Auditing Theory Answer Key 1

CHAPTER 1 PROFESSIONAL PRACTICE OF ACCOUNTANCY Questions 1.

Generally, to be a CPA one must meet certain education requirements, and pass the CPA exam. The CPA examination is prepared and graded twice each year. It is generally recognized as an academic examination. It includes multiple-choice questions in the following subjects namely, Theory of Accounts, Practical Accounting I, Practical Accounting II, Auditing Theory, Auditing Problems, Management Services, Business Law and Taxation.

2.

Refer to page 11 of the textbook.

3.

Refer to page 110 (Section 28 of the Philippine Accountancy Act of 2004) of the textbook.

4.

Competencies include both what individual auditors know and what individual auditors and audit teams do. Competencies are evidenced by auditors applying their skills in the delivery of services to clients or supporting the delivery of those services. These competencies categorized as “High Opportunity Competencies” and “Low Opportunity Competencies” are as follows: High Opportunity Competencies have a high likelihood of being building blocks for selling or delivering new assurance services. •

Analytical Skills

•

Business Advisory Skills

•

Business Knowledge

•

Capacity for Work

•

Comprehension of Client’s Business Processes

•

Communication Skills

•

Efficiency

•

Intellectual Capability

•

Learning and Rejuvenation

•

Marketing and Selling

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•

Model Building

•

People Development

•

Relationship Management

•

Responsiveness and Timeliness

•

Technology

•

Verification

Low Opportunity Competencies, while important to the delivery of current assurance services, are less likely to be exploited in the development of future services. •

Accounting and Auditing Standards

•

Administrative Capability

•

Managing Audit Risk

5.

Refer to page 4 of the textbook.

6.

The Philippine Accountancy Act of 2004 (R.A. 9298) Article I, Section 4, paragraphs (a) to (d) spell out the scope of the practice of accountancy as follows: •

Practice of Public Accountancy

•

Practice in Commerce and Industry

•

Practice in Education/Academe

•

Practice in the Government

7.

Refer to pages 8 to 10 of the textbook.

8.

Refer to page 11 of the textbook.

9.

Refer to pages 13 to 14 of the textbook.

10. Refer to pages 14 to 15 of the textbook. 11. Refer to pages 16 to 17 of the textbook.

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12. This is brought about by the nature of accounting standards and the demand for accounting-related information which have changed in several significant ways. These changes include: •

Global Harmonization of Accounting Standards

•

Expanded Accountability

•

More Detailed Reporting

•

Increased Risk Reporting

•

Global Audit Standards

13. (a) While university-level training is important, it is also necessary that professionals continue their education throughout their careers, as accounting and auditing standards will change. In this particular case, the staff member would need to stay abreast of current developments in order to meet the competence and capabilities element of the responsibilities principle. (b) Auditors need to be both independent in fact and independent in appearance. While a small financial investment might not impair the auditors’ actual state of mind (independence in fact), it is unlikely that financial statement users will perceive the auditor to be independent (independence in appearance). Professional standards would not consider the auditor independent in this case, as no direct financial interests in clients are permitted. Multiple Choice Questions 1. 2. 3. 4.

D C B B

CHAPTER 2 PRACTICE OF PUBLIC ACCOUNTANCY Questions 1.

Refer to page 29 of the textbook.

2.

Refer to pages 30 to 35 of the textbook.

3.

Refer to page 37 of the textbook.

4.

Refer to page 37 of the textbook.

5.

The following are the most sought - after services among professional accountants. A. Assurance Services. Examples are: 1.

Independent financial statement audit

2.

Reviews

3.

Other assurance services (e.g., CPA Web Trust, Business Performance Measurement Service)

B. Non-Assurance Services. Examples are:

6.

1.

Agreed-upon procedures

2.

Compilation

3.

Tax

4.

Management consultancy/advisory services

5.

Accounting and data processing

6.

Other non-assurance services (e.g., Information Technology System Services)

In an assurance engagement, a practitioner aims to provide a high or moderate level of assurance that an assertion being made by one party for use by another party can be relied upon while in a consulting engagement, the practitioner aims to provide professional advice on how the limited resources of an enterprise can be put into optimal use in order to attain the company’s objectives.

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Examples of assurance engagements on information technology are: a) CPA Web Trust Service b) Information System Reliability Service Refer to page 41 of the textbook for a brief discussion of these services.

8.

Refer to page 52 of the textbook.

9.

Refer to pages 44 to 52 of the textbook.

10. Refer to page 38 of the textbook. 11. Refer to page 47 of the textbook. 12. Refer to pages 52 to 54 of the textbook. 13. Refer to page 36 of the textbook. 14. Refer to pages 56 and 57 of the textbook.

Multiple Choice Questions 1. 2. 3. 4. 5.

C A D D D

6. 7. 8. 9. 10.

C D D D C

11. 12. 13. 14.

D C D C

Cases 1.

(a) The purpose of CPA reporting on internal control is to provide assurance about whether management’s assertion about internal control is fairly stated in all material respects, based on the control criteria being followed. Thus, for example, an examination provides the highest degree of assurance that information produced by the system will be reliable. (b) When involved in performing an examination on the effectiveness of internal control a practitioner should: • • • •

Plan the engagement. Obtain an understanding of internal control. Evaluate the design and operating effectiveness of internal control. Form an opinion about the fairness of management’s assertion on internal control.

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(a) PSA 100, Assurance Engagements, provide guidance for an engagement such as one on customer satisfaction. They provide guidelines on audits and related services such as examinations and reviews. (b) Suitable criteria are those that are objective and permit reasonably consistent measurements. In addition, the criteria must be sufficiently complete such that no relevant factors are omitted that would affect a conclusion about the subject matter. Finally, the criteria must measure some characteristic of the subject matter that is relevant to a user’s decision. (c)

INDEPENDENT ACCOUNTANTS’ REPORT We have examined the accompanying Schedule of Customer Satisfaction Measures for the three years ended December 31, 2013. This schedule is the responsibility of Gonzales, Inc.’s management. Our responsibility is to express an opinion on this schedule based on our examination. Our examination was conducted in accordance with standards on assurance engagements adopted in the Philippines and, accordingly, included examining, on a test basis, evidence supporting the schedule and performing such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion. In our opinion, the Schedule of Customer Satisfaction Measures referred to above presents fairly, in all material respects, the levels of customer satisfaction for the three years ended December 31, 2013, in conformity with the measurement and disclosure criteria set forth in Note 1.

Santos & Lopez, LLP March 1, 2014 NOTE TO INSTRUCTOR: If the CPAs believe that the criteria are not understandable by users other than management a paragraph must be added to the report restricting its use.

CHAPTER 3 OVERVIEW OF AUDITING Questions 1.

One definition of auditing is that it is a systematic process by which a competent, independent person objectively obtains and evaluates evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users. The Philippine Standards on Auditing (PSA) 120 “Framework of Philippine Standards on Auditing” states the objective of an audit as follows: “The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared in all material respects, in accordance with an identified financial reporting framework.”

2.

This apparent paradox arises from the distinction between the function of auditing and the function of accounting. The accounting function is the process of recording, classifying and summarizing 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 Philippine Financial Reporting Standards (PFRS), as well as Philippine Standards on Auditing (PSA). 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.

Purpose

Audits of Financial Statements To determine whether the financial statements are presented in accordance with PFRS.

Compliance Audits To determine whether the client is following specific procedures set by higher authority.

Operational Audits To evaluate whether operating procedures are efficient and effective.

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Compliance Audits Authority setting down procedures, internal or external Not standardized, but very specific and usually objective

Operational Audits Management of organization

Nature

Audits of Financial Statements Different groups for different purposes – many outside entities. Highly standardized

Performed by: CPAs COA Auditors BIR Auditors Internal Auditors

Almost universally Occasionally Never Frequently

Occasionally Frequently Universally Frequently

Frequently Frequently Never Frequently

Users of Audit Report

4.

The major differences in the scope of audit responsibilities are: 1.

2.

3.

4.

5.

Highly nonstandard; often very subjective

CPAs perform audits in accordance with Philippine Standards on Auditing of published financial statements prepared in accordance with identified and applicable Statements of Financial Accounting Standards. COA 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. BIR agents perform compliance audits to enforce the tax laws as defined by Congress, interpreted by the courts, and regulated by the BIR law. 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.

An independent audit is a means of satisfying the need for reliable information on the part of decision makers. Factors of a complex society which contribute to this need are: 1.

remoteness of information a. owners (stockholders) divorced from management b. directors not involved in day-to-day operations or decisions c. dispersion of the business among numerous geographic locations and complex corporate structures

2.

bias and motives of provider a. information will be biased in favor of the provider when his goals are inconsistent with the decision maker.

3.

voluminous data a. possibly millions of transactions processed daily via sophisticated computerized systems

Overview of Auditing b. c. 4.

6.

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multiple product lines multiple transaction locations

complex exchange transactions a. new and changing business relationships lead to innovative accounting and reporting problems b. potential impact of transactions not quantifiable, leading to increased disclosures

The four primary causes of information risk are remoteness of information, bias in motives of the provider, voluminous data, and existence of complex exchange transactions. The three main ways to reduce information risk are: 1. 2. 3.

User verifies the information itself. The users share the information risk with management. Have audited financial statements provided.

The advantages and disadvantages of each are as follows: User verifies information

Users share information risk with management Audited financial statements are prepared

7.

Advantages 1. User obtains information desired. 2. User can be more confident of the qualifications and activities of the person getting the information. 1. No audit costs incurred.

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.

Disadvantages 1. High cost of obtaining information. 2. Inconvenience to the person providing the information because large number of users would be on premises. 1. Users may not be able to collect on losses.

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.

Information risk is the possibility that information upon which a business decision is made is inaccurate. Four causes of information risk are: • remoteness of information, • biases and motives of the provider, • voluminous data, and • complex exchange transactions.

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Three primary ways users of information can reduce information risk are: • users can verify the information themselves, • users can share information risk with management, and • users can obtain audited financial statements.

9.

Four factors that are likely to significantly reduce information risk in the next five to ten years are: • technological advances, • more companies will go on–line, reducing the risk of investors obtaining outdated information, • new accounting and auditing standards, and • auditors will find more efficient and effective audit techniques.

10. Refer to pages 84 and 85 of the textbook. 11. A report by an independent public accountant concerning the fairness of a company’s financial statements is commonly required in the following situations: (1) Application for a bank loan. (2) Establishing credit for purchase of merchandise, equipment, or other assets. (3) Reporting operating results, financial position, and cash flows to absentee owners (stockholders or partners). (4) Issuance of securities by a corporation. (5) Annual financial statements by a corporation with securities listed on a stock exchange or traded over the counter. (6) Sale of an ongoing business. (7) Termination of a partnership. 12. To add credibility to financial statements is to increase the likelihood that they have been prepared following the appropriate criteria, usually the relevant and applicable PAS. As such, an increase in credibility results in financial statements that can be believed and relied upon by third parties. 13. Business risk is the risk that the investment will be impaired because a company invested in is unable to meet its financial obligations due to economic conditions or poor management decisions. Information risk is the risk that the information used to assess business risk is not accurate. Auditors can directly reduce information risk, but have only limited effect on business risk. 14. An operational audit attempts to measure the effectiveness and efficiency of a specific unit of an organization. It involves more subjective judgments than a compliance audit or an audit of financial statements because the criteria of effectiveness and efficiency of departmental performance are not as clearly established as are many laws and regulations or financial reporting standards.

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The report prepared after completion of an operational audit is usually directed to management of the organization in which the audit work was done. 15. The first quoted sentence overstates the case. Although annual audits by CPA firms are universal practice for large corporations, they are not essential to many small businesses. The financial statements of large corporations go to many stockholders (often hundreds of thousands) who demand the assurance of reliability supplied through independent audits by CPA firms. Moreover the SEC and the stock exchanges require that listed companies have annual audits. For a small business concern, the primary need for annual financial statements is to support an application for a bank loan. If a small business does not need to borrow, or can obtain borrowed funds without providing audited statements, the cost of an audit may not be justified. Often a small business can obtain from a CPA firm specialized services other than an audit, which are more useful and may cost less. Examples are the review or compilation of financial statements, installation of a computer based accounting system, or a study of internal control. Thus, the second quoted sentence, as well as the first, is too sweeping to be correct. A decision not to have an audit is not always “false economy.” 16. (a) An example of possible bias on the part of the provider of financial information is the situation in which an individual or business entity applies for a bank loan. In such circumstances, there is an incentive to overstate assets, income, and owner’s equity, and to overlook or minimize liabilities. Distortions of this type give the appearance of greater financial strength. (b) A bank loan officer may insist that a prospective borrower provide audited financial statements. This provides assurance that the data in the financial statements have been examined by independent competent persons. 17. Financial statements audits, operational audits, and compliance audits are similar in that each type of audit involves accumulating and evaluating evidence about information to ascertain and report on the degree of correspondence between the information and established criteria. The differences between each type of audit are the information being examined and the criteria used to evaluate the information. An example of a financial statement audit would be the annual audit of ABS-CBN Corporation, in which the external auditors examine ABSCBN’s financial statements to determine the degree of correspondence between those financial statements and generally accepted accounting principles. An example of an operational audit would be an internal auditor’s evaluation of whether the company’s computerized payroll-processing system is operating efficiently and effectively. An example of a compliance audit would be a BIR

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Solutions Manual – Public Accountancy Profession auditor’s examination of an entity’s tax return to determine the degree of compliance with the National Internal Revenue Code. 18. Refer to pages 83 to 84 of the textbook. 19. The text defines internal auditing as an independent appraisal activity in an entity. Internal auditing is itself a control that operates by examining and evaluating the adequacy and effectiveness of other controls. Independence is such an important aspect of internal auditing that the fourth section of the Statement of Responsibilities of Internal Auditing is devoted to independence. Organizations create internal auditing to serve or benefit the organization. The broad objective of internal auditing is to provide assistance to members of the organization to enable the members to meet their responsibilities effectively. Assistance may involve providing counsel or recommendations, analysis, or information. One goal of internal auditing should be to achieve effective control that is worth the cost. In describing the nature of internal auditing, the Statement of Responsibilities of Internal Auditing indicates that internal auditing functions by examining controls. The scope limits internal auditing’s responsibility for examining and evaluating performance to specific responsibilities that are assigned to individuals or units. Internal auditing examines and evaluates performance to compare the actual performance with plans, specified activities, standards, objectives, policies, and goals. Such evaluations are really evaluations of controls because plans, specified activities, standards, objectives, policies and goals are controls. Internal auditors may be called on to examine areas for which performance criteria have not been specified. When this occurs, internal auditors may select measurable criteria and report their findings in terms of those measurable criteria. For example, if internal auditors were called on to evaluate a credit department, they might present historical information as well as industry information to management as a basis for evaluating the credit department. 20. Independence is the essence of auditing and enables auditors to render impartial and unbiased judgments. The two conditions that contribute to an internal auditor’s independence are organizational status and auditor objectivity. The internal auditors’ status must be such that they are respected throughout the organization. Generally, the more respect management gives to the internal audit function, the greater the attention the whole organization pays to their findings and recommendations. Giving the highest-level person in internal auditing the status of vice president and having that person report to the board of directors’ audit committee give sufficient status to the internal audit function. Objectivity requires that internal auditors have an independent mental attitude and an honest belief in their work product.

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21. COA auditors perform operational or performance audits, compliance audits, and financial audits. 22. An independent auditor is usually a CPA who has received a license to perform the attest function. To be a CPA, one generally must meet certain educational requirements and pass an examination. Internal auditors are employees of the organization for which they do audits. They may perform financial auditing, compliance auditing, or operational auditing. They are not independent in the sense that external auditors are, although they may attain a degree of independence by their position in the organization. Governmental auditors are employees of various government agencies who perform financial, compliance, and operational auditing. For example, local governments employ auditors to verify that businesses collect and remit sales tax as required by law.

Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

D A A D B C B C B D

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

B A C C A D A A D C

21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

D B C B B C D C A A

31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

D B A D C D B C A B

CHAPTER 4 REGULATION OF THE PRACTICE OF PUBLIC ACCOUNTANCY Questions 1.

Refer to pages 110 (Section 28 of the Philippine Accountancy Act of 2004) of the textbook.

2.

Refer to pages 112 (Sections 34 & 35 of the Philippine Accountancy Act of 2004) of the textbook.

3.

Competencies include both what individual auditors know and what individual auditors and audit teams do. Competencies are evidenced by auditors applying their skills in the delivery of services to clients or supporting the delivery of those services. These competencies categorized as “High Opportunity Competencies” and “Low Opportunity Competencies” are as follows: High Opportunity Competencies have a high likelihood of being building blocks for selling or delivering new assurance services. •

Analytical Skills

•

Business Advisory Skills

•

Business Knowledge

•

Capacity for Work

•

Comprehension of Client’s Business Processes

•

Communication Skills

•

Efficiency

•

Intellectual Capability

•

Learning and Rejuvenation

•

Marketing and Selling

•

Model Building

•

People Development

•

Relationship Management

•

Responsiveness and Timeliness

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•

Technology

•

Verification

Low Opportunity Competencies, while important to the delivery of current assurance services, are less likely to be exploited in the development of future services.

4.

•

Accounting and Auditing Standards

•

Administrative Capability

•

Managing Audit Risk

Examples of typical lawsuits against CPAs are a)

Alleged misstatements that the auditor did not detect in the financial statements involving 1) improper or inadequate disclosure 2) inappropriate valuations

b) Alleged failure to detect defalcation as a result of negligence in the conduct of the audit c)

Alleged failure to complete the audit on the agreed-on date

d) Alleged inappropriate withdrawal from an audit 5.

Indications That Noncompliance May Have Occurred Examples of the type of information that may come to the auditor’s attention that may indicate that noncompliance with laws or regulations has occurred are listed below: •

Investigation by government departments or payment of fines or penalties.

•

Payments for unspecified services or loans to consultants, related parties, employees or government employees.

•

Sales commissions or agent’s fees that appear excessive in relation to those ordinarily paid by the entity or in its industry or to the services actually received.

•

Purchasing at prices significantly above or below market price.

•

Unusual payments in cash, purchases in the form of cashiers’ checks payable to bearer or transfers to numbered bank accounts.

•

Unusual transactions with companies registered in tax havens.

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•

Payments for goods or services made other than to the country from which the goods or services originated.

•

Payments without proper exchange control documentation.

•

Existence of an accounting system which fails, whether by design or by accident, to provide an adequate audit trail or sufficient evidence.

•

Unauthorized transactions or improperly recorded transactions.

•

Adverse media comment.

6.

Refer to page 119 of the textbook.

7.

PSA 260 (Clarified), “Communication with Those Charged with Governance” deals with the auditor’s responsibility to communicate with those charged with governance in relation to an audit of financial statements. Although this PSA applies irrespective of an entity’s governance structure or size, particular considerations apply where all of those charged with governance are involved in managing an entity, and for listed entities. This PSA does not establish requirements regarding the auditor’s communication with an entity’s management or owners unless they are also charged with a governance role.

8.

The increase in litigation against auditors seems to be happening for two reasons: a general increase in litigation in society, and the fact that investors and creditors who suffer losses will look for “deep pockets” to pay for those losses. Most accounting firms appear to have “deep pockets.”

9.

Due (professional) care is the standard by which the courts and the profession expect a CPA to practice. A CPA who is found to have exercised due professional care in an engagement should not have any liability to others.

10. The four gradations are none, negligence, gross negligence (sometimes referred to as constructive fraud), and fraud. At one extreme is the auditor who performs an appropriate audit and issues an appropriate report. This auditor’s degree of wrongdoing is “none.” An auditor who commits fraud is at the other extreme, since he or she knows that the financial statements are misstated and yet issues an unqualified opinion. An auditor is negligent if he or she does not do what a reasonably prudent auditor should do in the circumstances. An auditor is grossly negligent if he or she consistently fails to follow the standards of the profession on an engagement. 11. Auditors are responsible to clients for negligence, gross negligence, or fraud. 12. Refer to page 126 of the textbook.

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Solutions Manual – Public Accountancy Profession 13. Most courts have held that an auditor has a higher responsibility to communicate information beyond that required by PFRSs and PSAs. Courts have held that compliance with PFRSs is persuasive but not conclusive evidence. 14. An auditor should (a) follow the Philippine Standards on Auditing, the Code of Ethics for Professional Accountants in the Philippines, and where appropriate, PFRSs; (b) establish and follow appropriate quality control procedures; (c) evaluate whether a client has the necessary integrity and appropriate reputation in the community; (d) evaluate carefully why a client wants an audit; (e) conduct the audit with appropriate professional skepticism; (f) provide for appropriate levels of consultation for issues; and (g) provide for appropriate review of the audit. 15. The prudent man concept states that a man is responsible for conducting a job in good faith and with integrity, but is not infallible. Therefore, the auditor is expected to conduct an audit using due care, but does not claim to be a guarantor or insurer of financial statements.

Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

B C A B A C A C A B

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

A D C D C A A D B D

21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

B C A A A C C A A C

31.

B

CHAPTER 5 CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS IN THE PHILIPPINES Questions 1.

There is a special need for ethical behavior by professionals to maintain public confidence in the profession, and in the services provided by members of that profession. The ethical requirements for CPAs are similar to the ethical requirements of other professions. All professionals are expected to be competent, perform services with due professional care, and recognize their responsibility to clients. The major difference between other professional groups and CPAs is independence. Because CPAs have a responsibility to financial statement users, it is essential that auditors be independent in fact and appearance. Most other professionals, such as attorneys, are expected to be an advocate for their clients.

2.

Independence in fact exists when the auditor is actually able to maintain an unbiased attitude throughout the audit, whereas independence in appearance is dependent on others’ interpretation of this independence and hence their faith in the auditor. Activities which may not affect independence in fact, but which are likely to affect independence in appearance are: (Notice that the first two are violations of the Code of Ethics.)

3.

1.

Ownership of a financial interest in the audited client.

2.

Directorship or officer of an audit client.

3.

Performance of management advisory or bookkeeping or accounting services and audits for the same company.

4.

Dependence upon a client for a large percentage of audit fees.

5.

Engagement of the CPA and payment of audit fees by management.

In return for the faith placed in CPAs by the public, CPAs should continually seek to demonstrate their dedication to professional excellence. The public interest is defined as the community’s collective well-being. CPAs handle ethical conflicts best by acting with integrity, objectivity, and due professional care and by having a genuine interest in serving the public.

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An ethical dilemma is a situation that a person faces in which a decision must be made about the appropriate behavior. There are many possible ethical dilemmas that one can face, such as finding a wallet containing money, or dealing with a supervisor who asks you to work hours without recording them. An ethical dilemma can be resolved using the six-step approach outlined below: 1. 2. 3. 4. 5. 6.

5.

Obtain the relevant facts. Identify the ethical issues from the facts. Determine who is affected by the outcome of the dilemma and how each person or group is affected. Identify the alternatives available to the person who must resolve the dilemma. Identify the likely consequence of each alternative. Decide the appropriate action.

Apparently, in ethical philosophy, the word “conscience” is used to describe the “undefinable mental process that yields moral decisions.” A close kin in the political science terms would be “anarchy.” Conscience might not be a sufficient guide for personal ethics decisions because the individual’s undefinable mental processes may be based on caprice, immaturity, ignorance, stubbornness, or misunderstanding. Conscience may fail to show the consistency, clarity, practicability, impartiality, and adequacy preferred in ethical standards and behavior. Exactly the same can be said about professional ethics decisions because a nonhypocritical individual can no more split his behavior between personal life and professional life than he can voluntarily split his own personality.

6.

A professional accountant must be prepared to be an agent, spectator, advisor, instructor, judge, and critic.

7.

Ethical responsibility for acts of non-CPAs under a CPA’s supervision falls under the latter’s jurisdiction. A CPA shall not permit others to carry out on his behalf, either with or without compensation, acts which, if carried out by the CPA, would place him in violation of the Code of Ethics.

8.

The auditor’s gain from having an audit committee is a direct communication pipeline to the board of directors.

9.

Serving as a purchasing agent places Ben Santos’ father in an “audit sensitive position.” Accordingly, Santos’ independence is impaired. Also, since Santos is a managerial employee, he can no longer work in the Manila office of the CPA firm. The CPA firm may retain its independence if Santos transfers to another office (or resigns).

Code of Ethics for Professional Accountants in the Philippines

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10. The CPA firm’s independence would not be impaired as long as Gary Angeles did not personally participate in the audit of this particular client. Once Gary rises to the position in which he becomes a “managerial employee” of the CPA firm, however, he must be transferred to an office which does not participate in this audit if the firm is to remain independent. 11. Historically, compensation for CPAs serving as expert witnesses had to be based on a standard per diem rate or a fixed sum. However, under certain situations, such contingent fees are allowed only from clients for which the CPA does not also provide to the client financial statement audits, reviews or certain compilations, or prospective financial information examinations. 12. Sanchez may only refer certain clients to his wife or to another life insurance agent who will share such a commission with his wife provided that he does not perform assurance as well as nonassurance services.

Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

D B D A A C A* A* A* A

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

A A A C C D A C A A

21. 22. 23. 24. 25. 26. 27.

A B D C C B D

*7. A fee for audit clients which is dependent upon the results achieved by the CPA’s efforts is a contingent fee and is prohibited for audit clients. *8. An auditor’s independence would not be considered to be impaired with respect to a financial institution in which the auditor maintains a checking account which is fully insured. *9. The declaration requires the preparer to acknowledge that the return is “true, correct, and complete...based on all information of which the preparer has any knowledge.”

Solutions Manual – Public Accountancy Profession

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a.

Interpretation – Honorary Directorships and Trusteeships Ela will not be considered independent unless: 1. 2. 3. 4.

b.

the position is in fact purely honorary, and listings of directors show she is an honorary director, and she restricts participation strictly to the use of her name, and she does not vote or participate in management functions.

Interpretation – Retired Partners and Firm Independence: Since Monte is still active with the firm as an ex-officio member of the income tax advisory committee, meeting monthly, his situation would impair the appearance of the firm’s independence. Monte should either resign from the Palm board or cease his association with the accounting firm.

c.

Interpretation – Accounting Services CPA Benitez must be careful to know whether outsiders would perceive relationships that would indicate status as an employee, hence impairing the appearance of independence. In particular, CPA Benitez must 1.

2.

3.

4.

d.

Not have any business connection with Hernan Corporation or with Mike Hernan that would in fact impair independence, objectivity and integrity, and Impress Mike Hernan (and the board of directors) that they must be able and willing to accept primary responsibility for the financial statements as their own, and Not take managerial responsibility for conducting operations of the Hernan Corporation (although Benitez’s supervision of the bookkeeper seems to have this characteristics), and Conduct the audit in conformity with PSA and not fail to audit records simply because they were processed under Benitez’s supervision.

Interpretation – Effect of Family Relationships on Independence Jack’s wife’s interest is attributed to him, and he would not be independent. The financial interest is considered direct.

e.

Interpretation Jack is still not independent, so long as the daughter is a dependent child. The financial interest is considered direct.

Code of Ethics for Professional Accountants in the Philippines f.

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Interpretation Still not enough. The grandfather (either Jack’s father or his father-in-law) is considered a nondependent close relative, but the appearance of independence is impaired. The grandfather’s investment is material (50 percent) in relation to his net financial resources.

2.

3.

a.

Pee and Co. / United Furniture, Inc.: This is a judgment call. In this case, the services can be considered temporary, mechanical in nature and performed on a one-time emergency basis. For these reasons, the SEC would probably not consider independence impaired.

b.

Renson & Co. / Spectrum Corporation Laser Division: The SEC would consider independence impaired because of the extent of the bookkeeping services and the relative size of the Division. The only solution that might work is to have another accounting firm audit the Laser Division financials so that Renson & Co. can write a report “in reliance on the work of other independent auditors.”

c.

Reyes & Co. / Valley Bank: The SEC would consider independence impaired because of the family relation of Annabelle, her connection with Valley’s financial statements and the fact that Kris is a “member” (partner) in the audit firm. (The PICPA would probably also consider independence impaired because of the apparent closeness of the two sisters and the “audit sensitivity” of Annabelle’s job).

d.

Cruz & Reyes / Jonas Tomas / Starex Money Market Fund: Jonas is a “member” since he is a manager and will provide audit services to SMMF. Cruz & Reyes’ independence is impaired since Jonas holds a direct financial interest.

Violation of Code of Professional Ethics?

Yes

No

Since Bella had an employment relationship with the client during part of the period covered by the financial statements, her independence is impaired. 4.

Violation of Code of Professional Ethics?

Yes

No

This is a violation. It is a contingent fee agreement. 5.

Although her decision will not be popular with the audit staff, Tracy Ong should thank the client but decline the offer, both for her and for the staff. She should explain that an outsider who had knowledge of all of the relevant facts might view the free use of a condominium as a sizable “gift” to the auditors, which might influence their independent mental attitude. Thus, we believe that to

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maintain an appearance of independence, the auditors should not accept this offer. 6.

No. CPAs may refuse client access to their working papers for any valid business purpose. Therefore, a CPA may require that fees be paid before working papers including such adjusting entries and supporting analysis are provided to the client.

7.

The answers provided in this section are based on the assumption that the traditional legal relationship exists between the CPA firm and the third party user. That is, there is no privity of contract, the known versus unknown third party user is not a significant issue, and high levels of negligence are required before there is liability. a.

False. There was no privity of contract between Tan and Cañada, therefore, ordinary negligence will usually not be sufficient for a recovery.

b.

True. If gross negligence is proven, the CPA firm can and probably will be held liable for losses to third parties.

c.

True. See a.

d.

False. Gross negligence (constructive fraud) is treated as actual fraud in determining who may recover from the CPA.

e.

False. JC is an unknown third party and will probably be able to recover damages only in the case of gross negligence or fraud.

Assuming a liberal interpretation of the legal relationship between auditors and third parties, the answers to a and d would probably both be true. The other answers would remain the same. 8.

Yes. Normally a CPA firm will not be liable to third parties with whom it has neither dealt nor for whose benefit its work was performed. One notable exception to this rule is fraud. When the financial statements were fraudulently prepared, liability runs to all third parties who relied upon the false information contained in them. Fraud can be either actual or constructive. Here, there was no actual fraud on the part of Dantes or the firm in that there was no deliberate falsehood made with the requisite intent to deceive. However, it would appear that constructive fraud may be present. Constructive fraud is found where the auditor’s performance is found to be grossly negligent. That is, the auditor really had either no basis or so flimsy a basis for his or her opinion that he or she has manifested a reckless disregard for the truth. Dantes’ disregard for standard auditing procedures would seem to indicate such gross negligence and, therefore, the firm is liable to third parties who relied on the financial statements and suffered a loss as a result.

Code of Ethics for Professional Accountants in the Philippines 9.

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a.

Yes. Carlos was a party to the issuance of false financial statements and as such is a joint tortfeasor. The elements necessary to establish an action for common law fraud are present. There was a material misstatement of fact, knowledge of falsity (scienter), intent that the plaintiff bank rely on the false statement, actual reliance, and damage to the bank as a result thereof. If the action is based upon fraud there is no requirement that the bank establish privity of contract with the CPA. Moreover, if the action by the bank is based upon ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party beneficiary (an exception to the strict privity requirement). Thus, the bank will be able to recover its loss from Carlos under either theory.

b.

No. The lessor was a party to the secret agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if he or she was damaged indirectly, his or her own fraudulent actions led to his or her loss, and the equitable principle of “unclean hands” precludes him or her from obtaining relief.

c.

Yes. Carlos had knowledge that the financial statements did not follow financial reporting standards and willingly prepared an unqualified opinion. The financial statements were not in accordance with financial reporting standards. That is a criminal act because there was an intent to deceive.

10. a.

Base, Umapas & Cañada is potentially liable to its client because of the possible negligence of its agent, the in-charge accountant on audit, in carrying out duties that were within the scope of his or her employment. Should there be a finding of negligence, liability would be limited to those losses that would have been avoided had reasonable care been exercised. There being no evidence of the assumption of a greater responsibility, the in-charge accountant’s conduct is governed by the usual standard; that is, that the accountant perform his or her duties with the profession’s standards of competence and care. A question of fact arises as to whether the duty of reasonable care was breached when the in-charge accountant failed to investigate further after being apprised by a competent subordinate of exceptions to 6 percent of the vouchers payable examined. Moreover, a question of causation arises as to whether further actions by the in-charge accountant would have disclosed the fraud. If both lack of due care and causation are established, recovery for negligence will be available to the client.

b.

In a properly organized liability partnership, the partner(s) and staff responsible for the engagement and the firm would be liable, as discussed in part a. However, other partners would not be liable.

5-8

Solutions Manual – Public Accountancy Profession 11. Ordinarily, users of financial statements, other than those who contracted for the audit and those known in advance to the auditor, may not recover for ordinary negligence by the auditor in the performance of an audit. Recovery of damages by third parties must usually be based on fraud. Actual knowledge of falsity (scienter) is also generally required for an action based on fraud; however, this requirement may be satisfied by the auditor’s reckless disregard for the truth or gross negligence. It appears that the three deficiencies in the audit by Gonzales & Esteban might be sufficient to satisfy either approach. Failure to check the existence of certain receivables, collectibility of other receivables, and existence of security investments, taken collectively if not individually, appear to show a reckless disregard for the truth by the auditor. In fact, the audit probably lacks sufficient competent evidential matter as a reasonable basis for an opinion regarding the financial statements under examination. The audit appears to have been conducted in a woefully inadequate fashion, without regard to the usual auditing standards and procedures necessary to exercise due professional care. Therefore, the auditors were grossly negligent in the performance of their duties. 12. Corpuz has stated that the CPA firm has “reviewed the books and records of Flores Ventures,” when in fact no such “review” has occurred. A “review” of financial statements consists of limited investigatory procedures designed to provide statement users with a limited degree of assurance that the financial statements are in conformity with financial reporting standards. Corpuz’s actions are similar to issuing an auditors’ report without first performing an audit. Such an action may well be considered an act of criminal fraud, intended to mislead users of the financial statements. If the financial statements of Flores Ventures turn out to be misleading, there is little doubt that any court would find the CPA firm guilty of at least constructive fraud and liable to any third party who sustains a loss as a result of reliance upon the statements. The fact that Corpuz violated Vasquez’s policy of submitting all reports for Vasquez’s review would not lessen the CPA firm’s liability. The concept of mutual agency allows Corpuz, as a partner, to commit the firm to contracts, including auditors’ reports and accountants’ reports. The fact that this report was not submitted for Vasquez’s review might be introduced as evidence against Corpuz in the event he is accused of criminal fraud. 13. (1) Yes, but only to the extent of P70,000. Beta is a third-party beneficiary of the contract between Mega and its auditors, and may therefore recover from the auditors losses caused by the CPAs’ ordinary negligence. However, the original P50,000 loan was made prior to Beta’s reliance upon the negligently audited financial statements. Thus, the auditors’ negligence was

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not the proximate cause of this portion of Beta’s loss. The auditors’ negligence may, however, be considered the proximate cause of the P70,000 loss incurred as a result of reliance upon the misleading statements. (2) The prospects for Manila’s recovery of its P30,000 loss are substantially less than those of Beta. Manila was not a third-party beneficiary to the contract. Thus, in many jurisdictions following Ultramares, Manila cannot recover losses attributable to the CPAs’ ordinary negligence. Similarly, it is doubtful that Manila would qualify as a foreseen third party as necessary under the Restatement approach. Even in a jurisdiction accepting the Rosenblum precedent, which allows third parties to recover losses caused by the auditors’ ordinary negligence, Manila would have to prove that it was a “foreseeable third party relying upon the financial statements for routine business purposes.” It is questionable whether the loan by Manila was either “reasonably foreseeable” or “routine,” as Manila was a customer of Mega, not a lender.

CHAPTER 6 MANAGEMENT OF A PUBLIC ACCOUNTANCY PRACTICE Questions 1.

The special function performed by the public accounting profession is the attestation to the fairness of the financial statements of clients. The special function ensures the reliability and integrity of the financial reporting system. Judge Burger described the special function as "certifying the public reports that collectively depict a corporation's financial status," which involves "a public responsibility transcending any employment relationship with the client."

2.

Complexity affects the demand for auditing services in that both users and management need the expertise of professionals who understand the underlying economic substance of transactions and financial instruments and, thus, who have the ability to determine the appropriate accounting best to "fairly" portray the economic substance of an organization's activities and financial condition. The business environment in which the auditor must function is increasingly complex. The major forms of complexity relate to:

3.

a.

Computer systems, which are becoming increasingly interdependent across organizations.

b.

Increased complexity of financial instruments and transactions entered into by organizations.

c.

The economic environment in which we all must operate. The changing environment includes such items as the increased need to have a global outlook in providing goods and services and the need to be attuned to societal regulations in such areas as environmental protection.

For the most part, local CPA firms are subject to the same auditing and accounting standards as the large international CPA firms. The differences relate to whether the audit firms have (a) public clients, or (b) international clients. If a firm has public clients, then the firm is subject to the standards of the PCAOB. If a firm has clients that are domiciled in other countries, then they should utilize international auditing standards. If the audit firm only has non-pubic clients, then they are subject to auditing standards promulgated by the PICPA.

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A network of accounting firms is a body to which individual CPA firms come together to pursue common interests. The services generally provided by the network include: •

centralized staff that provides accounting and auditing expertise to its members on a world-wide basis,

•

a referral service for audit firms that have clients in different parts of the country or world,

•

a referral service for a firm to utilize when clients desire expertise or consulting services that the audit firm does not provide.

•

standard audit programs and/or procedure’s manuals for the member audit firms.

In some cases, the network can be a network of firms that are not otherwise affiliated. In other cases, the network firms all operate under one common name, e.g. Grant Thornton International. 5.

a.

Professional skepticism represents a state of mind that is characterized by appropriate questioning and a critical assessment of audit evidence. When employing professional skepticism, auditors will not simply accept all evidence provided and assume that clients are unquestionably honest. However, the statement that “you really have to question everything the client tells you” is a bit exaggerative and goes beyond the concept of professional skepticism.

b.

It is correct that internal evidence is generally of lower quality than external evidence. However, the necessary quality of evidence depends upon the risk of material misstatement and the effectiveness of the client’s internal control. In this case, the staff auditor’s statement that internal evidence is obtained because of time and cost considerations is not appropriate, unless the risk of material misstatement permits lower quality of evidence because of other reasons.

c.

While appropriate planning will allow audits to be conducted on a timely basis, it is not appropriate for auditors to ignore transactions and events between the interim date (in this case, November 1) and the client’s fiscal year end. Some testing would need to be performed following the year end for transactions occurring between November 1 and December 31.

d.

While the primary purpose of evaluating internal control is to determine the nature, timing, and extent of substantive tests, auditors must still conduct some study of internal control to ensure that the condition of the client’s internal control has not changed from prior years. If it has, the substantive tests performed by auditors may no longer be appropriate. In addition, for

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public companies, auditors are required to study internal control and report on the effectiveness of the client’s internal controls under Auditing Standard No. 5. e.

For departures from PFRS, the choice among opinions would be between a qualified opinion (for less material departures) and an adverse opinion (for more material departures).

f.

While the concept of materiality does consider dollar amounts and their effects on users’ decisions, qualitative factors also need to be considered when assessing materiality. For example, a small dollar amount (in absolute terms) may influence a company’s ability to meet its earnings expectations or report higher earnings than in previous years. Situations such as this need to be considered as well as the absolute dollar amount of an item in assessing materiality.

Multiple Choice Questions 1. 2. 3. 4. 5.

D D D D A

Cases 1.

(1) Auditing does not involve the creation of goods. However, it does serve a worthwhile purpose in our society because it enhances the flow of reliable financial information needed to conduct commerce in our economy. It also assists in the conduct of government by providing reliable information for tax purposes and regulatory purposes. Audits have been legally mandated to ensure objective information. However, research has indicated that audits would be required even if not mandated. The initial audits performed in conjunction with the settlement of the new world arose because of owners' need to have an independent assessment of the returns earned by their managers. (2) The accounting profession did provide early warning signals of the potential problems within many industries. However, it clearly failed in other areas. Some of the problems were related to the impreciseness of accounting principles (e.g. Enron) while others were more closely related to regulatory failures (e.g. Savings & Loan Industry). However, many of the failures were due to systematic problems in the accounting profession that has been addressed by Sarbanes-Oxley.

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Solutions Manual – Public Accountancy Profession (3) Finding fraud may be important. However, many misstatements that are made in conjunction with an organization's financial statements are not intentional but are simply the result of errors. The audit function is designed to detect material misstatements -- whether they are due to errors or fraud. Thus, the audit function is actually broader than the colleague had desired. Ensuring that a financial statement contains no material misstatements also ensures that the auditor addresses the likelihood that material fraud may also have occurred. (4) There is a potential problem with the auditors being hired by management. The Sarbanes-Oxley Act requires companies that are publicly traded to have an audit committee composed of independent directors (nonmembers of management) that have the responsibility for evaluating the performance of the auditors. The audit committee should exist to present the views and interests of outside owners of the organization and provide effective insulation against undue pressure by management on the audit function. The SEC is very cognizant of independence issues and periodically addresses actions or relationships that they believe may impair the auditor’s independence. (5) PFRS represents rules and conventions that are acceptable at one point in time. Much of the diversity in accounting principles is necessary to reflect real economic differences between organizations and the types of transactions in which the organization is engaged. Beyond this argument, differences such as Weighted Average / FIFO accounting have evolved over the years. The profession attempts to mitigate the potential problems associated with the diversity by providing disclosure of the differences and by developing other procedures to make it difficult for firms to change accounting principles. Thus, the financial statements of a company should be comparable over a period of time. (6) It seems that this individual really wants to have a career in auditing. External auditing has changed; in today's environment, the auditor must thoroughly understand a company's business in order to audit it. A key function of internal auditors is to add value through their recommendations. (7) The external audit is designed to present an opinion on the fairness of a company’s financial statement in accordance with PFRS. It is not directly designed to assess the performance of management, although the financial statements may provide some evidence on the performance of management. (8) Auditors operate in an environment in which they must have a sense of trust with management – at least to the extent that confidential or proprietary information is not made public. Thus, if all recommendations made to management were to be made public, management might simply ask that

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recommendations no longer be made. Further, it must be recognized that many of the recommendations made to improve operations are informal in nature and might not be based on thorough study of a particular area. Auditors may justifiably fear litigation from recommendations made public that were made only on informal observations. (9) Congress, in developing the Sarbanes-Oxley Act believes this statement is true. Maintaining adequate controls is a significant part of corporate governance. Congress believes the owner (shareholder) should receive reports on the quality of controls implemented by management. In the first three years of public reports on internal control, there has been a dramatic change in the quality of controls in many organizations. During the first year of Sarbanes-Oxley, approximately 16% of the companies received adverse reports on the quality of their internal controls. This percentage has gone down dramatically. 2.

(a) There seems to be a misinterpretation on the part of many users that a "clean" audit opinion means that the company is in good health. This, unfortunately, is a miscommunication. A "clean" audit opinion means only that the financial statements are fairly presented, not that they represent a company that is in good financial health. The audit function provides data that are "fairly presented" in accordance with PFRS, but such information alone does not constitute all the information an informed user should know about a company. (b) The auditor is a guarantor only of following auditing standards in determining whether the statements are fairly presented, in all material respects, in accordance with financial reporting standards. Fair presentation is guaranteed only within the context of PFRS. (c) This question and should encourage a widely ranging discussion by users. Topics that might be addressed include these: 1. The potential deficiencies in PFRS. 2. The ability to detect fraud when management has attempted to cover it up. 3. The responsibilities of users to perform their own work and to not expect someone else to make decisions for them. 4. The overall responsibility of management for the integrity of the financial statements. 5. The value of reports on internal control. 6. The difficulty of measuring the economics of complex transactions.

CHAPTER 7 SYSTEM OF QUALITY CONTROL FOR PUBLIC ACCOUNTANCY FIRMS Questions 1.

Refer to page 292 of the textbook.

2.

Refer to pages 293 and 294 of the textbook.

3. Refer to pages 293 and 294 of the textbook. 4.

a.

Leadership responsibilities for quality within the firm

b.

Engagement performance

c.

Human resources

d.

Monitoring

e.

Human resources

f.

Relevant ethical requirements

g.

Acceptance and continuance of clients

h.

Leadership responsibilities for quality within the firm

i.

Engagement performance

Multiple Choice Questions 1. 2. 3. 4. 5.

A D D B C

6. 7. 8. 9. 10.

B A D B C

11. 12. 13. 14. 15.

D B C C D

16. 17. 18. 19.

C B C D

Solutions Manual – Public Accountancy Profession

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MORALES, CABRERA, & CO., CPAs 1.

a. b. c.

Hiring / Professional requirements To ensure that personnel who will be performing audits have adequate technical training and proficiency. New accountants hired must have an accounting degree from an accredited school.

2.

a. b. c.

Advancement / Professional requirements To ensure personnel are qualified to do the tasks they are assigned. An in-charge accountant must have served as a staff auditor on an audit in the client’s industry.

3.

a. b.

Skills and Competence To ensure that personnel continue to be updated on changes in accounting or auditing standards. Personnel will participate in forty hours of continuing education per year.

c. 4.

a. b. c.

Consultation To ensure that personnel have access to persons with more experience in dealing with problems they have encountered. For each industry for which the office has a client, a specialist will be identified.

5.

a. b. c.

Independence To ensure that personnel meet PICPA guidelines for independence. Firm personnel must list their investments. Personnel must report any stock acquisitions.

6.

a. b. c.

Supervision To ensure that work performed meets the firm’s standard of quality. Staff personnel are to follow firm guidelines for working paper development.

7.

a. b. c.

Inspection / Review To verify that quality control procedures are being followed. Inspect the audit programs for all engagements.

8.

a. b. c.

Acceptance and retention of clients To minimize the risk associated with clients. New clients must be investigated by a private investigative agency.

System of Quality Control for Public Accountancy Firms 9.

a. b. c.

2.

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Assigning personnel to engagements To ensure that personnel posses the degree of technical training and proficiency required for an engagement. To be eligible to be senior on an engagement, a person must have had experience in the industry.

Auditing standards indicate that auditors should report major issues discussed with the entity’s management prior to being retained as auditor, including discussions regarding the application of accounting principles and auditing standards. Discussion of such matters may place pressure on the auditor to yield to management’s view. Making the audit committee members aware of such matters should enable them to better monitor the auditor’s independence. Standards do not preclude clients from making suggestions about audit staff. Clients frequently make requests to have persons on the audit who have experience in the industry. If a client requests that minority persons not be assigned to an audit, however, the auditor must carefully consider the ethical implications of that request.

CHAPTER 8 PHILIPPINE STANDARDS ON AUDITING Questions 1.

Foreign public accounting firms have found that to retain their multinational clients, they have had to develop the capacity to provide services worldwide. Although the roots of at least two of the big firms in the United States are traceable to European ancestry, public accounting firm involvement in international activities has paralleled the gradual involvement of businesses in international activities. In the early 1900s, some public accounting firms established representative offices in foreign countries. As business activity expanded, the firms opened offices in foreign cities. During the 1970s, some countries forced these firms to close their offices. To be able to serve their clients, the firms established correspondent relationships with locally owned accounting firms; in these relationships, local partners remain separate, local, autonomous organizations. Because domestic and foreign partners in a correspondent relationship agree to follow a common code of ethics and practice guidelines, each is able to rely on the work the other performs. A big firm auditing a U.S. business with significant activities in France, for example, would rely on its Paris office to audit the activities of the business in France. The largest firms have organized worldwide partnerships to achieve a greater uniformity of quality, to facilitate management of personnel, and to coordinate research and professional development of personnel. Many small public accounting firms establish correspondent relationships with foreign public accounting firms or join a federation. Firms in a federation call on one another to perform services for clients, following agreed-upon standards in conducting the work they do for one another.

2.

Yes. According to paragraph 10 of the Preface to Philippine Standards on Auditing and Related Services, “an auditor may, in exceptional circumstances, judge it necessary to depart from a PSA in order to more effectively achieve the objective of an audit. When such a situation arises, the auditor should be prepared to justify the departure.”

3.

No. According to paragraph 14 of the Preface to the Philippine Standards on Auditing and Related Services, “PAPSs are issued to provide practical assistance to auditors in implementing the PSAs or to promote good practice. These Statements are not intended to have the authority of the PSAs.”

4.

Refer to page 329, paragraph 6 of PSA 120.

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Refer to page 329, paragraph 6 of PSA 120.

6.

Refer to pages 329 and 330, paragraphs 8, 9 and 10 of PSA 120.

Multiple Choice Questions 1. 2. 3. 4. 5.

D B B D C

6. 7. 8. 9. 10.

C C D D A*

11.

D

* b and d are also options available to the auditor

Cases 1.

The PICPA currently develops independence and ethical standards, quality control standards, and auditing and attestation standards that apply to its members. However, PICPA standards are applicable to the audits and auditors of nonpublic clients based on general acceptance by the courts, and adoption by state boards of accountancy and other regulatory bodies. The AICPA also has a voluntary peer review program, and enforces its standards on its members. The PCAOB was given the legal authority to develop independence and ethical standards, quality control standards, and auditing and attestation standards that apply to public company auditors and integrated audits. The PCAOB also is charged with performing inspections of registered audit firms, and may sanction the firms for noncompliance with its standards and the provisions of SarbanesOxley Act. The state boards of accountancy regulate CPA firms and CPAs in the various states and jurisdictions. They have the authority to establish their own standards, but have generally adopted the standards of other bodies such as the PICPA and the PCAOB. A state board enforces its standards in its state or jurisdiction and has the authority to revoke a CPA firm or individual CPA’s right to practice in the state.

2.

Applicable Technical and Professional Standards •

It was inappropriate for Arnold 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 or she may help in the conduct of the audit as long as there is proper supervision and review.

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•

Because of the financial interest in whether the bank loan is granted, Arnold is not independent.

•

Arnold did not review the work or the judgments of the assistants and clearly failed to adhere to this standard.

•

Arnold accepted the engagement without considering the availability of competent staff. Arnold failed to supervise the assistants and did not adequately plan the work.

•

Arnold and the assistants did not obtain the require understanding of the entity and its environment, including internal control.

•

Arnold acquired no evidence that would support the financial statements. Merely checking the mathematical accuracy of the records and summarizing the accounts is inadequate.

•

Arnold's report makes no reference to applicable reporting framework. Because Arnold did not conduct a proper audit, the report should state that no opinion can be expressed.

•

In this case both the statements and the auditor's report lack adequate disclosures.

Although Arnold’s report contains an expression of opinion, such opinion is not based on the results of a proper audit. Arnold should disclaim an opinion because he failed to conduct an audit in accordance with Philippine Standards on Auditing (PSAs). 3.

(a) When the auditors discover illegal acts by a public client, they should consider three major factors. First, the auditors should consider the effect of the acts on the client's financial statements, including the possibility of fines and loss of business. To comply with the applicable reporting framework, the financial statements must reflect the material effects of illegal acts. Second, the illegal acts may affect the auditors' assessment of the integrity of management. In deciding whether to continue to serve the client, the auditors should consider the nature of the illegal acts and management's response to the acts after they are uncovered. Third, the auditors should consider whether the occurrence of the illegal act indicates that there is a material weakness in the company’s internal control over financial reporting.

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(b) The following courses of action are available to the auditors: (1)

The auditors could issue an unqualified opinion and take no further steps regarding the illegal activities. This course of action could be argued on the basis that the effect of the acts on the financial statements is not material. If the auditors take this course of action, they should also consider whether the illegal act and related actions by management and the board indicate a material weakness exists that would affect their report on internal control over financial reporting.

(2)

The auditors could issue a qualified opinion because the financial statements depart from the applicable reporting framework, in that they fail to disclose the illegal acts. This course of action could be argued on the basis that any illegal activities by the client are material, especially when management fails to take any steps to prevent the acts. If the auditors take this course of action, they should also consider whether the illegal act and related actions by management and the board indicate a material weakness exists that would affect their report on internal control over financial reporting.

(3)

The auditors could withdraw from the engagement, because the client's failure to take actions to prevent such activities indicates that Generic's management lacks sufficient integrity.

(c) We believe that the auditors should consider withdrawing from the engagement. Generic's top management seems far too complacent regarding these activities. Their refusal to take any action to prevent the acts in the future provides a signal to lower level management that top management approves of illegal acts. The auditors clearly should question the integrity of management in this situation. 4.

The following memorandum summarizes the response of Alice Borromeo, CPA, to the request of a client for extension of the attest function to the problem of pollution control. Dear Jenny: As much as I support your strenuous efforts to minimize air and water pollution from the manufacturing operations of your company, there are specific reasons which make it impossible for me as a CPA to attest to the extent of your accomplishments in this area along the lines you have suggested. When we perform the attest function with respect to your financial statements each year, we are expressing our professional opinion that your financial statements are prepared in conformity with certain standards, or applicable reporting framework.

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In order for us to attest to the effectiveness of your pollution control program, recognized standards would have to be established in this field. No such standards presently exist for a factory to the best of my knowledge. Of course the national government has set standards for exhaust emissions on automobile engines and we could, by retaining independent consulting engineers, obtain a basis for attesting to the compliance of a given automobile engine to those standards. We are quite willing to extend the attest function in various directions if we can find a basis for objective comparison of a given operation with a clearly defined standard. Perhaps your engineering department can develop some specific quantitative data on the industrial waste from your operations. We might then be able to perform the necessary examination of such data to enable us to attest to the validity of your representations as to your operations. Of course, this would not be the same thing as providing your relative position in the industry. After reviewing this possibility with your engineering staff, if you would like to discuss the matter further with us, we will be glad to meet with you. Sincerely, Alice Borromeo

CHAPTER 9 OVERVIEW OF RISK-BASED AUDIT PROCESS Questions 1.

In their investigation of a prospective client, the CPAs should assess the backgrounds and reputations of the prospect and its major shareholders, directors, and officers. Thus, inquiries are made of underwriters, bankers, and attorneys that conduct business with the prospective client. Also, the CPAs are required to make inquiries of the prospect's predecessor auditors to obtain information that might enter into the acceptance decision, such as information regarding the integrity of management. The prospect's financial reports, SEC filings, credit reports, and tax returns are used as sources of financial background information.

2.

An engagement letter is sent to the client by the auditors to make clear the nature of the engagement, any limitations on the scope of the audit, work to be performed by the client's staff, and the basis for computing the auditors' fee. The engagement letter represents the written contract for the engagement, and its primary objective is to prevent possible misunderstandings between the client and the auditors. It constitutes an executory contract between the auditors and the client.

3.

“Shopping for accounting principles” is a practice whereby management changes auditors to a CPA firm that is more likely to allow an accounting principle that has been the subject of dispute with the company’s prior auditors. A number of mechanisms serve to discourage the practice, including: (1) the requirements under PAS No. 84 for the successor auditors to inquire of the predecessors about the reasons for the change in auditors, (2) the SEC 8-K requirements for management to report the reasons for a change in auditors which also require the auditors to express their agreement with the details, and (3) the requirements under PAS No. 97 that require accountants who are being asked to provide a report on the accounting treatment of an prospective or completed transaction to consult with the client’s auditors to ensure that they have a complete understanding of the form and substance of the transaction. In addition, the Sarbanes-Oxley Act of 2002 requires the audit committee to assume responsibility for engaging, compensating, and overseeing the auditors.

4.

The approach described in the statement is not appropriate. Materiality depends on both the dollar amount and the nature of the item. For example, auditors apply a more rigorous standard of materiality in evaluating transactions between

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related parties and potentially illegal acts than they apply to misstatements in accounts. 5.

The two types of misstatements due to fraud are (1) misstatements arising from fraudulent financial reporting, and (2) misstatements arising from misappropriation of assets (sometimes referred to as defalcation). Fraudulent financial reporting is of more concern to the auditors because it typically results in effects that are much more material to the financial statements. Defalcations often are not material to the financial statements.

6. A business risk is a treat to achieving management’s objectives. There are many examples of business risks that may result in a risk of material misstatement of the financial statements. Two are shown below: Business Risk

Risk of Material Misstatement

Rapidly changing technology in the client’s industry may threaten to cause the client’s products to become obsolete.

Inventory may be overvalued because it is not valued at net realizable value.

Economic conditions in the industry may result in significant uncollectible accounts receivable.

Accounts receivable may be overvalued because the allowance for uncollectible accounts is not adequate.

7.

The audit procedures to be followed in a given engagement depend upon such factors as the risks of material misstatement of the financial statements, the assumption about the effectiveness of internal control, the auditors' estimates of materiality, the nature of the accounting records, the caliber of accounting personnel, and any special objectives of the engagement. Consequently, a separate, tailor-made audit program should be prepared for each audit engagement.

8.

The quotation is misleading because it implies that an audit program is no more than a checklist of instructions for inexperienced auditors. Actually, audit programs are essential to assessing that all work is performed and are used on virtually all audit engagements regardless of the amount of experience of the auditor. Also, a written audit program is required for all audits.

9.

The risk of material misstatement is the probability that an account, class of transactions, or disclosure is materially misstated. It consists of inherent risk (the risk of material misstatement without considering internal control) and control risk (the risk that internal control will fail to prevent or detect and correct the material misstatement).

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10. Significant risks often relate to nonroutine transactions and estimation transactions. Such transactions typically involve more subjective judgment than routine transactions and, therefore, they often have a higher risk of material misstatement. Significant risks may also be fraud risks. 11. Factors which may cause an audit engagement to exceed the original time estimate include the following: (1) Accounting records may not be up to date and complete. (2) Inadequacies in internal control may be discovered necessitating a more detailed audit than anticipated. (3) A significant risk, such as a fraud risk, may be discovered requiring an extension of audit procedures. (4) Fraud may be discovered, and an extended investigation may be authorized by the client to clarify the situation. (5) Inadequate supervision of audit staff may permit unnecessary or misdirected work to be performed. (6) Findings during the course of the audit may cause the client to request extension of the scope of the work. In some engagements, clients are charged at agreed daily or hourly rates for the time used to perform the audit. The difficulty of forecasting time requirements is a principal reason for the use of per diem rates rather than quoting a fee for the entire engagement. For many engagements, a maximum fee is agreed upon; this plan may, of course, force the auditing firm to absorb part of the cost of unexpected amounts of work. A decision as to charging the client for unusual amounts of time will involve consideration of all aspects of the engagement and prior relations with the client. Generally, however, the client should not be billed for excessive time attributed to audit inefficiencies (e.g. item (5) above). 12. Underreporting of time results in the CPA firm not billing the client for all of the time actually involved in rendering the professional services. Thus, the firm's revenue is being restricted. In addition, the underreporting will cause the firm to underestimate the amount of time required for future engagements. Thus, auditors on future engagements will be expected to perform audit procedures in an unrealistically short period of time. This interferes with the performance of an effective audit as well as the realistic evaluation of firm personnel.

Solutions Manual – Public Accountancy Profession

9-4 Cases 1.

a.

Prior to acceptance of the engagement, Argante & Tan should have communicated with the predecessor auditor regarding: • • • •

b.

The form and content of engagement letters may vary, but they would generally contain information regarding: • • • • • •

• • • • • • 2.

a.

Facts that might bear on the integrity of management. Disagreements with management concerning accounting principles, auditing procedures, or other significant matters. The predecessor’s understanding about the reason for the change. Any other information that may be of assistance in determining whether to accept the engagement.

The objective of the audit. The estimated completion date. Management’s responsibility for the financial statements. The scope of the audit. Other communication of the results of the engagement. The fact that because of the test nature and other inherent limitations of any system of internal control, there is an unavoidable risk that even some material misstatement may remain undiscovered. Access to whatever records, documentation, and other information may be requested in connection with the audit. Arrangements with respect to client assistance in the performance of the audit engagement. Expectation of receiving from management written confirmation concerning representations made in connection with the audit. Notification of any changes in the original arrangements that might be necessitated by unknown or unforeseen factors. Request for the client to confirm the terms of the engagement by acknowledging receipt of the engagement letter. The basis on which fees are computed and any billing arrangements.

Typical engagement letter generally includes the following: • The name and address of the person or persons who retained the auditor to perform the auditing services. • An opening paragraph that confirms the understanding of the auditor and the client. • A summary of significant events that lead to the retention of the services of the auditor.

Overview of Risk-Based Audit Process • • • • • • • • • b.

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A general description of the CPA firm that will conduct the examination. A statement that the examination will be performed in accordance with auditing standards. A description of the scope of the services to be rendered, which should establish the nature of the engagement. Any scope restrictions or special limitations and their effect on the auditor’s report. A statement regarding the auditor’s responsibility for the detection of fraud. An indication of the possible use of client personnel in connection with the audit work to be performed. A statement that the auditor will provide a management letter if required in the circumstances. The method and timing of billings as well as billing rates and fee arrangements. Space for the client representative’s signature, which indicates “acceptance” of the letter and the understandings, therein.

The benefits of preparing an engagement letter include the avoidance of possible problems between the CPA and the client concerning (1) the scope of the work, (2) the service to be rendered, and (3) the audit fee. In addition, the “in-charge” auditor conducting the examination can avoid misunderstanding the nature and scope of the engagement if the engagement letter is included in the permanent section of the audit working papers. The letter should eliminate misunderstandings and confusion about the type of financial statements to be examined, the estimated report date, and the type of opinion expected. In addition to avoiding possible misunderstandings, any legal problems relating to the auditor’s failure to perform certain procedures can be reviewed with reference to the contractual commitment assumed. (For example, if scope limitations prevent the auditor from performing normal audit procedures, the auditor cannot be legally responsible if an irregularity is not detected when clearly it would have been detected if such procedures were performed.) The engagement letter is also useful as a reference document when preparing for future engagements.

c.

The CPA usually prepares the engagement letter as a follow-up to a verbal understanding that he and his client have reached. It is desirable that the client endorse and return an approved copy of the engagement letter to the CPA. It also is acceptable for the client to prepare his own letter summarizing his understanding of the nature of the engagement.

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3.

d.

Preferably the engagement letter should be sent at the beginning of the engagement so that misunderstandings, if any, can be remedied.

e.

Obviously, the engagement letter will be most useful in clarifying misunderstandings on a first engagement. But it is desirable that the letter be renewed periodically. Client personnel or the nature of the engagement may change, and the resubmission of the letter gives both parties an opportunity to review the circumstances. Accordingly, for recurring examinations of financial statements, it is appropriate to prepare an engagement letter at the start of each examination. For other continuing engagements, the engagement letter also should be updated periodically – probably on a yearly basis.

a.

The procedures that Francis should follow prior to accepting the engagement include the following: (1) Francis should explain to Nikolai the need to inquire of Jo and should request permission to make such inquiries. (2) Francis should request that Nikolai authorize Jo to respond fully to all of Francis’ inquiries since Jo would be prohibited from disclosing confidential information obtained in the course of his professional engagement with Nikolai. (3) Francis should advise Jo of Nikolai’s decision to change auditors as an act of professional courtesy. (4) Francis should make reasonable inquiries of Jo regarding matters that will aid in deciding whether to accept the engagement. (Francis’ inquiries should include questions regarding facts which might bear on the integrity of management, disagreements with management as to accounting principles, auditing procedures or other significant matters, and Jo’s understanding of the reason(s) for the change of auditors.) (5) Francis should weigh all the information received from Jo. If Jo does not respond fully to Francis’ questions, Francis should consider the implications of the limited response in deciding whether to accept the engagement. (6) After weighing all information received from Jo, Francis should inform Nikolai that a first-time audit is more time-consuming than a recurring audit because the new auditor is generally unfamiliar with client’s operations and does not have the benefit of past knowledge of company affairs to use a guide. (7) A discussion with Nikolai of the estimated required audit time and fee arrangement should be coordinated with a clear explanation of the purpose and scope of the audit. Any work that can be done by client

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personnel should also be discussed so that excess audit time might be eliminated and proposed report deadlines can be reasonably met. (8) To satisfy Francis’ quality control objectives, Francis should use procedures such as reviewing the financial statements of Nikolai; inquiring of third parties such as Nikolai’s banks, legal counsel, investment bankers, and others in the business community as to Nikolai’s reputation; and evaluating his ability to serve Nikolai properly with reference to industry expertise, size of engagement, and available staff. (9) If Francis has no reservations, after all significant factors have been considered, discussed, and agreed to, Francis should accept the engagement and confirm the understanding in an engagement letter. b.

Francis’ procedures on this first-time audit should include the following: (1) Francis should review the workpapers of Jo to obtain information that will help plan the audit work. (2) Francis should make arrangements as early as possible for the initial meeting with “key” company personnel who will be contacted throughout the engagement. (3) Since basic information about the company is not readily available to Francis on this first-time audit, information of a general nature should be obtained as early in the planning stage as possible. (Such information should include company history, nature of the business, credit policies, financing methods, sales methods and terms, seasonal business patterns, products, services, plant locations, internal procedures, accounting policies, tax status, etc. Client procedures manuals and manuals of accounts should be read to obtain such information.) (4) Francis should immediately start obtaining the data needed to create a permanent working paper file. (The file should include items such as articles of incorporation, minutes, internal audit reports, deeds of trust, pension agreements, loan agreements, leases, important contracts, and other pertinent data.) (5) Francis must determine the scope of work necessary to verify the opening balances. Such balances must be reviewed to determine whether they are stated on a basis comparable with those of the period under review. If Francis cannot verify the opening balances, Francis should consider disclaiming an opinion on the earnings statement and statement of changes in financial position. (6) The composition of all important accounts should be reviewed. Francis should limit his examination of prior period accounts to a review or

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survey of such accounts, without a detailed examination, unless the results of Francis’ survey and analyses indicate the need for further investigation of accounting methods in the prior years. (7) Francis must consider whether the financial statements are prepared using financial reporting standards that were consistently applied. If, after performing necessary audit procedures, Francis cannot be satisfied as to consistency, considerations must be given to qualifying the auditor’s report as to consistency. Francis should use professional judgment to determine the extent of reliance that should be placed on the work of Jo. The scope of Francis’ work may be reduced as a result of Francis’ consultation with Jo and a review of the prior-year workpapers of Jo. 4.

a.

A CPA can use the following sources of information to help decide whether to accept a new audit client. Financial information prepared by the prospective client: Annual reports to shareholders Interim financial statements Securities registration statements Annual report on SEC Reports to regulatory agencies Inquiries directed to the prospect’s business associates: Banker Legal counsel Underwriter Other persons, e.g., customers, suppliers Predecessor auditor, if any, communication, re: Integrity of management, Disagreements with management Analysis: Special or unusual risk related to the prospect Need for special skills (e.g., computer or industry expertise) Internal search for relationships that would comprise independence

b.

Students can decide this acceptance question either way, although the brief facts prejudice the conclusion toward nonacceptance. The CPA’s own firm decided to resign only 10 years ago, presumably over matters of ownermanager integrity. Yet, Mr. Sello appears to be a respected member of his new community. Maybe his “fast and loose” accounting past is behind him. Maybe not.

Overview of Risk-Based Audit Process 5.

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Benefits of engagement letters are: •

Helps establish an understanding between client and auditor of the terms of the engagement and the nature of the work.

•

Helps avoid quarrels and misunderstandings between client and auditor.

•

Helps avoid disputes over the audit fee.

•

Helps avoid legal liability assertions based on failure to do work that the CPA may not have contemplated or agreed to do.

CHAPTER 10 UNDERSTANDING THE ENTITY Questions 1.

A business risk is a treat to achieving management’s objectives. There are many examples of business risks that may result in a risk of material misstatement of the financial statements. Two are shown below: Business Risk

Risk of Material Misstatement

Rapidly changing technology in the client’s industry may threaten to cause the client’s products to become obsolete.

Inventory may be overvalued because it is not valued at net realizable value.

Economic conditions in the industry may result in significant uncollectible accounts receivable.

Accounts receivable may be overvalued because the allowance for uncollectible accounts is not adequate.

2.

An audit plan provides essential background information for an audit assignment, and outlines the objectives, timing, staffing, special risks and considerations, and other requirements of the engagement. An audit program is a detailed outline of the auditing work to be performed, specifying the procedures to be followed in verification of each item in the financial statements. Although both the audit plan and the audit program are technically plans, the audit plan serves more as a broad overview of the engagement, while the audit program is more specific and limited in scope.

3.

The purpose of the team meeting on fraud risk is designed to allow the more experienced team members to share insights and exchange ideas about how and where the entity’s financial statements might be susceptible to material misstatement due to fraud, to discuss how to design appropriate tests to detect the misstatements, and to emphasize the importance of maintaining the proper degree of professional skepticism regarding the possibility of fraud.

4.

During the planning process, the auditors make preliminary estimates of both risk and materiality for the engagement. The auditors must plan their engagements to reduce the audit risk of issuing an unqualified opinion on materially misstated financial statements to a relatively low level. At the account balance level, audit risk actually has three components: (1) inherent risk, (2) control risk, and (3) detection risk. On audits where the risk of

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Solutions Manual – Public Accountancy Profession misstatement is relatively high, the auditors must compensate by increasing the effectiveness of their audit procedures. They may design more effective procedures, increase the number of items selected for testing, or perform more procedures at the balance sheet date rather than at an interim date. They may also add an element of unpredictability to the procedures. The auditors' preliminary estimates of levels of materiality also affect the nature, timing, and extent of their planned procedures. Materiality levels determine which accounts are significant enough to require audit, affect the size of the test samples, and determine the dollar amount of individual items that warrant examination.

5.

(a) Auditors must obtain an understanding of the client and its environment in order to determine whether the client should be accepted and to plan the audit. This understanding encompasses the following: (1) The nature of the client, including the client’s application of accounting policies—The auditors’ understanding of this area will include the client’s competitive position, organizational structure, accounting policies and procedures, ownership, capital structure, and product lines. The understanding will also encompass an understanding of the client’s business model and its major business processes. (2) The industry, regulatory, and other external factors—The factors included here are industry conditions, such as the competitive environment, supplier and customer relationships, and technological developments. They also include the regulatory, legal, and political environment, and general economic conditions. (3) Objectives and strategies and related business risks—The auditors obtain an understanding of the operating and financing strategies of management. They also obtain an understanding of management’s risk assessment process. This assists the auditors in identifying significant business risks that may create risks of material misstatement of the financial statements. (4) Methods of measuring and reviewing performance—The auditors obtain an understanding of the methods management uses to measure and review performance at various levels within the organization. These methods are important to determining incentives of management and other employees. The measures may also be used in designing effective analytical procedures. (5) Internal control—The auditors’ understanding of internal control assists them in planning the audit and assessing control risk.

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(b) Sources of information on prospective clients include trade publications, and governmental agency publications. Previous audit reports, annual reports to stockholders, SEC filings, and prior years' tax returns are excellent sources of financial background information. Informal discussions between the auditors and key officers can provide information about the history, size, operations, accounting records, and controls of the enterprise. Inquiries of others within the organization can provide information that confirms inquiries of management, and provides more detailed information about risks and business processes. Inspection of internal documents and records can provide information about the nature of the client’s operations and internal control. The predecessor auditor may also provide information. (c) Knowledge of the client and its environment helps the auditors in: (1) Identifying areas that may need special consideration. (2) Identifying significant business risks that may result in risks of material misstatement of the financial statements. (3) Assessing inherent risk and making preliminary assessments of control risk. (4) Making judgments about the appropriateness of accounting principles in use and the adequacy of disclosures. (5) Evaluating the reasonableness of estimates, such as depreciation lives and the allowance for doubtful accounts. (6) Evaluating the reasonableness of management representations. (7) Developing an efficient audit strategy. (8) Determining the staffing requirements of the engagement. 6.

During the tour of the client's plant facilities, Sison inspects all inventory areas and makes note of the location, types, security, "housekeeping," and general condition of the inventories. He also visits the receiving and shipping departments and reviews the types of documents maintained. His observations in these areas enable him to form a preliminary impression of the adequacy of internal controls for inventories, and possible problems with respect to obsolete or slow-moving inventories. He also can begin formulating plans for staffing and carrying out the physical inventory observation. Sison’s observation of the productive processes will acquaint him with the client's physical plant facilities and layout, the nature of the products and computer applications employed in the production process. He may also obtain information on the client's documentation such as for production orders, raw materials requisitioned to production, direct and indirect labor, and inspection and testing of finished products. He meets the supervisory personnel, engineers, and other key personnel responsible for production, and through inquiries and conversations learns of any unique production problems, including excessive

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Solutions Manual – Public Accountancy Profession spoilage and scrap. As a result, he will be in a position to evaluate the client's cost accounting system during the course of the audit. He will also inquire about the details of the client’s business processes. Throughout the tour, Sison will add to his impression of the client's business processes, control procedures and accounting records. He will notice, for example, what personnel have access to computer terminals and accounting records, whether plant assets have identification tags, and whether documents such as production orders and receiving reports are serially numbered or controlled by the computer.

7.

(a) Misstatements due to fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in the financial statements to deceive financial statement users. Misstatements arising from misappropriation of assets (sometimes referred to as defalcation) involve the theft of an entity’s assets where the effect of the theft causes the financial statement not to be presented in conformity with generally accepted accounting principles. (b) The three conditions necessary for the commission of fraud include: (1) some type of incentive or pressure, (2) an opportunity to commit the fraud, and (3) an attitude that allows the individual to rationalize the act. In a case of fraudulent financial reporting, members of top management may have an incentive to commit the act relating to maintaining the value of their stock options. They may have an opportunity based on weaknesses in the corporate governance of the organization. Finally, they may be able to rationalize the act by assuming that the company will make enough income next period to allow them to correct the misstatement. (c) The auditors may respond to fraud risks by (1) a modification in the approach having an overall effect on how the audit is conducted, (2) an alteration in the nature, timing, and extent of the procedures performed, and (3) performance of procedures to further address the risk of management override of internal control.

8.

(a) Shin may respond to fraud risks in the following three ways: (1)

A modification in the overall approach to the audit which might involve: (a) Applying increased professional skepticism and designing procedures that provide more reliable evidence.

(b) Assigning additional staff with specialized skill and knowledge or by assigning more experienced staff to the engagement. Also the

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extent of the supervision of the staff should be adjusted to reflect the fraud risks. (c) Giving further consideration to the appropriateness of the accounting principles used by the client. (d) Incorporating an added element of unpredictability in the selection of auditing procedures. (2) An alteration in the nature, timing and extent of the procedures performed. For example, Shin might apply procedures that provide more reliable evidence, shift more audit tests to year-end, or increase sample sizes for certain substantive tests. (3) Perform procedures to further address the possibility of management override of internal control, including (1) examining journal entries and other adjustments for evidence of fraud, (2) reviewing accounting estimates for biases, and (3) evaluating the business rationale for significant unusual transactions. (b) Whenever the auditors believe that there is evidence that fraud may exist, the matter should be brought to the attention of an appropriate level of management. Fraud involving senior management and fraud that causes a material misstatement of the financial statements should be reported directly to the audit committee. In very serious situations the auditors should consider resigning the engagement. Multiple Choice Questions 1. 2. 3. 4. 5.

d a d d d

6. 7. 8. 9. 10.

d d d d d

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Solutions Manual – Public Accountancy Profession

Cases 1.

(1) (a) There is an increased risk of fraudulent financial reporting by subsidiary management. More specifically, subsidiary management would likely attempt to increase revenue or decrease expenses. (b) The auditors would probably respond by performing more procedures at the subsidiary location. Additional tests of revenue would be performed and the auditors would likely decide to observe inventory at year-end. In addition, some of the procedures may be performed on an unannounced basis. (2) (a) There is an increased risk of fraudulent financial reporting by management related to revenue. (b) The auditors would likely respond by utilizing more experienced audit team members. Specifically, audit staff that had experience with complex revenue contracts in the telecommunications industry. They would also likely increase the extent of the substantive tests of revenue. (3) (a) There is an increased risk that the futures traders will fraudulent overstate the value of the contracts to increase their compensation. (b) The auditors would likely respond to this situation by bringing in a specialist to assist in valuing the contracts. In addition, they would do extensive testing of the valuation of the contracts. (4) (a) There is an increased risk that management may be fraudulently overstating income at one or more of the stores. (b) The auditors would likely respond by doing increased testing of revenue and inventory at the stores. The auditors could use the results of the analytical procedures to identify stores that are more likely to have fraudulent reported results (e.g., those with unusually high profit margins). The auditors also may not disclose the locations that they intend to visit for inventory observation.

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Mr. Gian Lee President Palace Corporation Dear Mr. Lee: Our recent tour of Palace's plant was a most pleasant and interesting experience. The information obtained on this tour and during the discussion of your financial statements and accounting records has enabled us to plan the scope of an audit especially suited to your needs. Our fees are based on the time spent on the engagement by various members of our audit staff, and will be billed at our established rates. The total time required for an initial engagement is usually somewhat greater than in repeat examinations, since the latter do not require analysis of past years' transactions. Considerable savings in the cost of the audit may be made by utilizing the services of your accounting staff to help us in certain phases of the work. We can arrange for your employees to prepare for us a number of working papers. If you approve, we shall indicate to your chief accountant the exact nature of the working papers to be prepared. Our audit will be performed in accordance with generally accepted auditing standards and will include all procedures which we consider necessary to provide a basis for expression of our opinion on the fairness of the financial statements. The audit will include: (1) A consideration of the internal control. (2) Tests of the financial statement accounts and balances to the extent we consider necessary, based on our consideration of risks and internal control. (3) Preparation of the federal and state income tax returns. (4) Issuance of our auditor's report upon your financial statements. If our investigation indicates the desirability of any changes in internal control procedures, we shall prepare a report on this subject for your consideration. However, an audit cannot be relied upon to identify all weaknesses in internal control. The purpose of our audit is to enable us to express an opinion on the fairness of the financial statements; the audit is designed to provide reasonable, but not absolute, assurance of detecting material fraud and defalcations, and we will notify you if our audit does bring them to light. Although it is not possible to determine in advance the exact number of days required for the engagement, our estimates indicate that the total fee will be

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Solutions Manual – Public Accountancy Profession between ___________ and _________. The audit will be completed and our report submitted by March 1, 2014. We would like an opportunity during the next few days to discuss with you and your chief accountant the nature of the preliminary work to be done by your staff. We shall also be pleased to answer any further questions which you may have concerning the determination of audit fees. Very truly yours, Chariya, Modena and Company, CPAs

CHAPTER 11 CONSIDERATION OF INTERNAL CONTROL IN A FINANCIAL STATEMENTS AUDIT Questions 1.

An auditor obtains an understanding of a client’s internal control structure as a part of the control risk assessment process in order (1) to plan the nature, timing, and extent of subsequent substantive audit procedures, and (2) to obtain information about reportable conditions (control deficiencies) to report to the client.

2.

The primary reason for conducting an evaluation of a client’s existing internal control system is to give the auditors a basis for finalizing the details of the account balance audit program – to determine the nature, timing and extent of subsequent substantive audit procedures. A secondary purpose for conducting an evaluation of internal control is to be able to make constructive suggestions for improvements. Officially, the profession considers these suggestions a part of the audit function and does not define the work as a MAS consultation. Another purpose of the evaluation is to report to management and the board of directors or its audit committee any discovery of “any reportable conditions” of internal control deficiencies.

3.

Refer to page 590, 1st paragraph of the textbook.

4.

1.

Advantages of control questionnaire: Easy to complete. Checklist of questions. Less chance of overlooking something important. Disadvantages: May contain numerous irrelevant questions. Tendency to treat it like another form to fill out.

2.

Advantages of memorandum documentation: Can explain the precise controls applicable to the particular client. (precise tailoring) Requires penetrating analysis. Minimizes tendency toward perfunctory review.

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Solutions Manual – Public Accountancy Profession Disadvantages: Hard to write. Often lengthy. Hard to revise in subsequent years. 3.

5.

Advantages of flowchart: Graphic presentation of systems. Shows the steps required and the flow of forms and documents. Easy to read and analyze. Easy to update in subsequent years. Disadvantages: Takes some time to draw neatly.

“Observation,” in a test of control procedure, refers to auditors looking to see whether client personnel stamped, initialed, or left other signs that their assigned control procedures had been performed. “Reperformance,” in a test of control procedure, refers to auditors doing again the control that was supposed to have been performed by the client personnel (recalculating, looking up the right price, comparing quantities, and so forth).

6.

Written reports on internal accounting control (IAC) for external use. Type of Engagement Special IAC study

Character of Report Report on IAC with opinion on IAC system taken as a whole.

Service auditor engaged to report for benefit of user auditor and their mutual client.

A special-purpose report on IAC can take special forms, the main feature of which includes an opinion relating to the controls applied by the service organization to the client organization’s transactions.

7.

The auditor must obtain a sufficient understanding of the client’s system of internal financial controls to identify the types of potential material misstatements of financial statement components, and the risks associated with each. Such understanding is obtained by gathering evidence relating to the basic elements of the client’s internal financial controls.

8.

The auditor obtains an initial understanding of the client’s financial controls by studying the organizational structure, inquiring of management, and studying last year’s working papers if a recurring audit.

9.

The documentation of the auditor’s understanding must provide clear evidence of support for the auditor’s conclusions regarding the assessed level of control risk. This is especially necessary if control risk is assessed below the maximum

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level. The documentation at this point typically consists of some combination of narrative memoranda, questionnaires or checklists, and internal control flowcharts, as well as documentation of the auditor’s conclusions, and the reason(s) for assessing control risk below maximum, if applicable. 10. Testing of internal financial controls may permit the auditor to further reduce the assessed level of control risk. This, in turn, should lead to a decrease in the nature, timing, and/or extent of substantive audit testing in the circumstances. 11. The following factors may cause the auditor to decide not to test the client’s internal financial controls beyond obtaining an initial understanding: a. b.

Controls may already have been evaluated as ineffective; Further testing is not cost effective (i.e., the cost of further testing is greater than the cost savings resulting from reduced substantive testing)

12. Some combination of the following means is typically utilized by the auditor in testing a client’s internal financial controls: a. b. c.

Reprocessing transactions through the client’s system; Observation of controls; and Document examination and testing.

13. Misrepresentation is a form of financial statement misstatement caused by intentional efforts by management to distort reported financial position and/or results of operations. Misappropriation is a form of fraud whereby one or more employees effect a transfer of assets from employer to employee, accompanied by concealment in the form of account or substance alteration. 14. The following are some examples of internal control weaknesses and suggested expanded substantive testing, given the weaknesses: a. b. c.

Perpetual inventory records not maintained: Expand test counts during inventory observation Bank accounts not reconciled: Expand year-end audit of cash accounts Customer exceptions to monthly statements not investigated and cleared: Expand accounts receivable confirmation at year-end.

15. Reportable conditions are matters coming to the auditor’s attention, as a result of his/her study and evaluation of the client’s internal financial controls, relating to significant deficiencies in the design or operation or of the internal controls that could adversely affect the organization’s ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements. The purpose of the reportable conditions letter is to inform the audit committee, or similar body within the organization, of weaknesses for which they may not be aware. Such communication increases the likelihood that the weaknesses will be corrected on a timely basis.

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16. Use of any one of the approaches to studying and documenting a client’s internal financial controls, by itself, is inadequate. Each approach adds a needed dimension to the analysis. The memorandum requires depth of analysis not found in the flowchart. The flowchart, on the other hand, promotes ease of understanding and ready identification of strengths and weaknesses in controls. The questionnaires and checklists add the dimension of completeness of coverage. By using the three tools in combination, the auditor is able to gain a deeper and clearer understanding of each of the subsets of the transaction cycles, including major control strengths and weaknesses, thereby permitting more accurate control risk assessments and more useful substantive audit programs based on such assessments. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7.

b a b d b b b

8. 9. 10. 11. 12. 13. 14.

a b c b a b b

15. 16. 17. 18 19. 20. 21.

d c b b a d a

22. 23. 24. 25. 26. 27. 28.

a a d b d b d

Cases 1.

a.

b.

Given identified financial control weaknesses, the auditor may elect to expand the extent of substantive testing, or search for and test compensating controls. In the present case, the following errors and irregularities may occur, given the control weaknesses in the payroll subset of the expenditure cycle: 1.

Hours may be in error, inasmuch as the time cards are prepared by employees and not reviewed. This could lead to overstatement or understatement of wages expense in the income statement. This could also affect the carrying value of finished goods inventories if Quicky is a manufacturing company.

2.

The payroll could be “padded” inasmuch as signed checks are returned to the department supervisors for distribution. This could result in overstatements of salaries and wages expense on the income statement. It could also cause a finished goods inventory overstatement.

If, based on the initial understanding, controls are thought to be adequate, the auditor should consider the following alternatives:

Consideration of Internal Control in a Financial Statements Audit

c.

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1.

Document the understanding, assess control risk below maximum, as considered appropriate, and document the basis for conclusions; or

2.

Document the understanding and test controls as a means for further reduction in the assessed level of control risk. This alternative would be chosen if the following conditions exist: a.

Controls are thought to be effective; and

b.

Cost reductions through reduced substantive testing exceed cost of further testing of controls.

1.

Auditors must study and evaluate internal control each year because the environment within which the client operates is subject to constant change; and controls must adapt to these changes if the system is to remain effective. The auditor must identify the environmental changes and determine that the relevant control points remain covered after the changes.

2.

A minimum audit is necessary, even under conditions of excellent internal control, because of the following inherent limitations in all internal control systems: Internal control assumes the nonexistence of collusion; Management can override the financial controls; Temporary breakdowns in the control system may occur and produce material errors; Given that these inherent limitations could produce material financial statement misstatements, and given that the audit report provides reasonable assurance that the financial statements do not contain material misstatements, the auditor must perform a minimum audit, even under conditions of excellent internal control if such assurance is to be provided.

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Solutions Manual – Public Accountancy Profession

2. ISLANDER DRUG STORE, INC. Processing Cash Collections Internal Control Questionnaire -Question Are customers who pay by check identified via store I.D. card or other means? Does company policy prohibit accepting checks for anything except merchandise sales plus a nominal cash amount? Is a receipt produced by the cash register given to each customer? Is the reading of each cash register taken periodically by an employee who is independent of the handling of cash receipts? Are cash counts made on a surprise basis by an individual who is independent of the handling of cash receipts? Is the reading of each cash register compared regularly to the cash received? Is a summary listing of cash register readings prepared by an employee who is independent of physically handling cash receipts? Are receipts forwarded to an independent employee who makes the bank deposits? Are each day’s receipts deposited intact daily? Is the summary listing of cash register receipts reconciled to the duplicate deposit slips authenticated by the bank? Are entries to the cash receipts journal prepared from duplicate deposit slips or the summary listing of cash register readings? Are the entries to the cash receipts journal compared to the deposits per bank statement? Are areas involving the physical handling of cash reasonably safeguarded? Are employees who handle receipts bonded? Are charged back items (NSF checks, etc.) directed to an employee who does not physically handle receipts or have access to the books?

Yes

No

CHAPTER 12 FRAUD AND ERROR Questions 1.

Holding a belief that a potential conflict of interests always exists causes auditors to perform procedures to search for errors or irregularities that would have a material effect on financial statements. This tends to make audits more extensive for the auditor and more expensive for the client. The situation is not a desirable one in the vast majority of audits where no errors or irregularities exist.

2.

Errors and irregularities: Auditors are required to plan the audit to detect errors and irregularities that would have a material effect on the financial statements. Clients’ illegal acts: Auditors are not required to search for illegal acts, but they are warned to be alert to any that might be detected in the ordinary course of an audit.

3.

Seven major assertions in financial statements: a.

Existence assertion: The practical objective is to establish with evidence that assets, liabilities and equities actually exist and that sales and expense transactions actually occurred. Cut-off can be considered an aspect of the existence assertion.

b.

Occurrence assertion: The practical objective is to establish with evidence that recorded transactions or events that occurred during a given accounting period pertained to the entity.

c.

Completeness assertion: The practical objective is to establish with evidence that all transactions of the period are in the financial statements and all transactions that properly belong in the preceding or following accounting periods are excluded. Another term for these aspects of completeness is cut-off. Completeness also refers to proper inclusion in financial statements of all assets, liabilities, revenue, expense, and related disclosures.

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Solutions Manual – Public Accountancy Profession d.

Rights and Obligations assertion: The practical objectives related to rights and obligations are to establish with evidence that assets are owned (or rights such as capitalized leases are shown) and liabilities are owed.

e.

Measurement assertion: The practical objective is to establish with evidence that a transaction or event is recorded at the proper amount and revenue or expense is allocated to the proper period.

f.

Valuation assertion: The practical objective is to establish with evidence that proper values have been assigned to things (assets, liabilities, equities and related disclosures) and events (revenues, expenses and related disclosures). Auditing Standards refer to the practical objective of obtaining evidence about “valuations” achieved by cost allocations such as depreciation and inventory costing methods.

g.

Presentation and Disclosure assertion: The practical objective is to establish with evidence that accounting principles used by management are appropriate in the circumstances and are applied properly, and that disclosures contain all information required by generally accepted accounting principles.

4.

Benefits of preliminary assessment of materiality: Fine-tune the audit for effectiveness and efficiency. Help auditors avoid surprises related to: Finding out too late about not auditing enough. Finding out later about auditing too much. Is P500,000 material? Maybe. Absolute size. If you think so, it’s material just because it’s a large number. Relative size. No. If P500,000 is less than 5% of a relevant base. Maybe. If P500,000 is between 5% and 10% of a relevant base. Yes. If P500,000 is 10% or more of a relevant base. Nature of the item. Yes, P500,000 is material if it arises from an illegal act.

5.

Yes, auditors have credited discovery of errors and irregularities to analytical review procedures in 27.1% of the cases in a set of audits, and another 18.5% discovery rate was attributed to “prior expectations” and “discussions.”

Fraud and Error 6.

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In assessing inherent risk and control risk, the auditor must consider the types of errors or irregularities that might occur and their impact on the financial statements (materiality.) In evaluating materiality, the auditor should consider the impact of errors and irregularities both individually and in the aggregate. Auditing Standards require that the auditor design the audit to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements. Auditing Standards require that audit risk and materiality be considered both in planning the audit and in evaluating audit results. Control risk and inherent risk are also directly related to the setting of materiality thresholds. If, for example, application of analytical procedures (inherent risk analysis) leads the auditor to suspect earnings inflation, individual item materiality thresholds should be reduced accordingly (i.e., either the materiality percentage or the amount of unaudited income should be decreased.) Similarly, if control risk analysis leads the auditor to suspect numerous errors, aggregate materiality thresholds need to be lowered accordingly.

7.

An auditor’s reaction to an immaterial error may differ from his or her reaction to an immaterial irregularity. Auditors generally accumulate the amount of individual immaterial errors to be sure that the aggregate of all errors is not material. In addition, the auditor is concerned about whether an error came from a misunderstanding or other cause that would have resulted in yet more errors during the period. An auditor is expected to report all irregularities to the audit committee or the board of directors and senior management.

8.

Refer to pages 436 to 437 of the textbook.

9.

Refer to pages 440 to 441 of the textbook.

10. Refer to page 430 of the textbook. 11. The factors that should be considered are the peso amount of the account, the likelihood of error, and the cost of auditing the account. 12. The auditor deals with both inherent risk and control risk during the planning phase of the audit. Inquiry of client personnel, study of the business and industry, application of analytical procedures, and documentation of the auditor’s initial understanding of internal control are all performed during the planning phase of the audit. Further study of internal control procedures may occur after the planning phase if the auditor wishes to further reduce the assessed level of control risk, and considers it economically feasible to do so.

Solutions Manual – Public Accountancy Profession

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Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

d c c b d a c d c d

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

d a c c a a a d b d

21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

b d d c d a b a a b

31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

b a d a d d c b a a

41. 42. 43. 44. 45. 46. 47. 48. 49. 50.

b d a c c d d c b d

51. 52. 53. 54. 55. 56. 57. 58. 59. 60.

a a b a c d b d d c

61. a 62. c 63. d

Cases 1.

a.

Antonio’s activity is an irregularity (intentional distortion of financial statements) rather than error (unintentional mistake). It is also an illegal act on Antonio’s individual part.

b.

The problem does not describe the kind of related party transactions discussed in PSA 550.

c.

Yes, a weakness in internal control exists. It may be considered a material weakness because the compensating control (internal auditors’ work on slow-moving inventory) did not operate in a timely enough manner to detect the irregularity before it had gotten large. If a material weakness in internal control exists, Brava & Campos are obligated to report it to management and/or the board of directors.

2.

d.

The problem description indicates that this element of the audit was conducted in a negligent manner. There’s nothing wrong about auditing a sample of the transactions, but Campos’ follow-up and explanation of the missing receiving reports leaves much to be desired. At the very least he could have reviewed the reports produced by Antonio at a later date, and he could have traced the purchases to the inventory records and perhaps noticed an over-stocking condition. The auditors had some evidence that an irregularity might exist, but they failed to apply extended audit procedures properly.

a.

Yes. Nicolas was a party to the issuance of false financial statements and as such is a joint tortfeasor. The elements necessary to establish an action for common law fraud are present. There was a material misstatement of fact, knowledge of falsity (scienter), intent that the plaintiff bank rely on the false statement, actual reliance and damage to the bank as a result thereof. If

Fraud and Error

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action is based upon fraud there is no requirement that the bank establish privity of contract with the CPA. Moreover, if the action by the bank is based upon ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party beneficiary (an exception to the strict privity requirement). Thus, the bank will be able to recover its loss from Nicolas under either theory. b.

No. The lessor was a party to the secret agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if he was damaged indirectly, his own fraudulent actions led to his loss, and the equitable principle of “unclean hands” precludes him from obtaining relief.

c.

Nicolas was not independent. His report is improper and he is probably subject to disciplinary action by the professional organization or regulatory body. According to the ethics interpretation on actual or threatened litigation: “An expressed intention by the present management to commence litigation against the auditor alleging deficiencies in audit work for the client is considered to impair independence if the auditor concludes that there is a strong possibility that such a claim will be filed.”

CHAPTER 13 CORPORATE GOVERNANCE AND AUDITS Questions 1.

Corporate governance is defined as: “a process by which the owners and creditors of an organization exert control and require accountability for the resources entrusted to the organization. The owners (stockholders) elect a board of directors to provide oversight of the organization’s activities and accountability back to its stakeholders.” The key players in corporate governance are the stockholders (owners), board of directors, audit committees, management, regulatory bodies, and both internal and external auditors.

2.

In the past decade, all parties failed to a certain extent. For detailed analysis, see exhibit in the chapter and repeated here: Corporate Governance Responsibilities and Failures Overview of Corporate Governance Failures

Party Stockholders

Overview of Responsibilities Broad Role: Provide effective oversight through election of Board process, approve major initiatives, buy or sell stock.

Board of Directors

Broad Role: the major representative of stockholders to ensure that the organization is run according to the organization charter and there is proper accountability. Specific activities include: • Selecting management. • Reviewing management performance and determining compensation. • Declaring dividends • Approving major changes, e.g. mergers • Approving corporate strategy • Overseeing accountability activities.

Management

Broad Role: Operations and Accountability. Managing the organization effectively and provide accurate and

Focused on short-term prices; failed to perform long-term growth analysis; abdicated all responsibilities to management as long as stock price increased. • Inadequate oversight of management. • Approval of management compensation plans, particularly stock options that provided perverse incentives, including incentives to manage earnings. • Non-independent, often dominated by management. • Did not spend sufficient time or have sufficient expertise to perform duties. • Continually re-priced stock options when market price declined.

•

Earnings management to meet analyst expectations.

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Solutions Manual – Public Accountancy Profession Overview of Corporate Governance Failures

Party

Overview of Responsibilities timely accountability to shareholders and other stakeholders. Specific activities include: • Formulating strategy and risk appetite. • Implementing effective internal controls. • Developing financial reports. • Developing other reports to meet public, stakeholder, and regulatory requirements.

Fraudulent financial reporting. Pushing accounting concepts to achieve reporting objective. • Viewed accounting as a tool, not a framework for accurate reporting.

• •

Audit Committees of the Board of Directors

Broad Role: Provide oversight of the internal and external audit function and the process of preparing the annual accuracy financial statements and public reports on internal control. Specific activities include: • Selecting the external audit firm. • Approving any non-audit work performed by audit firm. • Selecting and/or approving the appointment of the Chief Audit Executive (Internal Auditor), • Reviewing and approving the scope and budget of the internal audit function. • Discussing audit findings with internal auditor and external auditor and advising the Board (and management) on specific actions that should be taken.

• Similar to Board members – did not have expertise or time to provide effective oversight of audit functions. • Were not viewed by auditors as the ‘audit client’. Rather the power to hire and fire the auditors often rested with management.

Self-Regulatory Organizations: AICPA, FASB

Broad Role: Setting accounting and auditing standards dictating underlying financial reporting and auditing concepts. Set the expectations of audit quality and accounting quality. Specific roles include: • Establishing accounting principles • Establishing auditing standards • Interpreting previously issued standards • Implementing quality control processes to ensure audit quality. • Educating members on audit and accounting requirements.

• AICPA: Peer reviews did not take a public perspective; rather than looked at standards that were developed and reinforced internally. • AICPA: Leadership transposed the organization for a public organization to a “trade association” that looked for revenue enhancement opportunities for its members. • AICPA: Did not actively involve third parties in standard setting. • FASB: Became more rule-oriented in response to (a) complex economic transactions; and (b) an auditing profession that was more oriented to pushing the rules rather than enforcing concepts. • FASB: Pressure from Congress to develop rules that enhanced economic growth, e.g. allowing organizations to not expense stock options.

Corporate Governance…

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Overview of Corporate Governance Failures Party Other SelfRegulatory Organizations, e.g. NYSE, NASD

Overview of Responsibilities Broad Role: Ensuring the efficiency of the financial markets including oversight of trading and oversight of companies that are allowed to trade on the exchange. Specific activities include: • Establishing listing requirements – including accounting requirements, governance requirements, etc. • Overseeing trading activities,

Regulatory Agencies: the SEC

Broad Role: Ensure the accuracy, timeliness, and fairness of public reporting of financial and other information for public companies. Specific activities include: • Reviewing all mandatory filings with the SEC, • Interacting with the FASB in setting accounting standards, • Specifying independence standards required of auditors that report on public financial statements, • Identify corporate frauds, investigate causes, and suggest remedial actions. Broad Role: Performing audits of company financial statements to ensure that the statements are free of material misstatements including misstatements that may be due to fraud. Specific activities include: • Audits of public company financial statements, • Audits of non-public company financial statements, • Other accounting related work such as tax or consulting.

• Identified problems but was never granted sufficient resources by Congress or the Administration to deal with the issues.

Broad Role: Perform audits of companies for compliance with company policies and laws, audits to evaluate the efficiency of operations, and audits to determine the accuracy of financial reporting processes. Specific activities include: • Reporting results and analyses to management, (including operational management), and audit committees, • Evaluating internal controls.

• Focused efforts on ‘operational audits’ and assumed that financial auditing was addressed sufficiently by the external audit function. • Reported primarily to management with little effective reporting to the audit committee. • In some instances (HealthSouth, WorldCom) did not have access to the corporate financial accounts.

External Auditors

Internal Auditors

• Pushed for improvements for better corporate governance procedures by its members, but failed to implement those same procedures for its governing board, management, and trading specialists.

• Pushed accounting concepts to the limit to help organizations achieve earnings objectives. • Promoted personnel based on ability to sell “non-audit products”. • Replaced direct tests of accounting balances with a greater use of inquiries, risk analysis, and analytics. • Failed to uncover basic frauds in cases such as WorldCom and HealthSouth because fundamental audit procedures were not performed.

13-4 3.

Solutions Manual – Public Accountancy Profession The board of directors is often at the top of the list when it comes to responsibility for corporate governance failures. Some of the problems with the board of directors included: o o

o o o 4.

Inadequate oversight of management. Approval of management compensation plans, particularly stock options that provided perverse incentives, including incentives to manage earnings. Non-independent, often dominated by management. Did not spend sufficient time or have sufficient expertise to perform duties. Continually re-priced stock options when market price declined.

Some of the ways the auditing profession was responsible were: • Too concerned about creating “revenue enhancement” opportunities for the firm, and less concerned about their core services or talents • Were willing to “push” accounting standards to the limit to help clients achieve earnings goals • Began to use more audit “shortcuts” such as inquiry and analytical procedures instead of direct testing of account balance. • Relied on management representations instead of testing management representations. •

Were too often ‘advocates’ of management rather than protectors of users

5.

Users should expect auditors to have the expertise, independence, and professional skepticism to render an unbiased and justified opinion on the financial statements. Auditors are expected to gather sufficient applicable evidence to render an independent opinion on the financial statements.

6.

Management is responsible for issued financial statements. Although other parties may be sued for what is contained in the statements, management is ultimately responsible. Ownership is important because it establishes responsibility and accountability. Management must set up and monitor financial reporting systems that help it meet its reporting obligations. It cannot delegate this responsibility to the auditors.

7.

An audit committee is a subcommittee of the board of directors that is composed of independent, outside directors. The audit committee has oversight responsibility (on behalf of the full board of directors and its stockholders) for the outside reporting of the company (including annual financial statements); risk monitoring and control processes; and both internal and external audit functions.

Corporate Governance… 8.

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An outside director is not a member of management, legal counsel, a major vendor, outside service provider, former employee, or others who may have a personal relationship with management that might impair their objectivity or independence. The audit committee is responsible for assessing the independence of the external auditor and engage only auditors it believes are independent. Auditors are now hired and fired by audit committee members, not management. The intent is to make auditor accountability more congruent with stockholder and third-party needs.

9.

The external auditor should discuss any controversial accounting choices with the audit committee and must communicate all significant adjustments made to the financial statements during the course of the audit. In addition, the processes used in making judgments and estimates as well as any disagreements with management should be communicated. Other items that need to be communicated include: • • • • • •

All adjustments that were not made during the course of the audit, Difficulties in conducting the audit, The auditor’s assessment of the accounting principles used and overall fairness of the financial presentation, The client’s consultation with other auditors, Any consultation with management before accepting the audit engagement, Significant deficiencies in internal control.

10. The auditor might utilize the following procedures in determining the actual level of governance in an organization: • •

• • •

observe the functioning of the audit committee by participating in the meetings, noting the quality of the audit committee questions and responses, interactions with management regarding issues related to the audit, e.g. o providing requested information on a timely basis, o quality of financial personnel in making judgments, o accounting choices that tend to ‘push the limits’ towards aggressiveness or creating additional reported net income, o the quality of internal controls within the organization. review the minutes of the board of directors meetings to determine that they are consistent with good governance, review internal audit reports and especially determine the actions taken by management concerning the internal auditor’s findings and recommendations, review the compensation plan for top management,

Solutions Manual – Public Accountancy Profession

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review management expense reimbursements to determine (a) completeness of documentation, (b) appropriateness of requested reimbursement, and (c) extent of such requests. review management’s statements to the financial press to determine if they are consistent with the company’s operations.

•

•

Multiple Choice Questions 1. 2. 3. 4. 5.

d d a d d

Cases 1.

a.

The auditor might use the following approaches to determine whether a corporate code of ethics is actually followed: observe corporate behavior in tests performed during the audit, e.g. approaches the company takes to purchasing goods, promoting personnel, and so forth, • observe criteria for promoting personnel; for example does performance always take on greater importance than how things are done, • observe corporate plans to communicate the importance of ethical behavior, e.g. webcasts, emails, and so forth to communicate the importance of ethics, • review activity on the client’s whistleblowing website, or a summary of whistleblowing activities reported by the internal auditor, • read a sample of self-evaluations by corporate officers, the board, and the audit committee and compare with the auditor’s observations of behavior, • examine sales transactions made during the end of quarters to determine if the sales reflect ‘performance goals’ as opposed to the company’s code of ethics. Are auditors equipped to make subjective judgments? This should be a great discussion question because many young people are attracted to the accounting profession because there are rules and relative certainty as to how things are done. However, as the profession is evolving, more judgments are required in both auditing and accounting. Audit personnel need to be equipped to make judgments on whether the company’s governance structure operates as intended and whether there are deficiencies •

b.

Corporate Governance…

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in internal control when it does not operate effectively. The profession believes that auditors can make such judgments. c.

Assessing the competence of the audit committee can occur in a number of ways. Fortunately, the most persuasive evidence comes from the auditor’s direct interaction with the audit committee on a regular basis. The auditor can determine the nature of questions asked, the depth of understanding shared among audit committee members, and the depth of items included in the audit committee agenda. Many audit committees have self-assessment of their activities using criteria developed by CPA firms, or by the National Association of Corporate Directors. The auditor should also review the minutes of the audit committee meetings and determine the amount of time spent on important issues. An external auditor should be very reluctant to accept an audit engagement where the audit committee is perceived to be weak. There are a number of reasons including: •

• •

d.

Internal auditing is an integral part of good corporate governance. contributes to corporate governance in three distinct ways: •

•

• 2.

a.

The lack of good governance most likely influences the organization’s culture and is correlated with a lack of commitment to good internal control. The auditor has less protection from the group that is designed to assist the auditor in achieving independence. The company may be less likely to be fully forthcoming in discussions with the auditor regarding activities that the auditor might question. It

It assists the audit committee in its oversight role by performing requested audits and reporting to the audit committee, It assists senior management in assessing the continuing quality of its oversight over internal control throughout the organization, It assists operational management by providing feedback on the quality of its operations and controls.

Corporate governance is defined as: “a process by which the owners and creditors of an organization exert control and require accountability for the resources entrusted to the organization. The owners (stockholders) elect

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Solutions Manual – Public Accountancy Profession a board of directors to provide oversight of the organization’s activities and its accountability to stakeholders.” The key players in corporate governance are the stockholders (owners), board of directors, audit committees, management, regulatory bodies, and auditors (both internal and external). b.

In the past decade especially, all parties failed to a certain extent. For detailed analysis, see exhibit 2.2 in the chapter and reproduced below: Corporate Governance Responsibilities and Failures Overview of Corporate Governance Failures Focused on short-term prices; failed to perform long-term growth analysis; abdicated all responsibilities to management as long as stock price increased.

Party Stockholders

Overview of Responsibilities Broad Role: Provide effective oversight through election of Board process, approve major initiatives, buy or sell stock.

Board of Directors

Broad Role: the major representative of stockholders to ensure that the organization is run according to the organization charter and there is proper accountability. Specific activities include: • Selecting management. • Reviewing management performance and determining compensation. • Declaring dividends • Approving major changes, e.g. mergers • Approving corporate strategy • Overseeing accountability activities.

• Inadequate oversight of management. • Approval of management compensation plans, particularly stock options that provided perverse incentives, including incentives to manage earnings. • Non-independent, often dominated by management. • Did not spend sufficient time or have sufficient expertise to perform duties. • Continually re-priced stock options when market price declined.

Management

Broad Role: Operations and Accountability. Managing the organization effectively and provide accurate and timely accountability to shareholders and other stakeholders. Specific activities include: • Formulating strategy and risk appetite. • Implementing effective internal controls. • Developing financial reports. • Developing other reports to meet public, stakeholder, and regulatory requirements.

• Earnings management to meet analyst expectations. • Fraudulent financial reporting. • Pushing accounting concepts to achieve reporting objective. • Viewed accounting as a tool, not a framework for accurate reporting.

Corporate Governance…

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Overview of Corporate Governance Failures • Similar to Board members – did not have expertise or time to provide effective oversight of audit functions. • Were not viewed by auditors as the ‘audit client’. Rather the power to hire and fire the auditors often rested with management.

Party Audit Committees of the Board of Directors

Overview of Responsibilities Broad Role: Provide oversight of the internal and external audit function and the process of preparing the annual accuracy financial statements and public reports on internal control. Specific activities include: • Selecting the external audit firm. • Approving any non-audit work performed by audit firm. • Selecting and/or approving the appointment of the Chief Audit Executive (Internal Auditor), • Reviewing and approving the scope and budget of the internal audit function. • Discussing audit findings with internal auditor and external auditor and advising the Board (and management) on specific actions that should be taken.

SelfRegulatory Organizations: AICPA, FASB

Broad Role: Setting accounting and auditing standards dictating underlying financial reporting and auditing concepts. Set the expectations of audit quality and accounting quality. Specific roles include: • Establishing accounting principles • Establishing auditing standards • Interpreting previously issued standards • Implementing quality control processes to ensure audit quality. • Educating members on audit and accounting requirements.

• AICPA: Peer reviews did not take a public perspective; rather than looked at standards that were developed and reinforced internally. • AICPA: Leadership transposed the organization for a public organization to a “trade association” that looked for revenue enhancement opportunities for its members. • AICPA: Did not actively involve third parties in standard setting. • FASB: Became more rule-oriented in response to (a) complex economic transactions; and (b) an auditing profession that was more oriented to pushing the rules rather than enforcing concepts. • FASB: Pressure from Congress to develop rules that enhanced economic growth, e.g. allowing organizations to not expense stock options.

Other SelfRegulatory

Broad Role: Ensuring the efficiency of the financial markets including oversight of trading

• Pushed for improvements for better corporate governance procedures by its

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Solutions Manual – Public Accountancy Profession Overview of Corporate Governance Failures members, but failed to implement those same procedures for its governing board, management, and trading specialists.

Party Organizations, e.g. NYSE, NASD

Overview of Responsibilities and oversight of companies that are allowed to trade on the exchange. Specific activities include: • Establishing listing requirements – including accounting requirements, governance requirements, etc. • Overseeing trading activities,

Regulatory Agencies: the SEC

Broad Role: Ensure the accuracy, timeliness, and fairness of public reporting of financial and other information for public companies. Specific activities include: • Reviewing all mandatory filings with the SEC, • Interacting with the FASB in setting accounting standards, • Specifying independence standards required of auditors that report on public financial statements, • Identify corporate frauds, investigate causes, and suggest remedial actions. Broad Role: Performing audits of company financial statements to ensure that the statements are free of material misstatements including misstatements that may be due to fraud. Specific activities include: • Audits of public company financial statements, • Audits of non-public company financial statements, • Other accounting related work such as tax or consulting.

• Identified problems but was never granted sufficient resources by Congress or the Administration to deal with the issues.

Broad Role: Perform audits of companies for compliance with company policies and laws, audits to evaluate the efficiency of operations, and audits to determine the accuracy of financial reporting processes. Specific activities include: • Reporting results and analyses to

• Focused efforts on ‘operational audits’ and assumed that financial auditing was addressed sufficiently by the external audit function. • Reported primarily to management with little effective reporting to the audit committee.

External Auditors

Internal Auditors

• Pushed accounting concepts to the limit to help organizations achieve earnings objectives. • Promoted personnel based on ability to sell “non-audit products”. • Replaced direct tests of accounting balances with a greater use of inquiries, risk analysis, and analytics. • Failed to uncover basic frauds in cases such as WorldCom and HealthSouth because fundamental audit procedures were not performed.

Corporate Governance… Party

• c.

Overview of Responsibilities management, (including operational management), and audit committees, Evaluating internal controls.

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Overview of Corporate Governance Failures • In some instances (HealthSouth, WorldCom) did not have access to the corporate financial accounts.

There is an inverse relationship between corporate governance and risk to the auditor i.e. the better the quality of corporate governance, the lower the risk to the auditor. This relationship occurs because lower levels of corporate governance implies two things for the auditor: •

•

There is more likelihood that the organization will have misstatements in its financial statements because the commitment to a strong organizational structure and oversight is missing, There is greater risk to the auditor because the governance structure is not designed to prevent/detect such misstatements, and will likely not be as forthcoming when the auditor questions potential problems.

3.

Element of Poor Corporate Governance

The company is in the financial services sector and has a large number of consumer loans, including mortgages, outstanding.

The CEO and CFO’s

Audit Activity to Determine if Governance is actually Poor This is not necessarily poor governance. However, the auditor needs to determine the amount of risk that is inherent in the current loan portfolio and whether the risk could have been managed through better risk management by the organization.

This is a rather common compensation package and,

Risk Implication of Poor Governance The lack of good risk management by the organization increases the risk that the financial statements will be misstated because of the difficulty of estimating the allowance for loan losses. The auditor will have to focus increased efforts on estimating loan losses, including a comparison of how the company is doing in relation to the other companies in the financial sector. In combination with other things, the use of

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Solutions Manual – Public Accountancy Profession

Element of Poor Corporate Governance

compensation is based on three components: (a) base salary, (b) bonus based on growth in assets and profits, and (c) significant stock options.

The audit committee meets semi-annually. It is chaired by a retired CFO who knows the company well because she had served as the CFO of a division of the firm before retirement. The other two members are local community members – one is the President of the Chamber of Commerce and the other is a retired executive from a successful local manufacturing firm.

Audit Activity to Determine if Governance is actually Poor by itself, is not necessarily poor corporate governance. However, in combination with other things, the use of ‘significant stock options’ may create an incentive for management to potentially manage reported earnings in order to boost the price of the company’s stock. The auditor can determine if it is poor corporate governance by determining the extent that other safeguards are in place to protect the company.

There is a strong indicator of poor corporate governance. If the audit committee meets only twice a year, it is unlikely that it is devoting appropriate amounts of time to its oversight function, including reports from both internal and external audit. There is another problem in that the chair of the audit committee was previously employed by the company and would not meet the definition of an independent director. Finally, the problems with the other two members is

Risk Implication of Poor Governance ‘significant stock options’ may create an incentive for management to potentially manage reported earnings in order to boost the price of the company’s stock. The auditor should carefully examine if the company’s reported earnings and stock price differs broadly from companies in the same sector. If that is the case, there is a possibility of earnings manipulation and the auditor should investigate to see if such manipulation is occurring. This is an example of poor governance because (1) it signals that the organization has not made a commitment to independent oversight by the audit committee, (2) the lack of financial expertise means that the auditor does not have someone independent that they can discuss controversial accounting or audit issues that arise during the course of the audit. If there is a disagreement with management, the audit committee does not have the expertise to make independent judgments on whether the auditor or

Corporate Governance… Element of Poor Corporate Governance

Audit Activity to Determine if Governance is actually Poor that there is no indication that either of them have sufficient financial expertise.

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Risk Implication of Poor Governance management has the appropriate view of the accounting or audit issues.

The company has an internal auditor who reports directly to the CFO, and makes an annual report to the audit committee.

The good news is that the organization has an internal audit activity.

The bad news is that a staff of one isn’t necessarily as large or as diverse as it needs to be to cover the major risks of the organization. The external auditor will be more limited in determining the extent that his or her work can rely on the internal auditor.

The CEO is a dominating personality – not unusual in this environment. He has been on the job for 6 months and has decreed that he is streamlining the organization to reduce costs and centralize authority (most of it in him).

A dominant CEO is not especially unusual, but the centralization of power in the CEO is a risk that many aspects of governance, as well as internal control could be overridden. The auditor should look at policy manuals, as well as interview other members of management and the board – especially the audit committee.

The centralization of power in the CEO is a risk that many aspects of governance, as well as internal control could be overridden. This increases the amount of audit risk.

The Company has a loan committee. It meets quarterly to approve, on an ex-post basis all loans that are over $300 million (top 5% for this institution).

The auditor should observe the minutes of the loan committee to verify its meetings. The auditor should also interview the chairman of the loan committee to understand both its policies and its attitude towards controls and risk.

There are a couple of elements in this statement that carries great risk to the audit and to the organization. First, the loan committee only meets quarterly. Economic conditions change more rapidly than once a quarter, and thus the review is not

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Solutions Manual – Public Accountancy Profession

Element of Poor Corporate Governance

The previous auditor has resigned because of a dispute regarding the accounting treatment and fair value assessment of some of the loans.

Audit Activity to Determine if Governance is actually Poor

The auditor should contact the previous auditor to obtain an understanding as to the factors that led the previous auditor to either resign or be fired. The auditor is also concerned with who led the charge to get rid of the auditor.

Risk Implication of Poor Governance timely. Second, the only loans reviewed are (a) large loans that (b) have already been made. Thus, the loan committee does not act as a control or a check on management or the organization. The risk is that many more loans than would be expected could be delinquent, and need to be written down. This is a very high risk indicator. The auditor would look extremely bad if the previous auditor resigned over a valuation issue and the new auditor failed to adequately address the same issue. Second, this is a risk factor because the organization shows that it is willing to get rid of auditors with whom they do not agree. This is a problem of auditor independence and coincides with the above identification of the weakness of the audit committee. This action confirms a generally poor quality of corporate governance.

4.

a&b.

Cookie jar reserves are essentially funds that companies have “stashed away” to use when times get tough. The rationale is that the reserves are then used to “smooth” earnings in the years when earnings needs a

Corporate Governance…

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boost. “Smooth” earnings typically are looked upon more favorably by the stock market. An example of a cookie jar reserve would be overestimating an allowance account, such as allowance for doubtful accounts. The allowance account is then written down (and into the income statement) in a bad year. Auditors may have allowed cookie jar reserves because they are known to smooth earnings, and smooth earnings are rewarded by the market. On the flip side, fluctuating earnings are penalized, and present more risk to the company of bankruptcy or other problems.

The Sarbanes-Oxley Act addressed the issue by creating an oversight body, the PCAOB, but also addressed the issue in other ways. For example, Congress felt that creating more effective Boards would decrease the use of earnings management. Allowing improper revenue recognition is one thing that auditors may have done in their unwillingness to say “no” to clients. For example, companies shipped out goods to customers at the end of the year for deep discounts and allowed returns at the beginning of the next year. This practice is known as channel stuffing. Since the goods had a great chance of being returned, it would be improper to recognize all as revenue. Again, auditors were unwilling to say “no” to clients. Greed is probably the reason here. If companies claim more revenue, their stock would grow in the short-term, making management richer, and making management more willing to give pay raises to their auditors. With the establishment of stronger audit committees and certification of financial statements in the Sarbanes-Oxley Act, this kind of accounting trickery will certainly decrease. Creative accounting for M&A included the use of the “pooling” method of accounting. Pooling allowed acquiring companies to value existing assets at historical costs and did not require the recognition of goodwill for the acquisition. Because true costs (values) were not shown on the financial statements, management was often encouraged to bid up prices for acquisitions with the result that many of them were not economic. The creative accounting also shielded the income statement from charges that would have otherwise hit income including: goodwill amortization, depreciation, and depletion expenses. Greed, the same reasons as the revenue recognition issue, was most likely the motivation for this creative accounting.

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Solutions Manual – Public Accountancy Profession Discussion between an educated audit committee and auditor plus certification of financial statements required by Sarbanes-Oxley will certainly address this issue. Assisting management to meet earnings. Too often, auditors confused ‘financial engineering’ with value-adding. In other words, auditors often sought to add value to their clients by finding ways to push accounting to achieve earnings objectives sought by management. These earnings objectives then played a major role in escalating stock prices – all desired because of the heavy emphasis of management compensation on stock options. Incentives were misaligned. Most of management compensation came in the form of stock options.

5.

a.

This is intended to be an open-ended discussion. There are a number of factors that have been mentioned in the discussions regarding auditor independence. The following is representative of some issues discussed: • •

• • •

• • •

•

The audit firm’s policy for rotating auditors in charge of the engagement, Whether or not the client has hired personnel from the audit firm for significant financial or management positions in the company, such as the Chief Financial Officer was the former partner in charge of the audit engagement, The nature of non-audit services provided by the audit firm, The existence of any social or other relationships with management, Audit committee experience with the audit firm in other situations, such as the auditor provides services for other entities with which the audit committee member has an association, The existence of any charges brought against the auditing firm by the SEC, The audit firm’s involvement in significant lawsuits where their judgment has been questioned, The amount of fees charged by the auditing firm. If the audit fees are too low, the audit committee should question the thoroughness and independence of the work. If fees from non-audit work are high, the audit committee will want to question that relationship and possible effect on judgments made by the auditor. The manner in which individual audit partners are compensated by the public accounting firm. For example, if an audit partner’s compensation is determined significantly by whether or not a client

Corporate Governance…

• • • •

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is retained, then there might be questions about what the auditor would do to retain the client. The general reputation of the firm. The firm’s policies and procedures for attracting and retaining talented audit personnel. The process of assigning personnel to an audit. The firm’s expertise in the industry.

b.

The main way that the audit committee can influence the independence of the internal audit department is by choosing who is in charge of the department. The “tone at the top” in the internal audit department will go a long way. Further, the audit committee ought to approve the scope of the internal audit charter, approve annual audit plans, as well as annual budgets.

c.

1. Tax Return for Company: Approval argument. The auditor is already aware of all the information, so can efficiently prepare the return. Tax accounting is different than audit accounting, so accounting treatments can be different in both settings and will not affect each other. Non-Approval: On the other hand, some argue that tax preparation is a consulting activity, i.e. the auditor would need to be a client advocate and thereby should not prepare the tax return. 2. Tax Return for Management and Board Members: Approval: The auditor is an expert. The services can be viewed as a benefit for management and the board. Not Approve: Performance of the tax services too closely aligns the auditor with management and the board. The auditor has to be a client advocate in developing the tax returns. This may mentally conflict with the auditor’s need to be objective in all other work involving the client. 3. Tax Return paid for by Managers, not company: Approval: This is an independent service not paid for by the company. Not Approve: The argument is the same as #2 above. Although paid for by the individuals, there is still the possibility of conflict. 4. Overseas Assistance for Internal Audit Department: Do not approve. It is the responsibility of management to prepare a review of internal control, and the auditor does an independent analysis.

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Solutions Manual – Public Accountancy Profession Further, the performance of internal audit work is one of the areas that have been explicitly prohibited by the SEC. 5. Security Audit of Information Systems: Approve. This is not a conflict of interest as it is an audit or assurance service. 6.

Train Operating Personnel on Internal Controls: Approve. Auditors are experts on this area. There is no direct conflict with the performance of the audit. Better trained personnel should imply better internal controls – beneficial for both management and the auditor. Not Approve. The PCAOB is explicit that management has the responsibility to design, implement, and evaluate internal control. Thus, training personnel is a management task that cannot be performed by the auditor. It could, however, be performed by a different public accounting firm.

7.

Perform Internal Audit Work for the Company: Do not approve. It is the responsibility of management to prepare a review of internal control, and the auditor does an independent analysis. Usually internal audit is responsible for “management’s” end of assessing internal controls. The audit of effectiveness and efficiency is akin to consulting and would be interpreted by most people as compromising the auditor’s independence.

8.

Provide, at no cost, Seminars to Audit Committee Members. Approve. The audit committee can make a decision as to whether a particular member will attend the seminar. It is one way that an audit committee member can keep up on the profession. The only potential problem would occur if the audit committee only relied on the audit firm for updates on accounting and audit issues.

9.

Seminars for both Audit and Non-Audit Clients. Recommend Approval. The key is whether the audit committee feels that it may lose some of its objectivity in performing its oversight role.

CHAPTER 14 DESIGNING AN EFFECTIVE RESPONSE TO ASSESSED RISKS Questions 1.

Inspection techniques include physical examination of assets, examination of documents and records, performance of mechanical accuracy tests, and analytical procedures.

2.

Vouching and tracing are two types of commonly performed documentation. Vouching involves the examination of documents that served as a basis for recording the transaction. Vouching usually starts with a recorded transaction and works back to the documents and addresses existence. Tracing involves determining whether source documents have been recorded properly in the accounting records. By tracing, an auditor can obtain evidence that the recording of the transaction is complete.

3.

An inquiry involves requesting information from client personnel and receiving their response. The request and response may be either written or oral. A confirmation is a response a third party makes directly to the auditor on the request of a client. The response includes information about certain transactions, relationships, and/or balances that have an impact on a specific financial statement assertion.

4.

Confirmations are usually considered more reliable because they are from outside parties, while inquiries are made of client personnel.

5.

When equivalent procedures are available to satisfy the need for evidence, an auditor may consider cost in selecting among the alternatives.

6.

Vouching is relevant to testing the existence of sales; tracing is not. Tracing is relevant to testing the completeness of sales, but vouching is not.

Multiple Choice Questions 1. 2.

c d

3. 4.

c a

5. 6.

c c

7. 8.

a d

9.

d

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Solutions Manual – Public Accountancy Profession

Cases 1.

2.

Types of procedures used by auditors in general, with examples: 1.

Recalculation by the auditor * recomputing the client’s calculation of depreciation expense

2.

Observation by the auditor * observation, test-counting of client’s physical inventory-taking

3.

Confirmation by letter * obtaining accounts receivable confirmations * obtaining client’s lawyer’s letter

4.

Inquiry and written representations * ask client personnel about accounting events * complete an internal control questionnaire * obtain written client representation letter

5.

Vouching * find brokers’ invoices and cancelled checks showing agreement with record amounts for securities investments

6.

Tracing * select a sample of shipping documents and trace them to sales invoices, sales journal recording and posting to general ledger

7.

Scanning * scan expense accounts for credit entries * scan payroll check lists for unusually large checks

8.

Analytical procedures – any example that fits one of these: * compare financial information with prior periods * compare financial information with budgets and forecasts * study predictable financial information patterns (e.g., ratio analysis) * compare financial information to industry statistics * study financial information in relation to nonfinancial information

a.

A material decline in sales may indicate unrecorded sales; a decrease in cost of goods sold may be due to unrecorded purchases; and an increase in cost of good sold may be the result of omissions from the ending inventory. An increase or decrease in gross profit will result from any one or a combination of the above omissions.

b.

A decline in the miscellaneous revenue account balance, or the absence of a previously existing source of miscellaneous revenue, could be attributable to a failure to record miscellaneous revenue.

Designing an Effective Response…

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c.

Unrecorded accounts payable at year-end would cause an increase in calculated accounts payable turnover.

d.

An apparent increase in accounts receivable turnover may, in fact, be the result of failure to record credit sales transactions.

e.

A higher than average operating return may be indicative of unrecorded purchases or operating expenses; a lower than average return could result from unrecorded sales.

CHAPTER 15 AUDIT EVIDENCE Review Questions 1.

Refer to page 614, 2nd and 4th paragraphs of the textbook.

2.

Refer to page 614, 3rd paragraph of the textbook.

3.

Refer to page 616, 3rd paragraph of the textbook.

4.

Refer to page 6177, 1st paragraph of the textbook.

5.

Refer to page 617, 2nd paragraph of the textbook.

6.

Refer to page 618, 4th paragraph of the textbook.

7.

External documentary evidence is evidential matter obtained from the other party to an arm’s-length transaction or from outside independent agencies. External evidence reaches the auditor directly and does not pass through the hands of the client. External-internal documentary evidence is documentary material that originates outside the bounds of the client’s data processing system but which has been received and processed by the client. Internal documentary evidence consists of documentary material that is produced, circulates, and is finally stored within the client’s information system. Such evidence is not touched by outside parties at all or is several steps removed from third-party attention.

8.

Auditors can help the effectiveness of confirmation requests by: a. b.

c.

Having the confirmation letters printed on the client’s letterhead and signed by a client officer. Being careful to be assured of reliable addresses for recipients; that is, being assured that the confirmations are not misdirected (for example, to a client’s accomplices in fraud). Asking confirmation of information that recipient can supply, like the amount of a balance or the amounts of specified invoices or notes (not the balances of homeowners’ mortgages or financial amounts, like certificates of deposit with accrued interest, for which people usually do not keep their own accounting records).

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Solutions Manual – Public Accountancy Profession d. e.

9.

Controlling the mailing and return of confirmations so the client cannot tamper with them. Receiving the reply directly, so the client cannot intercept and alter them.

Factual evidence is direct evidence, in that conclusions may be drawn from the evidence without further corroboration. An example of factual audit evidence is physical observation of inventory for existence. Inferential evidence is indirect, in that direct conclusions cannot be drawn from the evidence. The auditor typically examines other evidence to further corroborate the inferences drawn. An oral statement by a product manager that one or more products are fully saleable and not obsolete is an example of inferential evidence. The auditor may perform inventory turnover tests and/or determine the date of last sale of the product to further corroborate the product manager’s statement.

10. Sufficiency of audit evidence is a matter of audit judgment. Materiality and the quality of internal control are important ingredients in determining sufficiency. If internal control produces over sales processing and cash receipts, for example, are effective, the auditor may elect to confirm fewer customers’ accounts receivables than under conditions of weak internal control. 11. Physical evidence tests the existence assertion. Examples of physical evidence are inventory observation, examination of securities, inspection of plant asset additions, and count of cash on hand. 12. The quality of existing internal control is the major factor supporting the strength of documentary evidence. A voucher produced under conditions of strong internal control over the processing of vendors’ invoices, for example, possesses greater validity and is therefore stronger evidence than vouchers produced under weak control conditions. 13. Auditing standards define an accounting estimate as “an approximation of a financial statement element, item or amount.” Estimates are used because (1) an amount is uncertain pending specific future events or (2) relevant data cannot be accumulated on a timely, cost-effective basis. Examples of accounting estimates include allowance for uncollectible accounts, obsolete inventory, useful lives and residual values of fixed assets, natural resources and intangibles, accruals for taxes on real and personal property, accruals based on actual assumptions in pension plans, contract revenue using percentage of completion method, litigation losses, fair values in nonmonetary exchanges, and current values in personal financial statements. 14. In evaluating the reasonableness of accounting estimates, an auditor should consider the internal controls related to the estimates in order to reduce the likelihood of material misstatements in the estimates, whether the accounting

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estimates are reasonable given the situation, and whether the accounting estimates are presented in accordance with appropriate accounting principles. 15. Evidence is persuasive if the auditor considers the evidence to be sufficient and competent enough to afford a reasonable basis for an opinion. Multiple Choice Questions 1. 2. 3.

d d c

4. 5. 6.

c a d

7. 8. 9.

d b d

10. d 11. a 12. b

13. b

Cases 1.

2.

a.

Evidential matter obtained from independent sources outside an enterprise provides greater assurance of reliability (competency) than that which is secured solely within the enterprise.

b.

Accounting data and financial statements developed under satisfactory conditions of internal control are more reliable (competent) than those which are developed under unsatisfactory conditions of internal control.

c.

Direct personal knowledge obtained by the independent auditor through physical examination, observation, computation, and inspection is more persuasive than information obtained indirectly.

1.

Types of evidence Evidential items/sources d. Letter from creditor a. Monthly statements b. Voucher register c. Audit computation of discounts

in reliability rank 1. External 2. External-internal 3. Internal 4. Mathematical (based on unaudited data)

2. c. a. d. b.

Audit computation of expense amounts Letter from bond trustee Cancelled checks Minutes of directors’ meetings

1. 2. 3. 4.

Mathematical (based on unaudited data) External External-internal Internal

CHAPTER 16 BASIC AUDIT SAMPLING CONCEPTS Review Questions 1.

Refer to page 648, 3rd paragraph of the textbook.

2.

Refer to page 648, 4th paragraph of the textbook.

3.

Refer to page 650 of the textbook.

4.

Audit conclusions can be made only about the population from which the sample was drawn, and a conclusion can only be valid if the sample on which it is based actually shows the characteristics of the population. Auditors can attempt to achieve representativeness, but they cannot guarantee it. Sampling risk – the probability that the sample does not adequately reflect the population – always exists.

5.

Refer to page 656, 2nd paragraph; page 657, 1st paragraph of the textbook.

6.

Refer to page 657, 6th paragraph of the textbook.

7.

Refer to page 662, paragraphs 1 to 4 of the textbook.

8.

Refer to page 662, paragraphs 3 and 4 of the textbook.

9.

Refer to page 663, 4th paragraph & page 664, 1st to 3rd paragraph of the textbook.

10. Sampling risk is the probability that the auditor’s conclusions concerning the population will be in error. In terms of conclusions regarding internal control, sampling risk consists of two subsets: Alpha risk, the risk that the auditor will assess control risk too high and perform more substantive testing than is necessary under the circumstances; and Beta risk, the risk that the auditor will assess control risk too low and perform less substantive testing than is necessary. For control testing purposes, the auditor is more concerned with beta risk than alpha risk, because beta risk poses the threat of underauditing and is therefore the basis for the audit opinion. The auditor controls this risk by setting beta risk sufficiently low as to maintain overall audit risk at a level less than or equal to 10%.

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11. Refer to pages 675 of the textbook. 12. Refer to pages 670 of the textbook. Multiple Choice Questions 1. 2.

b c

3. 4.

d c

5. 6.

d b

7. 8.

a d

9. a 10. c

Comprehensive Cases 1.

a.

Areas requiring the auditors to make judgment decisions when statistical sampling techniques are employed (only four required): (1) Defining population, characteristics to be tested, and deviations. Unless a relationship is defined between the occurrence rate of deviations in the population and either the validity of the client’s financial statement or the strength of internal control, little useful information is gained by estimating the occurrence rate. (2) Determining the appropriate statistical selection techniques for drawing a random sample. The auditors must recognize the advantages and disadvantages of stratified selection, unstratified selection, and systematic selection, and determine which technique is appropriate for selecting an economical random sample. (3) Establishing the required maximum tolerable deviation rate and the risk of assessing control risk too low for the procedure. This requires judgment decisions regarding materiality, time, cost, and the planned assessed level of control risk. (4) Interpreting sample results. This requires a decision as to whether the results support the auditors’ planned assessed level of control risk, or whether additional sampling is necessary to reach a conclusion. (5) Following up on the discovery of critical errors or unacceptable deviation rates. (6) Determining the circumstances under which statistical sampling is appropriate, and those in which other techniques should be used in lieu, of or to supplement, the statistical sampling techniques. This is an open-ended question. The student may identify numerous other areas in which the auditors must make judgment decisions.

b.

If the CPAs’ sample shows an unacceptable deviation rate, they may take the following actions: (1) They may enlarge their sample to increase the precision of their estimate.

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(2) They may isolate the type of deviation and expand examination as it relates to the transactions that give rise to that type of misstatement. (3) The auditors’ usual response to an unacceptably high deviation rate is to increase their assessed level of control risk. Accordingly, the auditors would increase the intensity of their substantive tests. c.

Techniques for selecting an unstratified random sample of accounts payable vouchers include the following: Random Sample. A random sample is a sample of a given size drawn from a population in a manner such that every possible sample of that size is equally likely to be drawn. Items may be selected randomly by: (1) Table of Random Numbers. Use one of a number of published tables. Using four columns in the table, select the first 80 numbers which fall within the range of 1 to 3,200. The starting point in the table should be selected randomly and the path to be followed through the table should be set in advance and followed consistently. (2) Random Number Generator: Using generalized audit software, generate a list of 80 random numbers. Systematic Sample. A systematic sample is drawn by selecting every nth item beginning with a random start. (1) Every nth item. Select every 40th voucher after selecting the initial voucher (from 1 to 40) randomly. (2) Several random starting points. For example, use two random starting points and select 40 of the 80 vouchers from each of the two sequences. Select every 80th voucher (3,200/40) after each of the two random starting points between 1 and 80 for each of the two sequences.

2.

a.

(1) Since the results of tests of controls typically play a significant role in determining the nature, timing, and extent of other audit procedures, the auditors usually specify a low level of risk of assessing control risk too low. It is usually set at 5 or 10 percent. (2) In determining the tolerable deviation rate, an auditor should consider the planned assessed level of control risk and the extent of assurance desired from the evidential matter included in the sample. (3) In determining the expected population deviation rate, an auditor should consider the results of prior years’ tests, the overall control environment, or utilize a preliminary sample.

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Solutions Manual – Public Accountancy Profession b.

(1) There is a decrease in sample size if the acceptable level of the risk of assessing control risk too low is increased. (2) There is a decrease in sample size if the tolerable deviation is increased. (3) There is an increase in sample size if the population deviation rate is increased.

c.

Using a statistical sampling approach, Figure 17.4 reveals that 7 deviations in a sample of size 100 results in an achieved upper deviation rate of 12.8%, well in excess of the tolerable deviation rate (8%). The sample results should thus be interpreted as not supporting the planned assessed level of control risk. Using a nonstatistical sampling approach, the 7% estimated population deviation rate identified in the sample (7 deviations / 100 sample items) approaches the tolerable deviation rate of 8%. Therefore, using a nonstatistical approach, the sample result would also be interpreted as not supporting the planned assessed level of control risk.

d.

Statistical sampling allows the auditors to quantify sampling risk. As described in part (c), only when statistical sampling is used do the auditors know that the achieved upper deviation rate is 12.8%.

CHAPTER 17 AUDIT SAMPLING FOR TESTS OF CONTROLS Questions 1.

A test of control procedure is a statement of a. b.

2.

Identification of a population from which sampling units are to be drawn. Expression of an action taken to produce evidence about a client control procedure.

Compliance deviations should be defined in advance so auditors will know what to look for and will know one when they see it. Seven Examples – Based on Seven General Control Objectives:

3.

Objective

Example

1.

Validity

1.

Sale recorded without supporting shipping orders.

2.

Authorization

2.

Lack of credit manager approval for a credit sale.

3.

Accuracy

3.

Mathematical errors in sales invoice calculations.

4.

Classification

4.

Sales classified in wrong product line revenue account.

5.

Proper Period

5.

Sales recorded in month (quarter, year) before the actual shipment.

6.

Accounting

6.

Sales charges fail to be posted to a customer’s account.

7.

Completeness

7.

Shipments fail to be billed to customers and recorded as sales and receivables.

Judgments affecting sample size for test of controls auditing. Judgment 1.

Acceptable risk of assessing control risk too low

Influence on sample size Inverse.

The greater the acceptable risk, the smaller the sample.

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Acceptable risk of assessing control risk too high

Inverse.

The greater the acceptable risk, the smaller the sample.

3.

Tolerable deviation rate

Inverse.

The higher the tolerable rate, the smaller the sample.

4.

Expected population deviation rate (an estimate rather than a judgment)

Direct.

The higher the expected rate, the larger the sample.

The sample size is also directly related to the population size, although the influence is generally minor. The larger the population, the larger the sample, but not much. 4.

The risk of assessing the control risk too low has the potential of affecting audit effectiveness, thus damaging the quality of the audit for users. Professionally, in light of responsibility to users, effectiveness is more important than efficiency, which is affected by the risk of assessing the control risk too high.

5.

Expanded risk model: AR = IR x CR x AP x TD Solve for TD, when: .048 = 1.0 x .4 x .6 x TD

TD

=

.048 1.0 x .4 x .6

=

.2

The tolerable misstatement (P10,000) and estimated standard deviation (P25.00) are “noise” in the question. 6.

The “connection” is a direct relationship between control risk and the tolerable deviation rate. (1) When larger values are planned for control risk (say, 0.95, 0.90) in an audit plan, more analytical procedure and test of detail work will be done. Auditors will not rely very much on internal controls. Therefore, not much help is expected from the controls anyway, so the tolerable deviation rate can be larger. The direct relation is: The higher the control risk, the higher the tolerable deviation rate can be. (2) When lower values are assigned to control risk (say, 0.10, 0.20) in an audit plan, less analytical procedure and test of detail work will be done. Auditors intend to rely on internal accounting controls. Therefore, effective compliance with control policies and procedures is important, and the tolerable deviation rate ought to be low. The direct relation is: The higher the planned control risk, the higher the tolerable deviation rate can be.

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7.

Based on the specifications of risk of assessing control risk too low, tolerable deviation rate and expected population deviation rate, sample sizes would be determined independently for the two populations in the subdivision. If the criteria are at least as stringent for each of the two as they would be for the undivided population, the sum of the two sample sizes would be at least twice the size of the sample figured for the single population (provided both subdivided populations have 1,000 or more units).

8.

Further reduction of the assessed level of control risk is justified only when the upper occurrence limit is