ACC 300 Auditing and Assurance
CHAPTER 1
AN INTRODUCTION TO ASSURANCE AND FINANCIAL STATEMENT AUDITING
Answers to Review Questions
1-1 The study of auditing is more conceptual in nature compared to other accounting courses. Rather than focusing on learning the rules, techniques, and computations required to prepare financial statements, auditing emphasizes learning a framework of analytical and logical skills to evaluate the relevance and reliability of the systems and processes responsible for financial information, as well as the information itself. To be successful, students must learn the framework and then learn to use logic and common sense in applying auditing concepts to various circumstances and situations. Understanding auditing can improve the decision-making ability of consultants, business managers, and accountants by providing a framework for evaluating the usefulness and reliability of information—an important task in many different contexts.
1-2There is a demand for auditing in a free-market economy because the agency relationship between an absentee owner and a manager produces a natural conflict of interest due to the information asymmetry that exists between the owner and manager. As a result, the agent agrees to be monitored as part of his/her employment contract. Auditing appears to be a cost-effective form of monitoring. The empirical evidence suggests auditing was demanded prior to government regulation. In 1926, before it was required by law, independent auditors audited 82 percent of the companies on the New York Stock Exchange. Additionally, many private companies and municipalities not subject to government regulations, such as the Securities Act of 1933 and Securities Exchange Act of 1934, also purchase various forms of auditing and assurance services.
1-3The agency relationship between an owner and manager produces a natural conflict of interest because of differences in the two parties’ goals and because of the information asymmetry that exists between them. That is, the manager may well have different goals than the owner, and generally has more information about the "true" financial position and results of operations of the entity than the absentee owner does. If both parties seek to maximize their own self-interest, it is likely that the manager will not act in the best interest of the owner and may manipulate the information provided to the owner accordingly.
1-4Independence is a bedrock principle for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report objectively and truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner.
1-5Auditing (broadly defined) is a systematic process of (1) objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and (2) communicating the results to interested users. Attest services occur when a practitioner issues a report on subject matter, or an assertion about subject matter, that is the responsibility of another party. Assurance services are independent professional services that improve the quality of information, or its context, for decision makers.
1-6The phrase systematic process implies that there should be a well-planned, logical approach for conducting an audit that involves objectively obtaining and evaluating evidence.
1-7Materiality is defined as "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement" (AU 320, PCAOB AS No. 11). Audit risk is defined as the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated (AU 320, PCAOB AS No. 12). The concept of materiality is reflected in the wording of the auditor's standard audit report through the phrase "the financial statements present fairly in all material respects." This is the manner in which the auditor communicates the notion of materiality to the users of the auditor's report. The auditor's standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements. The term "reasonable assurance" implies that there is some risk that a material misstatement could be present in the financial statements and the auditor will fail to detect it.
1-8On most audits, it is not feasible or cost-effective to audit all transactions. For example, in a small business, the auditor might be able to examine all transactions that occurred during the period. However, it is unlikely that the owner of the business could afford to pay for such an extensive audit. For a large organization, the sheer volume of transactions prevents the auditor from examining every transaction. Thus, there is a trade-off between the exactness or precision of the audit and its cost.
1-9The major phases of the audit are:
• Client acceptance/continuance and establishing an understanding with the client • Preliminary engagement activities
• Plan the audit
• Consider and audit internal control
• Audit business processes and related accounts
• Complete the audit
• Evaluate results and issue audit report
1-10The auditor’s understanding of the entity and its environment includes knowledge about: (1) the client’s industry, regulatory, and other external factors, (2) the nature of the entity, (3) its objectives and strategies, (4) its measurement and performance review process, and (5) the entity’s system of internal control.
1-11 The four paragraphs of the auditor's standard unqualified report for a public company client are: (1) the introductory paragraph, (2) the scope paragraph, (3) the opinion paragraph, and (4) an explanatory paragraph referring to the audit of internal control, as illustrated in this chapter.
1-12Auditors frequently face situations where no standard audit procedure exists, such as the example from the text of verifying the inventory of cattle. Such circumstances require that the auditor exercise creativity and innovation when planning and administering audit procedures where little or no guidance or precedent exists. Every client is different, and applying auditing concepts in different situations requires logic and common sense, and frequently creativity and innovation.
Answers to Multiple-Choice Questions
|1-13 |b | |1-19 |a | |1-14 |b | |1-20 |d | |1-15 |c | |1-21 |d | |1-16 |c | |1-22 |d | |1-17 |c | |1-23 |b | |1-18 |c | | | |
Solutions to Problems
1-26a. Evidence that assists the auditor in evaluating financial statement assertions consists of the underlying accounting data and any additional information available to the auditor, whether originating from the client or externally. b. Management makes assertions about components of the financial statements. For example, an entity's financial statements may contain a line item that accounts receivable amount to $1,750,000. In this instance, management is asserting, among other things, that the receivables exist, the entity owns the receivables, and the receivables are properly valued. Audit evidence helps the auditor determine whether management’s assertions are being met. If the auditor is comfortable that he or she can provide reasonable assurance that all assertions are met for all accounts, he or she can issue a clean audit report. In short, the assertions are a conceptual tool to help the auditor ensure that she or he has “covered all the bases.” c. In searching for and evaluating evidence, the auditor should be concerned with the relevance and reliability of evidence. If the auditor mistakenly relies on evidence that does not relate to the assertion being tested, an incorrect conclusion may be reached about the management assertion. Reliability refers to the ability of evidence to signal the true state of the assertion, i.e., whether it is actually being met or not.
29. Scope paragraph: “These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.” The use of the term reasonable assurance indicates that there is no guarantee that the financial statements are correct, only reasonable assurance. Also the statement that the financials are “free of material misstatement” indicates that the financials may have some error that is not material. “An audit also includes assessing the accounting principles used and significant estimates made…” The explanation that management uses estimates indicates that some of the figures in the financial statements are not exact.
“We believe that our audits provide a reasonable basis for our opinion.” This statement indicates that the audit is not “proof” that the financial statements are exact, only that there is reasonable evidence about their accuracy.
Opinion paragraph: “…the consolidated financial statements referred to above present fairly, in all material respects,…” This sentence indicates that the financial statements are a “fair”, not exact, representation. Also, the idea of materiality is revisited here, indicating that there may still be immaterial errors in the financial statements.
AN INTRODUCTION TO ASSURANCE AND FINANCIAL STATEMENT AUDITING
Answers to Review Questions
1-1 The study of auditing is more conceptual in nature compared to other accounting courses. Rather than focusing on learning the rules, techniques, and computations required to prepare financial statements, auditing emphasizes learning a framework of analytical and logical skills to evaluate the relevance and reliability of the systems and processes responsible for financial information, as well as the information itself. To be successful, students must learn the framework and then learn to use logic and common sense in applying auditing concepts to various circumstances and situations. Understanding auditing can improve the decision-making ability of consultants, business managers, and accountants by providing a framework for evaluating the usefulness and reliability of information—an important task in many different contexts.
1-2There is a demand for auditing in a free-market economy because the agency relationship between an absentee owner and a manager produces a natural conflict of interest due to the information asymmetry that exists between the owner and manager. As a result, the agent agrees to be monitored as part of his/her employment contract. Auditing appears to be a cost-effective form of monitoring. The empirical evidence suggests auditing was demanded prior to government regulation. In 1926, before it was required by law, independent auditors audited 82 percent of the companies on the New York Stock Exchange. Additionally, many private companies and municipalities not subject to government regulations, such as the Securities Act of 1933 and Securities Exchange Act of 1934, also purchase various forms of auditing and assurance services.
1-3The agency relationship between an owner and manager produces a natural conflict of interest because of differences in the two parties’ goals and because of the information asymmetry that exists between them. That is, the manager may well have different goals than the owner, and generally has more information about the "true" financial position and results of operations of the entity than the absentee owner does. If both parties seek to maximize their own self-interest, it is likely that the manager will not act in the best interest of the owner and may manipulate the information provided to the owner accordingly.
1-4Independence is a bedrock principle for auditors. If an auditor is not independent of the client, users may lose confidence in the auditor’s ability to report objectively and truthfully on the financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor is not independent, the owner will not trust the auditor’s work. Thus, the agent will not hire the auditor because the auditor’s report will not be effective in reducing information risk from the perspective of the owner.
1-5Auditing (broadly defined) is a systematic process of (1) objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and (2) communicating the results to interested users. Attest services occur when a practitioner issues a report on subject matter, or an assertion about subject matter, that is the responsibility of another party. Assurance services are independent professional services that improve the quality of information, or its context, for decision makers.
1-6The phrase systematic process implies that there should be a well-planned, logical approach for conducting an audit that involves objectively obtaining and evaluating evidence.
1-7Materiality is defined as "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement" (AU 320, PCAOB AS No. 11). Audit risk is defined as the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated (AU 320, PCAOB AS No. 12). The concept of materiality is reflected in the wording of the auditor's standard audit report through the phrase "the financial statements present fairly in all material respects." This is the manner in which the auditor communicates the notion of materiality to the users of the auditor's report. The auditor's standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements. The term "reasonable assurance" implies that there is some risk that a material misstatement could be present in the financial statements and the auditor will fail to detect it.
1-8On most audits, it is not feasible or cost-effective to audit all transactions. For example, in a small business, the auditor might be able to examine all transactions that occurred during the period. However, it is unlikely that the owner of the business could afford to pay for such an extensive audit. For a large organization, the sheer volume of transactions prevents the auditor from examining every transaction. Thus, there is a trade-off between the exactness or precision of the audit and its cost.
1-9The major phases of the audit are:
• Client acceptance/continuance and establishing an understanding with the client • Preliminary engagement activities
• Plan the audit
• Consider and audit internal control
• Audit business processes and related accounts
• Complete the audit
• Evaluate results and issue audit report
1-10The auditor’s understanding of the entity and its environment includes knowledge about: (1) the client’s industry, regulatory, and other external factors, (2) the nature of the entity, (3) its objectives and strategies, (4) its measurement and performance review process, and (5) the entity’s system of internal control.
1-11 The four paragraphs of the auditor's standard unqualified report for a public company client are: (1) the introductory paragraph, (2) the scope paragraph, (3) the opinion paragraph, and (4) an explanatory paragraph referring to the audit of internal control, as illustrated in this chapter.
1-12Auditors frequently face situations where no standard audit procedure exists, such as the example from the text of verifying the inventory of cattle. Such circumstances require that the auditor exercise creativity and innovation when planning and administering audit procedures where little or no guidance or precedent exists. Every client is different, and applying auditing concepts in different situations requires logic and common sense, and frequently creativity and innovation.
Answers to Multiple-Choice Questions
|1-13 |b | |1-19 |a | |1-14 |b | |1-20 |d | |1-15 |c | |1-21 |d | |1-16 |c | |1-22 |d | |1-17 |c | |1-23 |b | |1-18 |c | | | |
Solutions to Problems
1-26a. Evidence that assists the auditor in evaluating financial statement assertions consists of the underlying accounting data and any additional information available to the auditor, whether originating from the client or externally. b. Management makes assertions about components of the financial statements. For example, an entity's financial statements may contain a line item that accounts receivable amount to $1,750,000. In this instance, management is asserting, among other things, that the receivables exist, the entity owns the receivables, and the receivables are properly valued. Audit evidence helps the auditor determine whether management’s assertions are being met. If the auditor is comfortable that he or she can provide reasonable assurance that all assertions are met for all accounts, he or she can issue a clean audit report. In short, the assertions are a conceptual tool to help the auditor ensure that she or he has “covered all the bases.” c. In searching for and evaluating evidence, the auditor should be concerned with the relevance and reliability of evidence. If the auditor mistakenly relies on evidence that does not relate to the assertion being tested, an incorrect conclusion may be reached about the management assertion. Reliability refers to the ability of evidence to signal the true state of the assertion, i.e., whether it is actually being met or not.
29. Scope paragraph: “These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.” The use of the term reasonable assurance indicates that there is no guarantee that the financial statements are correct, only reasonable assurance. Also the statement that the financials are “free of material misstatement” indicates that the financials may have some error that is not material. “An audit also includes assessing the accounting principles used and significant estimates made…” The explanation that management uses estimates indicates that some of the figures in the financial statements are not exact.
“We believe that our audits provide a reasonable basis for our opinion.” This statement indicates that the audit is not “proof” that the financial statements are exact, only that there is reasonable evidence about their accuracy.
Opinion paragraph: “…the consolidated financial statements referred to above present fairly, in all material respects,…” This sentence indicates that the financial statements are a “fair”, not exact, representation. Also, the idea of materiality is revisited here, indicating that there may still be immaterial errors in the financial statements.
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