the CPA firm issues a report that expresses a conclusion about the reliability of an assertion that is the responsibility of another party. The four categories of attestation services are audits of historical financial statements, attestation on the effectiveness of internal control over financial reporting, reviews of historical financial statements, and other attestation services. b. Accounting and bookkeeping services Accounting services involve preparing the client ’ s financial statements from the client ’ s records. Bookkeeping services include the preparation of the client ’ s journals and ledgers as well as financial statements. c. Tax services Tax services include preparation of corporate, individual, and estate returns as well as tax - planning assistance. d. Management consulting and risk advisory services These services range from suggestions to improve the client ’ s accounting system to advice on risk management or on computer installations. 2. The six organizational structures available to CPA firms are proprietorship, general partnership, general corporation, professional corporation, limited liability company , and limited liability partnership. CPA firms are typically not organized as a general partnership because a general partnership offers less protection from legal liability relative to other structures such as a limited liability partnership. P. 38 1. The Public Company Accounting Oversight Board provides oversight for auditors of public companies, including establishing auditing and quality control standards for public company audits, and performing inspections of the quality controls at audit firms performing those audits.

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    2 - 2 Concept Checks (continued) 2. The AICPA is the organization that sets professional requirements for CPAs. The AICPA also conducts research and publishes materials on many different subjects related to accounting, auditing, management consulting and advisory services, and taxes. The organization also prepares and grades the CPA examinations, provides continuing education to its members, and develops specialty designations to help market and assure the quality of services in specialized practice areas. 3. International Standards on Auditing (ISAs) are issued by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) and are designed to improve the uniformity of auditing practices and related services throughout the world. AICPA Statements on Auditing Standards (SASs) are established by the Auditing Standards Board of the AICPA, and are applicable to private entities within the United States. As a result of efforts by the Auditing Standards Board of the AICPA to converge U.S. standards with international standards, AICPA auditing standards and International Standards on Auditing are similar in most respects. PCAOB Auditing Standards apply only to U.S. publicly traded companies and other SEC registrants, including broker - dealers. However, given that the PCAOB initially adopted existing standards established by the Auditing Standards Board as interim auditing standards, standards for audits of U.S. public and private companies are mostly similar.  Review Questions 2 - 1 The major characteristics of CPA firms that permit them to fulfill their social function competently and independently are: 1. Organizational form A CPA firm exists as a separate entity to avoid an employer - employee relationship with its clients. The CPA firm employs a professional staff of sufficient size to prevent one client from constituting a significant portion of total income and thereby endangering the firm ’ s independence. 2. Conduct A CPA firm employs a professional staff of sufficient size to provide a broad range of expertise, continuing education, and promotion of a professional independent attitude and competence. 3. Peer review This practice evaluates the performance of CPA firms in an attempt to keep competence high. 2 - 2 The Public Company Accounting Oversight Board (PCAOB) was established by the Sarbanes - Oxley Act of 2002 in the wake of multiple accounting scandals and alleged audit failures, including those of Enron and WorldCom. The PCAOB provides oversight for auditors of public companies, including establishing auditing and quality control standards for public company audits, and performing inspections of the quality controls at audit firms performing those audits.

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    2 - 3 2 - 3 The purpose of the Securities and Exchange Commission is to assist in providing investors with reliable information upon which to make investment decisions. Since most reasonably large CPA firms have clients that must file reports with the SEC each year (all companies filing registration statements under the securities acts of 1933 and 1 934 must file audited financial statements and other reports with the SEC at least once each year), the profession is highly involved with the SEC requirements. The SEC has considerable influence in setting generally accepted accounting principles and disclosure requirements for financial statements because of its authority for specifying reporting requirements considered necessary for fair disclosure to investors. In addition, the SEC has power to establish rules for any CPA associated with audited financial statements submitted to the Commission. 2 - 4 Statements on Standards for Attestation Engagements provide a framework for attest engagements, including detailed standards for specific types of attestation engagements. 2 - 5 The PCAOB has responsibility for establishing auditing standards for U.S. public companies, while the Auditing Standards Board ( ASB ) of the AICPA establishes auditing standards for U.S. private companies. Prior to the creation of the PCAOB, t he ASB had responsibility for establishing auditing standards for both public and private companies. Because e xisting auditing standards were adopted by the PCAOB as interim auditing standards for public company audits , there is considerable overlap in the two sets of auditing standards . 2 - 6 International Standards on Auditing (ISAs) are issued by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) and are designed to improve the uniformity of auditing practices and related services throughout the world. The IAASB issues pronouncements on a variety of audit and attest functions and promotes their acceptance worldwide. As a result of efforts by the Auditing Standards Board to converge U.S. GAAS with international standards, AICPA auditing standards and International Standards on Auditing are similar in most respects. 2 - 7 A uditing standards represent the combination of the four principles and all the Statements on Auditing Standards (SASs) that are codified in the AU - C sections. The principles outlined in Figure 2 - 2 provide a framework for the auditing standards. Examples of auditing standards include any of the SASs (e.g., SAS No. 125) , covering topics such as audit planning or assessing the risk of material misstatement . Generally accepted accounting principles are specific rules for accounting for transactions occurring in a business enterprise. Examples may be any of the opinions of the FASB , such as accounting for leases, pensions, or fair value assets .

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    2 - 4 2 - 8 Auditors develop their competency and capabilities for performing an audit through formal education in auditing and accounting, adequate practical experience, and continuing professional education. Auditors can demonstrate their proficiency by becoming licensed to practice as CPAs, which requires successful completion of the Uniform CPA Examination. The specific requirements for licensure vary from state to state. 2 - 9 For the most part, auditing standards, including SASs, are general rather than specific. Many practitioners along with critics of the profession believe the standards should provide more clearly defined guidelines as an aid in determining the extent of evidence to be accumulated. This would eliminate some of the difficult audit decisions and provide a source of defense if the CPA is charged with conducting an inadequate audit. On the other hand, highly specific requirements could turn auditing into mechanical evidence gathering, void of professional judgment. From the point of view of both the profession and the users of auditing services, there is probably a greater harm from defining authoritative guidelines too specifically than too broadly. 2 - 1 0 Quality controls are the procedures used by a CPA firm that help it meet its professional responsibilities to clients. Quality controls are therefore established for the entire CPA firm as opposed to individual engagements. 2 - 1 1 The element of quality control is personnel management. The purpose of the requirement is to help assure CPA firms that all new personnel are qualified to perform their work competently. A CPA firm must have competent employees conducting the audits if quality audits are to occur. 2 - 1 2 A peer review is a review, by CPAs, of a CPA firm ’ s compliance with its quality control system. A mandatory peer review means that such a review is required periodically. AICPA member firms are required to have a peer review every three years. Registered firms with the PCAOB are subject to quality inspections. These are different than peer review s because they are performed by independent inspection teams rather than another CPA firm. Peer reviews can be beneficial to the profession and to individual firms. By helping firms meet quality control standards, the profession gains if reviews result in practitioners doing higher quality audits. A firm having a peer review can also gain if it improves the firm ’ s practices and thereby enhances its reputation and effectiveness, and reduces the likelihood of lawsuits. Of course , peer reviews are costly. There is always a trade - off between cost and benefits.  Multiple Choice Questions From CPA Examinations 2 - 1 3 a. (2) b. ( 3 ) c. (3) 2 - 1 4 a . ( 1 ) b . ( 2 ) c . ( 1 )  Multiple Choice Questions From Becker CPA Exam Review 2 - 1 5 a . ( 1 ) b . ( 4 ) c . (3)

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    2 - 5  Discussion Questions And Problems 2 - 1 6 a. The main objective of an audit of financial statements is 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 in a written report on whether the financial statements are presented fairly, in all material respects, in accordance with an applicable financial reporting framework. b. No. In an audit of the financial statements , the auditor performs audit procedures to obtain reasonable assurance about whether the financial statements contain material misstatements. While a high level of assurance, reasonable assurance is less than a guarantee ― which implies absolute (100%) assurance. In an audit, the auditor issues an opinion on whether the financial statements are presented fairly, but the auditor is not guaranteeing that the financial statements are accurate with certainty. c. No. Fraud is a broad legal concept that describes any intentional deceit meant to deprive another person or party of their property or rights. The auditor does not take responsibility for detecting all types of fraud, given many types of fraud do not impact the financial statements. Instead, t he auditor performs auditing procedures to obtain reasonable assurance that the financial statements do not contain material misstatements, whether due to fraud or error. Thus, the auditor is concerned with detecting fraud that leads to a material misstatement. T he auditor is not responsible for detecting fraud that does not lead to a material misstatement. d. Each entity faces a number of risks unique to the nature of its business and industry. The types of operations, the extent of regulation, how the organization obtains capital to fund its business model, and the nature of accounts in the financial statements , among other factors, each trigger different types of risks that could lead to material misstatement s. In a ddition, there are unique accounting standards for certain industries that impact how transactions, accounts, and disclosures are reported in financial statements. Thus, a thorough understanding of the client ’ s business e. is critical to assessing the risk of material misstatements in the financial statements when planning the audit. The auditor is responsible for obtaining sufficient appropriate audit evidence about whether the financial statements are free of material misstatements. In addition to understanding whether the amounts reported in the financial statements are mathematically accurate, the auditor obtains other types of information to determine that the amounts reported represent valid transactions and accounts and that all valid transactions and accounts are included in those statements. Evidence is also gathered to determine that the entity has the rights to assets and has the obligation to repay liabilities

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    2 - 6 2 - 1 6 (continued) reflected in those financial statements and whether the correct disclosures are included in the financial statements as required by accounting standards. 2 - 1 7 a. Engagement performance b. Leadership responsibilities c . Monitoring d . Engagement performance e . Engagement performance f . Relevant ethical requirement g . Human resources h . Human resources i . Acceptance and continuation of clients and engagements j . Engagement performance 2 - 18 a. The AICPA Auditing Standards Board (ASB) is responsible for issuing standards in the U.S. to be used by auditors when auditing the financial statements of all entities other than U.S. publicly traded companies. The Public Company Accounting Oversight Board (PCAOB) is responsible for issuing standards to be used by auditors when auditing a U.S. public company or other entities registered with the SEC (e.g. , broker - dealers) . b. The International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC) is responsible for issuing International Standards on Auditing (ISAs). The ISAs do not override a specific country ’ s regulations governing the audit of financial statements. c. The ASB has revised most of its standards to converge them with the international standards. As a result, U.S. standards are mostly consistent with international standards, except for certain requirements that reflect unique characteristics of the U.S. environment. d. When developing a new SAS, the ASB uses the ISAs as the base standard and then modifies that base standard only when appropriate for the U. S . environment. e. The PCAOB develops and issues its standards. While the PCAOB considers existing international standards, it does not start with the ISA standard as the base. f. When conducting an audit of a client that is listed on both a foreign stock exchange and a U.S. stock exchange, the auditor would have to satisfy both the relevant international auditing standards as well as the PCAOB auditing standards. This does not mean the auditor conducts two separate audits, but rather their procedures must satisfy both sets of standards , which will be similar in many ways but may also require the auditor to perform additional procedures required by one, but not the other, set of standards.

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    2 - 7 2 - 19 a. AICPA auditing standards. b. International auditing standards. c. PCAOB auditing standards. d. PCAOB auditing standards (reporting in the U.K. will be under international auditing standards). e. AICPA auditing standards. f. AICPA auditing standards. g. PCAOB auditing standards. h. International auditing standards. 2 - 2 0 BRIEF DESCRIPTION OF PRINCIPLE HOLMES ’ ACTIONS RESULTING IN FAILURE TO COMPLY WITH PRINCIPLE RESPONSIBILITIES PRINCIPLES The audit or must possess the competency and capabilities to perform the audit. It was inappropriate for Holmes to hire the two students to conduct the audit. The audit must be conducted by persons with proper education and experience in the field of auditing. Although a junior assistant has not completed his formal education, he may help in the conduct of the audit as long as there is proper supervision and review. The auditor must comply with ethical requirements , which include maintaining i ndependence in mental attitude in all matters relating to the audit. To satisfy this principle , Holmes must be without bias with respect to the client under audit. Holmes has an obligation for fairness to the owners, management, and creditors who may rely on the report. Because of the financial interest in whether the bank loan is granted to Ray, Holmes is independent in neither fact nor appearance with respect to the assignment undertaken. The auditor must maintain professional skepticism and exercise professional judgment in the performance of the audit and the preparation of the report. This principle requires Holmes to perform the audit with due care, which imposes on Holmes and everyone in Holmes’ organization a responsibility to observe the principles of performance and reporting. Maintaining professional skepticism and exercising professional judgment require critical review at every level of supervision of the work done and the judgments exercised by those assisting in the audit. Holmes did not review the work or the judgments of the assistants and clearly failed to adhere to this sta ndard.

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    2 - 8 2 - 20 (continued) BRIEF DESCRIPTION OF PRINCIPLE HOLMES’ ACTIONS RESULTING IN FAILURE TO COMPLY WITH PRINCIPLE PERFORMANCE PRINCIPLES The auditor must adequately plan the work and must properly supervise any assistants. This principle recognizes that early appoint ment of the auditor has advantages for the auditor and the client. Holmes accepted the engagement without considering the availability of competent staff. In addition, Holmes failed to supervise the assistants. The work performed was not adequately planned. The auditor must identify and assess the risks of material misstatement based on a sufficient understanding of the entity and its environment, including its internal control, to design the nature, timing, and extent of further audit procedures. Holmes did not obtain an understanding of the entity or its internal control, nor did the assistants obtain such an understanding. There appears to have been no audit at all. The work performed was more an accounting service than it was an auditing service. The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit. Holmes acquired no evidence that would support the financial statements. Holmes merely checked the mathematical accuracy of the records and summarized the accounts. Standard audit procedures and techniques were not performed.

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    2 - 9 2 - 2 0 (continued) BRIEF DESCRIPTION OF PRINCIPLE HOLMES ’ ACTIONS RESULTING IN FAILURE TO COMPLY WITH PRINCIPLE REPORTING PRINCIPLES The auditor must express an opinion in a written report about whether the financial statements are presented in accordance with the applicable financial reporting framework . The auditor must either express an opinion regarding the financial statements, taken as a whole, or state that an opinion cannot be expressed in the auditor ’ s report. When the auditor cannot express an overall opinion, the auditor should state the reasons therefor in the auditor ’ s report. In all cases where an auditor ’ s name is associated with financial statements, the auditor should clearly indicate the character of the auditor ’ s work, if any, and the degree of responsibility the auditor is taking, in the auditor ’ s report. Holmes ’ report made no reference to generally accepted accounting principles. Because Holmes did not conduct a proper audit, the report should state that no opinion can be expressed as to the fair presentation of the financial statements in accordance with generally accepted accounting principles. Although Holmes ’ report contains an expression of opinion, such opinion is not based on the results of a proper audit. Holmes should disclaim an opinion because he failed to conduct an audit in accordance with auditing standards. The auditor must assess whether the financial statements are presented in accordance with the financial reporting framework. Holmes ’ improper audit would not enable him to determine whether generally accepted accounting principles were consistently applied. Holmes ’ report should make no reference to the consistent application of accounting principles. Management is primarily responsible for adequate disclosures in the financial statements, but when the statements do not contain adequate disclosures the auditor should make such disclosures in the auditor ’ s report. In this case both the statements and the auditor ’ s report lack adequate disclosures.

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    2 - 10 2 - 2 1 a. The objective of the IAASB is to serve the public interest by setting high - quality auditing and assurance standards and by facilitating the convergence of international and national standards, thereby enhancing the quality and uniformity of practice throughout the world and strengthening public confidence in the global auditing and assurance profession. International Standards on Auditing (ISA) are used by auditors in countries that have adopted ISAs as their auditing standards b. The IAASB follows a du e process in setting standards.  The standards - setting Public Interest Activity Committees (PIAC) identify new projects based on review of international developments and consultation with the Public Interest Oversight Board. PIAC meetings are open to the public and written materials are prepared in English .  The PIAC is responsible for consulting with the PIAC Consultative Advisory Group (CAG) on the identi fi cation and prioritization of projects to be undertaken by the PIAC.  The project may be assigned to a task force, which considers whether to hold a public forum or roundtable.  When the Project Task Force is satisf ied that it has a proposed draft pronouncement that is ready for exposure, it pre sents the draft to the PIAC for approval. The PIAC votes on the approval of the exposure draft.  Draft pronouncements are exposed for a minimum of 90 days.  The task force considers all comments and whether re - exposure is needed.  When the Project Task Force is satisfied that it has a proposed final pronouncement ready for approval, it presents the revised content of the exposed standard to the PIAC for approval.  The PIAC votes on the approval or withdrawal of the pronouncement. c. The IAASB is committed to transparency. Where practicable, meetings are broadcast over the Internet or recorded. Meeting agendas and minutes are published on the International Federation of Accountants (IFAC) W eb site. All exposure drafts are subject to public exposure for a minimum of 90 days. Meetings of the PIAC are open to the public.

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    3 - 1 Chapter 3 Audit Reports  Concept Checks P. 57 1. The standard unmodified opinion audit report for a nonpublic entity contains the following eight parts: 1. Report title : Auditing standards require that the report be titled and that the title includes the word independent . 2. Audit report address : The report is usually addressed to the company, its stockholders, or the board of directors. 3. Introductory paragraph : The introductory paragraph of the report makes the simple statement that the CPA firm has done an audit . Second, it lists the financial statements that were audited, including the balance sheet dates and the accounting periods for the income statement and statement of cash flows. 4. Management’s responsibility : This paragraph indicates that the financial statements are the responsibility of management, including selecting appropriate accounting principles and maintaining internal control over financial reporting. The paragraph must be preceded by the heading “Management’s Responsibility for the Financial Statements”. 5. Auditor’s responsibility : The auditor’s responsibility section of the report includes three paragraphs and it must include the heading “Auditor’s Responsibility” . The first paragraph indicates that the auditor’s responsibility is to express an opinion on the statements based on an audit conducted in accordance with auditing standards, and that the audit provides reasonable assurance that the financial statement s are free of material misstatement. The second paragraph is the scope paragraph and is a factual statement about what the auditor did in the audit. The paragraph briefly describes important aspects of an audit, including that the procedures depend on the auditor’s judgment and assessment of the risks of material misstatements. The scope paragraph also indicates that the auditor considers the entity’s internal control, but not for the purposes of expressing an opinion on the effectiveness of internal control over financial reporting. The last sentence of the paragraph indicates that the audit includes evaluating the appropriateness of accounting policies selected, the reasonable - ness of accounting estimates, and the overall financial statement presentation.

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    3 - 2 Concept Check, P. 57 (continued) The third paragraph indicates that the auditor believes the audit evidence is sufficient and appropriate to provide a basis for the audit opinion. 6. Opinion paragraph : The final paragraph in the standard report states the auditor’s conclusions based on the results of the audit. The paragraph must include the title “Opinion”. 7. Signature and Address of CPA firm : The name identifies the CPA firm or practitioner who performed the audit, and the city and state where the auditor is located. 8. Audit report date : The appropriate date for the report is the one on which the auditor completed the auditing procedures needed to obtain sufficient appropriate evidence to support the opinion. 2. The auditor should include an explanatory paragraph in an unmodified opinion audit report when the audit is completed with satisfactory results and the financial statements are fairly presented, but the auditor believes it is important to draw the reader’s attention to certain matters or the auditor is required to provide additional information. The following are the most important causes of the addition of an emphasis of matter explanatory paragraph or a modification in the wording of the standard unmodified opinion audit report: • Lack of consistent application of generally accepted accounting principles • Substantial doubt about going concern • Auditor agrees with a departure from promulgated accounting principles • Emphasis of other matters • Reports involving other auditors P. 69 1. The three conditions requiring a departure from an un modified opinion are: 1. The scope of the audit has been restricted . One example is when the client will not permit the auditor to confirm material receivables. Another example is when the engagement is not agreed upon until after the client’s year - end when it may be impossible to physically observe inventories. 2. The financial statements have not been prepared in accordance with generally accepted accounting principles . An example is when the client insists upon using replacement costs for fixed assets. 3. The auditor is not independent . An example is when the auditor owns stock in the client’s business.

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    3 - 3 Concept Check, P. 69 (continued) 2. The three alternative opinions that may be appropriate when the client’s financial statements are not in accordance with GAAP are an unmodified opinion, qualified as to opinion only, and adverse opinion. Determining which is appropriate depends entirely upon materiality. An unmodified opinion is appropriate if the GAAP departure is immaterial (standard unmodified) or if the auditor agrees with the client’s departure from GAAP (unmodified with explanatory paragraph). A qualified opinion is appropriate when the deviation from GAAP is material but not highly material; the adverse opinion is appropriate when the deviation is highly material.  Review Questions 3 - 1 Auditor s ’ reports are important to users of financial statements because they inform users of the auditor ’ s opinion as to whether or not the financial statements are fairly stated or whether no conclusion can be made with regard to the fairness of their presentation. Users especially look for any deviation from the wording of the standard un modified report and the reasons and implications of such deviations. Having standard wording improves communications for the benefit of users of the auditor ’ s report. When there are departures from the standard wording, users are more likely to recognize and consider situations requiring a modification or qualification to the auditor ’ s report or opinion. 3 - 2 The purpose of the scope paragraph under the auditor ’ s responsibility is to inform the financial statement users of the nature of the audit procedures performed. The information in the scope paragraph includes: 1. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. 2. The audit procedures selected depend on the auditor ’ s judgment, and consider the auditor ’ s assessment o f the risks of material misstatement, whether due to fraud or error . 3. As part of this risk assessment, t he auditor considers internal control over financial reporting in the design of the audit procedures. The assessment is not for the purpose of expressing an opinion on internal control over financial reporting, and the auditor do es not express such an opinion. 4. An audit includes evaluating the appropriateness of the accounting policies used, the reasonableness of significant estimates, and the overall presentati on of the financial statements. 3 - 3 The purpose of the opinion paragraph is to state the auditor ’ s conclusions based upon the results of the audit evidence. The most important information in the opinion paragraph includes:

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    3 - 4 3 - 3 (continued) 1. The words “ in our opinion , ” which indicate that the conclusions are based on professional judgment. 2. A statement about whether the financial statements were presented fairly and in accordance with generally accepted accounting principles along with indication of the fiscal year(s) associated with those statements . 3 - 4 The auditor ’ s report should be dated February 17, 201 7 , the date on which the auditor concluded that he or she had sufficient appropriate evidence to support the auditor ’ s opinion . 3 - 5 A standard un modified opinion audit report may be issued under the following circumstances: 1. All statements — balance sheet, income statement, statement of retained earnings, and statement of cash flows — are included in the financial statements. 2. Sufficient appropriate evidence has been accumulated and the auditor has conducted the engagement in a manner that enables him or her to conclude that the audit was performed in accordance with auditing standards . 3. The financial statements are presented in accordance with appropriate accounting standards such as U.S. generally accepted accounting principles or IFRS . This also means that adequate disclosures have been included in the footnotes and other parts of the financial statements. 4. There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of the report. 3 - 6 The introductory, scope , and opinion paragraphs are modified to include reference to management ’ s report on internal control over financial reporting, and the scope of the auditor ’ s work and opinion on internal control over financial reporting. The introductory and opinion paragraphs also refer to the framework used to evaluate internal control. Two additional paragraphs are added between the scope and opinion paragraphs that define internal control and describe the inherent limitations of internal control. 3 - 7 T he standard un modified opinion audit report for a non - public entity under AICPA auditing standards and the standard unqualified report for a public company under PCAOB auditing standards are very similar in substance. The introductory paragraphs are similar, although the public company report includes the responsibilit ies of management and the auditor. In contrast, the report for the non - public entity in Figure 3 - 1 has separate paragraphs for management ’ s and the auditor ’ s responsibility. These paragraphs provide additional information on the nature of these responsibilities.

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    3 - 5 3 - 7 (continued) The scope paragraphs in each report are similar. However, there are differences in the description of the nature of the auditor ’ s testing. The report for the non - public company indicates that the procedures are based on the auditor ’ s judgment and consider the risks of material misstatement. The report for the non - public company also indicates that the auditor considers internal control in designing the audit procedures, and not for the purpose of expressing an opinion on intern al control. 3 - 8 An un modified opinion audit report with an explanatory paragraph or modified wording is the same as a standard un modified opinion report except that the auditor believes it is necessary to provide additional information about the audit or the financial statements. For a qualified report, either there is a scope limitation (condition 1) or a failure to follow generally accepted accounting principles (condition 2). Under either condition, the auditor concludes that the overall financial statements are fairly presented. Two examples of an un modified opinion audit report with an explanatory paragraph or modified wording are: 1. The entity changed from one generally accepted accounting principle to another generally accepted accounting principle. 2. A shared report involving the use of other auditors. 3 - 9 When another CPA has performed part of the audit, the primary auditor issues one of the following types of reports based on the circumstances. 1. No reference is made to the other auditor. This will occur if the other auditor audited an immaterial portion of the financial statement s , the other auditor is known or closely supervised, or if the principal auditor has thoroughly reviewed the other auditor ’ s work. 2. Issue a shared opinion in which reference is made to the other auditor. This type of report is issued when it is impractical to review the work of the other auditor or when a portion of the financial statements audited by the other CPA is material in relation to the total. 3. The report may be qualified if the principal auditor is not willing to assume any responsibility for the work of the other auditor. A disclaimer may be issued if the segment audited by the other CPA is highly material. 3 - 1 0 Even though th is change has been reflected in the financial statements , a separate explanatory paragraph is required to explain the change in generally accepted accounting principles in the first year in which the change took place. 3 - 1 1 Changes that affect the consistency of the financial statements may involve any of the following:

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    3 - 6 3 - 1 1 (continued) a. Change in accounting principle b. Change in reporting entity c. Corrections of errors involving accounting principles. An example of a change that affects consistency would be a change in the method of computing depreciation from straight line to an accelerated method. A separate explanatory paragraph is required if the amounts are material. Comparability refers to items such as changes in estimates, presentation, and events rather than changes in accounting principles. For example, a change in the estimated life of a depreciable asset will affect the comparability of the statements. In that case, no explanatory paragraph for lack of consistency is needed because the same method of depreciation is used in both years , but the information may require disclosure in the statements. 3 - 1 2 When the audit report contains a qualified opinion, the eight elements of the standard audit report are as follows: 1. Report title : Same as standard unmodified opinion report . 2. Audit report address : Same as standard unmodified opinion report . 3. Introductory paragraph : Same as standard unmodified opinion report . 4. Management’s responsibility : Same as standard unmodified opinion report. 5. Auditor’s responsibility : The first two auditor responsibility paragraphs are the same as the standard unmodified opinion report . The third paragraph is modified to state that the audit evidence obtained provides a sufficient and appropriate basis for the qualified audit opinion. That paragraph is following by a new paragraph that describes the basis for the qualified opinion. 6. Opinion paragraph : The opinion paragraph is modified to include the term except for in the opinion paragraph. 7. Signature and Address of CPA firm : Same as standard unmodified opinion report . 8. Audit report date : Same as standard unmodified opinion report. 3 - 1 3 A qualified opinion states that there has been either a limitation on the scope of the audit of material accounts, transactions, or disclosures or a material departure from GAAP in the financial statements, but that the auditor believes that the overall financial statements are fairly presented. This type of opinion may not be used if the auditor believes the exceptions being reported upon are extremely material, in which case a disclaimer or adverse opinion would be used. An adverse opinion states that the auditor believes the overall financial statements are so materially misstated or misleading that they do not present fairly in accordance with GAAP the financial position, results of operations, or cash flows.

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