Solutions manual of auditing and assurance services 13e by arens elder and beasley

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Solutions Manual

Auditing and
Assurance Services
Thirteenth Edition
Global Edition

Alvin A. Arens
Randal J. Elder
Mark S. Beasley

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ISBN-13:
ISBN-10:

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978-0-13-611920
0-13-6119121


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CONTENTS
I.

THE AUDITING PROFESSION
1
2
3
4
5

The Demand for Audit and Other Assurance Services .................
The CPA Profession.........................................................
Audit Reports .................................................................
Legal Liability .................................................................
Professional Ethics ..........................................................

1-1
2-1
3-1
4-1
5-1

II. THE AUDIT PROCESS
6
7
8
9
10
11
12
13

Audit Responsibilities and Objectives .....................................
Audit Evidence ...............................................................
Audit Planning and Analytical Procedures................................
Materiality and Risk .........................................................
Section 404 Audits of Internal Control and Control Risk ................
Fraud Auditing ...............................................................
The Impact of Information Technology on the Audit Process ..........
Overall Audit Plan and Audit Program ....................................

6-1
7-1
8-1
9-1

10-1
11-1
12-1
13-1

III. APPLICATION OF THE AUDIT PROCESS TO THE SALES AND
COLLECTION CYCLE
14
15
16
17

Audit of the Sales and Collection Cycle: Tests of Controls
and Substantive Tests of Transactions ...................................
Auditing Sampling for Tests of Controls
and Substantive Tests of Transactions ...................................
Completing the Tests in the Sales and Collection Cycle:
Accounts Receivable ........................................................
Audit Sampling for Tests of Details of Balances .........................

14-1
15-1
16-1
17-1

IV. APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
18

19
20

21
22
23

Audit of the Acquisition and Payment Cycle:
Tests of Controls, Substantive Tests of Transactions,
and Accounts Payable ......................................................
Completing the Tests in the Acquisition and Payment Cycle:
Verification of Selected Accounts ..........................................
Audit of the Payroll and Personnel Cycle .................................
Audit of the Inventory and Warehousing Cycle ..........................
Audit of the Capital Acquisition and Repayment Cycle .................
Audit of Cash Balances .....................................................

18-1
19-1
20-1
21-1
22-1
23-1

V. COMPLETING THE AUDIT
24

Completing the Audit ........................................................

24-1

VI. OTHER ASSURANCE AND NONASSURANCE SERVICES
25

26

Other Assurance Services ..................................................
Internal and Governmental Financial Auditing
and Operational Auditing ...................................................

25-1
26-1


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Chapter 1
The Demand for Audit and Other Assurance Services
 Review Questions

1-1
The relationship among audit services, attestation services, and assurance
services is reflected in Figure 1-3 on page 13 of the text. An assurance service is
an independent professional service to improve the quality of information for
decision makers. An attestation service is a form of assurance service in which
the CPA firm issues a report about the reliability of an assertion that is the
responsibility of another party. Audit services are a form of attestation service in
which the auditor expresses a written conclusion about the degree of
correspondence between information and established criteria.
The most common form of audit service is an audit of historical financial
statements, in which the auditor expresses a conclusion as to whether the
financial statements are presented in conformity with generally accepted
accounting principles. An example of an attestation service is a report on the
effectiveness of an entity’s internal control over financial reporting. There are

many possible forms of assurance services, including services related to
business performance measurement, health care performance, and information
system reliability.
1-2
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.

2.

3.

4.

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
Biases and motives of provider
a.
Information will be biased in favor of the provider when his or
her goals are inconsistent with the decision maker's goals.
Voluminous data
a.
Possibly millions of transactions processed daily via

sophisticated computerized systems
b.
Multiple product lines
c.
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

1-1


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1-3

1.

2.

3.

Risk-free interest rate This is approximately the rate the bank could
earn by investing in U.S. treasury notes for the same length of time
as the business loan.
Business risk for the customer This risk reflects the possibility that

the business will not be able to repay its loan because of economic
or business conditions such as a recession, poor management
decisions, or unexpected competition in the industry.
Information risk This risk reflects the possibility that the information
upon which the business risk decision was made was inaccurate. A
likely cause of the information risk is the possibility of inaccurate
financial statements.

Auditing has no effect on either the risk-free interest rate or business risk.
However, auditing can significantly reduce information risk.
1-4
The four primary causes of information risk are remoteness of information,
biases and motives of the provider, voluminous data, and the existence of complex
exchange transactions.
The three main ways to reduce information risk are:
1.
2.
3.

User verifies the information.
User shares the information risk with management.
Audited financial statements are provided.

The advantages and disadvantages of each are as follows:
ADVANTAGES

DISADVANTAGES

USER VERIFIES
INFORMATION

1. User obtains information
desired.
2. User can be more confident
of the qualifications and
activities of the person
getting the information.

1. High cost of obtaining
information.
2. Inconvenience to the
person providing the
information because
large number of users
would be on premises.

USER SHARES
INFORMATION
RISK WITH
MANAGEMENT

1. No audit costs incurred.

1. User may not be able
to collect on losses.

AUDITED
FINANCIAL
STATEMENTS
ARE PROVIDED

1. Multiple users obtain the
information.
2. Information risk can usually
be reduced sufficiently to
satisfy users at reasonable
cost.
3. Minimal inconvenience to
management by having
only one auditor.

1. May not meet needs
of certain users.
2. Cost may be higher
than the benefits in
some situations, such
as for a small
company.

1-2


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1-5
To do an audit, there must be information in a verifiable form and some
standards (criteria) by which the auditor can evaluate the information. Examples
of established criteria include generally accepted accounting principles and the
Internal Revenue Code. Determining the degree of correspondence between
information and established criteria is determining whether a given set of

information is in accordance with the established criteria. The information for
Jones Company's tax return is the federal tax returns filed by the company. The
established criteria are found in the Internal Revenue Code and all
interpretations. For the audit of Jones Company's financial statements the
information is the financial statements being audited and the established criteria
are generally accepted accounting principles.
1-6
The primary evidence the internal revenue agent will use in the audit of
the Jones Company's tax return include all available documentation and other
information available in Jones' office or from other sources. For example, when
the internal revenue agent audits taxable income, a major source of information
will be bank statements, the cash receipts journal and deposit slips. The internal
revenue agent is likely to emphasize unrecorded receipts and revenues. For
expenses, major sources of evidence are likely to be cancelled checks, vendors'
invoices and other supporting documentation.
1-7
This apparent paradox arises from the distinction between the function of
auditing and the function of accounting. The accounting function is the recording,
classifying and summarizing of economic events to provide relevant information
to decision makers. The rules of accounting are the criteria used by the auditor
for evaluating the presentation of economic events for financial statements and
he or she must therefore have an understanding of generally accepted
accounting principles (GAAP), as well as auditing standards. The accountant
need not, and frequently does not, understand what auditors do, unless he or she
is involved in doing audits, or has been trained as an auditor.

1-3


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1-8

OPERATIONAL
AUDITS

COMPLIANCE
AUDITS

AUDITS OF
FINANCIAL
STATEMENTS

PURPOSE

To evaluate
whether
operating
procedures are
efficient and
effective

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

To determine
whether the

overall financial
statements are
presented in
accordance with
specified criteria
(usually GAAP)

USERS OF
AUDIT
REPORT

Management of
organization

Authority setting
down procedures,
internal or external

Different groups
for different
purposes — many
outside entities

NATURE

Highly
nonstandard;
often subjective

Not standardized,

but specific and
usually objective

Highly
standardized

PERFORMED
BY:
CPAs

Frequently

Occasionally

Almost
universally

GAO
AUDITORS

Frequently

Frequently

Occasionally

IRS
AUDITORS

Never

Universally

Never

INTERNAL
AUDITORS

Frequently

Frequently

Frequently

1-9
Five examples of specific operational audits that could be conducted by an
internal auditor in a manufacturing company are:
1.

2.
3.

Examine employee time cards and personnel records to determine
if sufficient information is available to maximize the effective use of
personnel.
Review the processing of sales invoices to determine if it could be
done more efficiently.
Review the acquisitions of goods, including costs, to determine if
they are being purchased at the lowest possible cost considering
the quality needed.

1-4


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1-9 (continued)
4.
5.

Review and evaluate the efficiency of the manufacturing process.
Review the processing of cash receipts to determine if they are
deposited as quickly as possible.

1-10 When auditing historical financial statements, an auditor must have a
thorough understanding of the client and its environment. This knowledge should
include the client’s regulatory and operating environment, business strategies
and processes, and measurement indicators. This strategic understanding is also
useful in other assurance or consulting engagements. For example, an auditor
who is performing an assurance service on information technology would need to
understand the client’s business strategies and processes related to information
technology, including such things as purchases and sales via the Internet.
Similarly, a practitioner performing a consulting engagement to evaluate the
efficiency and effectiveness of a client’s manufacturing process would likely start
with an analysis of various measurement indicators, including ratio analysis and
benchmarking against key competitors.
1-11

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

2.

3.

4.

CPAs perform audits in accordance with auditing standards of
published financial statements prepared in accordance with generally
accepted accounting principles.
GAO auditors perform compliance or operational audits in order to
assure the Congress of the expenditure of public funds in accordance
with its directives and the law.
IRS agents perform compliance audits to enforce the federal tax
laws as defined by Congress, interpreted by the courts, and regulated
by the IRS.
Internal auditors perform compliance or operational audits in order
to assure management or the board of directors that controls and
policies are properly and consistently developed, applied and
evaluated.

1-12 The four parts of the Uniform CPA Examination are: Auditing and Attestation,
Financial Accounting and Reporting, Regulation, and Business Environment and
Concepts.
1-13 It is important for CPAs to be knowledgeable about e-commerce technologies
because more of their clients are rapidly expanding their use of e-commerce.
Examples of commonly used e-commerce technologies include purchases and
sales of goods through the Internet, automatic inventory reordering via direct
connection to inventory suppliers, and online banking. CPAs who perform audits
or provide other assurance services about information generated with these

technologies need a basic knowledge and understanding of information technology
and e-commerce in order to identify and respond to risks in the financial and
other information generated by these technologies.
1-5


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 Multiple Choice Questions From CPA Examinations

1-14

a.

(3)

b.

(2)

c.

(2)

d.

(3)

1-15

a.

(2)

b.

(3)

c.

(4)

d.

(3)

 Discussion Questions And Problems

1-16

1-17

a.

The relationship among audit services, attestation services and
assurance services is reflected in Figure 1-3 on page 13 of the text.
Audit services are a form of attestation service, and attestation
services are a form of assurance service. In a diagram, audit
services are located within the attestation service area, and
attestation services are located within the assurance service area.

b.

1.
2.

(1)
(2)
(3)

3.
4.
5.
6.

(2)
(2)
(2)
(2)

7.
8.
9.

(2)
(2)
(3)

Audit of historical financial statements
An attestation service other than an audit service; or

An assurance service that is not an attestation service
(WebTrust developed from the AICPA Special Committee
on Assurance Services, but the service meets the
criteria for an attestation service.)
An attestation service other than an audit service
An attestation service other than an audit service
An attestation service other than an audit service
An attestation service that is not an audit service
(Review services are a form of attestation, but are
performed according to Statements on Standards for
Accounting and Review Services.)
An attestation service other than an audit service
An attestation service other than an audit service
An assurance service that is not an attestation service

a.

The interest rate for the loan that requires a review report is lower
than the loan that did not require a review because of lower
information risk. A review report provides moderate assurance to
financial statement users, which lowers information risk. An audit
report provides further assurance and lower information risk. As a
result of reduced information risk, the interest rate is lowest for the
loan with the audit report.

b.

Given these circumstances, Vial-tek should select the loan from
City First Bank that requires an annual audit. In this situation, the
additional cost of the audit is less than the reduction in interest due

to lower information risk. The following is the calculation of total
costs for each loan:

1-6


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1-17 (continued)

LENDER
Existing loan
First National Bank
City First Bank
c.

COST OF CPA
SERVICES

ANNUAL
INTEREST

ANNUAL
LOAN COST

None

0

$ 332,500

$ 332,500

Review

$ 20,000

$ 297,500

$ 317,500

Audit

$ 45,000

$ 262,500

$ 307,500

Vial-tek should select the loan from First National Bank due to the
higher cost of the audit and the reduced interest rate for the loan
from First National Bank. The following is the calculation of total
costs for each loan:

LENDER
Existing loan
First National Bank
City First Bank

1-18

CPA
SERVICE

CPA
SERVICE

COST OF CPA
SERVICES

ANNUAL
INTEREST

ANNUAL
LOAN COST

None

0

$ 332,500

$ 332,500

Review

$ 20,000

$ 280,000

$ 300,000

Audit

$ 50,000

$ 262,500

$ 312,500

d.

Vial-tek may desire to have an audit because of the many other
positive benefits that an audit provides. The audit will provide Vialtek’s management with assurance about annual financial information
used for decision-making purposes. The audit may detect errors or fraud,
and provide management with information about the effectiveness of
controls. In addition, the audit may result in recommendations to
management that will improve efficiency or effectiveness.

e.

The auditor must have a thorough understanding of the client and its
environment, including the client’s e-commerce technologies, industry,
regulatory and operating environment, suppliers, customers, creditors,
and business strategies and processes. This thorough analysis helps
the auditor identify risks associated with the client’s strategies that
may affect whether the financial statements are fairly stated. This
strategic knowledge of the client’s business often helps the auditor
identify ways to help the client improve business operations, thereby
providing added value to the audit function.

a.

The services provided by Consumers Union are very similar to
assurance services provided by CPA firms. The services provided
by Consumers Union and assurance services provided by CPA
firms are designed to improve the quality of information for decision
makers. CPAs are valued for their independence, and the reports
provided by Consumers Union are valued because Consumers
Union is independent of the products tested.
1-7


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1-18 (continued)
b.

The concepts of information risk for the buyer of an automobile and
for the user of financial statements are essentially the same. They
are both concerned with the problem of unreliable information being
provided. In the case of the auditor, the user is concerned about
unreliable information being provided in the financial statements.
The buyer of an automobile is likely to be concerned about the
manufacturer or dealer providing unreliable information.

c.

The four causes of information risk are essentially the same for a
buyer of an automobile and a user of financial statements:

(1)
Remoteness of information It is difficult for a user to obtain
much information about either an automobile manufacturer
or the automobile itself without incurring considerable cost.
The automobile buyer does have the advantage of possibly
knowing other users who are satisfied or dissatisfied with a
similar automobile.
(2)
Biases and motives of provider There is a conflict between
the automobile buyer and the manufacturer. The buyer wants
to buy a high quality product at minimum cost whereas the
seller wants to maximize the selling price and quantity sold.
(3)
Voluminous data There is a large amount of available
information about automobiles that users might like to have
in order to evaluate an automobile. Either that information is
not available or too costly to obtain.
(4)
Complex exchange transactions The acquisition of an
automobile is expensive and certainly a complex decision
because of all the components that go into making a good
automobile and choosing between a large number of
alternatives.

d.

The three ways users of financial statements and buyers of
automobiles reduce information risk are also similar:
(1)
User verifies information him or herself That can be obtained

by driving different automobiles, examining the specifications of
the automobiles, talking to other users and doing research in
various magazines.
(2)
User shares information risk with management
The
manufacturer of a product has a responsibility to meet its
warranties and to provide a reasonable product. The buyer
of an automobile can return the automobile for correction of
defects. In some cases a refund may be obtained.
(3)
Examine the information prepared by Consumer Reports
This is similar to an audit in the sense that independent
information is provided by an independent party. The
information provided by Consumer Reports is comparable to
that provided by a CPA firm that audited financial statements.
1-8


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1-19

a.

The following parts of the definition of auditing are related to the
narrative:
(1)
Virms is being asked to issue a report about qualitative and
quantitative information for trucks. The trucks are therefore

the information with which the auditor is concerned.
(2)
There are four established criteria which must be evaluated
and reported by Virms: existence of the trucks on the night
of June 30, 2009, ownership of each truck by Regional
Delivery Service, physical condition of each truck and fair
market value of each truck.
(3)
Susan Virms will accumulate and evaluate four types of
evidence:
(a)
Count the trucks to determine their existence.
(b)
Use registrations documents held by Oatley for
comparison to the serial number on each truck to
determine ownership.
(c)
Examine the trucks to determine each truck's physical
condition.
(d)
Examine the blue book to determine the fair market
value of each truck.
(4)
Susan Virms, CPA, appears qualified, as a competent,
independent person. She is a CPA, and she spends most of
her time auditing used automobile and truck dealerships and
has extensive specialized knowledge about used trucks that
is consistent with the nature of the engagement.
(5)
The report results are to include:

(a)
which of the 35 trucks are parked in Regional's
parking lot the night of June 30.
(b)
whether all of the trucks are owned by Regional
Delivery Service.
(c)
the condition of each truck, using established
guidelines.
(d)
fair market value of each truck using the current blue
book for trucks.

b.

The only parts of the audit that will be difficult for Virms are:
(1)
Evaluating the condition, using the guidelines of poor, good,
and excellent. It is highly subjective to do so. If she uses a
different criterion than the "blue book," the fair market value
will not be meaningful. Her experience will be essential in
using this guideline.
(2)
Determining the fair market value, unless it is clearly defined
in the blue book for each condition.

1-9


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1-20 a.
narrative:

b.

The following parts of the definition of auditing are related to the
(1) Haraldsson is being asked to issue a report about qualitative
and quantitative information for the buses. The buses and their
value are therefore the information with which she is
concerned.
(2) There are four established criteria which must be evaluated and
reported by Haraldsson: existence of the buses on the night of
August 31, 2008, ownership of each bus by Danville Bus
Services, physical condition of each bus and fair market value
of each bus.
(3) Annaliese Haraldsson will accumulate and evaluate four types
of evidence:
(e)
Count the buses to determine their existence.
(f)
Use registrations documents held by Olson for
comparison to the serial number on each bus to
determine ownership.
(g)
Examine the buses to determine each bus's physical
condition. She can examine the bus’s condition
herself or hire an expert to do so.
(h)
Examine the blue book to determine the fair market

value of each bus.
(4) Annaliese Haraldsson, CPA, appears qualified, as a competent,
independent person. She is a CPA, and she spends most of
her time auditing used automobile, bus, and truck dealerships,
and has experience that is consistent with the nature of the
engagement.
(5) The report results are to include:
(i)
which of the 20 buses are parked in Danville's parking
lot the night of August 31.
(j)
whether all of the buses are owned by Danville Bus
Services.
(k)
the condition of each bus, using established
guidelines.
(l)
fair market value of each bus using the current blue
book for buses.
The only parts of the audit that will be difficult for Haraldsson are:
(1)
Evaluating the condition, using the guidelines of poor, good,
and excellent. It is highly subjective to do so. One method is
to find the “blue book” value. (Note: Kelley Blue Book is a
United States automotive vehicle valuation company that
gives used vehicle pricing information. Because of its
popularity, the term “blue book” has become synonymous
with the car’s market value.) If she uses a different criterion
than the "blue book," the fair market value will not be
meaningful. Her experience will be essential in using this

guideline.

1-10


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(2)

1-21

Determining the fair market value, unless it is clearly defined
in the blue book for each condition.

a. The major advantages and disadvantages of a career as an CAO
auditor, tax authority agent, CPA, or internal auditor are:

EMPLOYMENT

ADVANTAGES

DISADVANTAGES

CAO AUDITOR

1. Increasing opportunity for
experience in operational
auditing.
2. Exposure to highly
sophisticated statistical

sampling and computer
auditing techniques.

1. Possibility of limited
exposure to diversity of
enterprises and industries.
2. Bureaucracy of federal
government.

TAX
AUTHORITY
AGENT

1. Extensive training in
individual, corporate, gift,
trust and other taxes is
available with concentration
in area chosen.
2. Hands-on experience with
sophisticated selection
techniques.
1. Extensive training in audit of
financial statements,
compliance auditing and
operational auditing.
2. Opportunity for experience in
auditing, tax consulting, and
management consulting
practices.
3. Experience in a diversity of

enterprises and industries
with the opportunity to
specialize in a specific
industry.
4. Experience with risk
assessment and sampling
techniques
1. Extensive exposure to all
segments of the enterprise
with which employed.
2. Constant exposure to one
industry presenting
opportunity for expertise in
that industry.
3. Likely to have exposure to
compliance, financial and
operational auditing.

1. Experience limited to
taxes.
2. No experience with
operational or financial
statement auditing.
3. Training is not extensive
with any business
enterprise.
1. Exposure to taxes and to
the business enterprise
may not be as in-depth as
the internal revenue agent

or the internal auditor.
2. Likely to be less exposed
to operational auditing
than is likely for internal
auditors.

CPA

INTERNAL
AUDITOR

1-11

1. Little exposure to taxation
and the audit thereof.
2. Experience is limited to
one enterprise, usually
within one or a limited
number of industries.


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1-22

(b)

Other auditing careers that are available are:
ƒ Auditors within many of the branches of the federal government
(e.g., Atomic Energy Commission)

ƒ Auditors for many state and local government units (e.g., state
insurance or bank auditors)

a.

The conglomerate should either engage the management advisory
services division of a CPA firm or its own internal auditors to
conduct the operational audit.
The auditors will encounter problems in establishing criteria for
evaluating the actual quantitative events and in setting the scope to
include all operations in which significant inefficiencies might exist.
In writing the report, the auditors must choose proper wording to
state that no financial audit was performed, that the procedures
were limited in scope and that the results reported do not
necessarily include all the inefficiencies that might exist.

b.

 Internet Problem Solution: Sarbanes—Oxley Act Internal Control Reporting

Requirements
1-1

The Sarbanes-Oxley Act (SOX), also known as the Public Company
Accounting Reform and Investor Protection Act, was signed into law on
July 30, 2002. Considered by many to be the most sweeping corporate
reform legislation since the 1933 and 1934 securities legislation, SOX
ushered in a variety of new requirements including reporting on internal
control over financial reporting. The newly created Public Company
Accounting Oversight Board (PCAOB) was charged with establishing

standards applicable to audits of internal control over financial reporting.
Visit the PCAOB’s website (below) to review the full text of SOX to answer
the following questions:
[ />
1.

According to Section 404 of SOX a public company’s annual report
must include an internal control report. What are the two required
elements of management’s report on internal control?

1-12


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Internet Problem 1-1 (continued)
Answer: According to Section 404 the two required elements of
management’s report on internal control are:
a.

b.

2.

a statement that management is responsible for establishing
and maintaining an adequate internal control structure and
procedures for financial reporting.
an assessment, as of the end of the most recent fiscal year
of the issuer, of the effectiveness of the internal control
structure and procedures of the issuer for financial reporting.

What obligation does a public company’s auditor have with respect
to internal control over financial reporting according to Section 404?
Answer: With respect to the internal control assessment prepared
by management, the company’s auditing firm that prepares or
issues the audit report for the company shall attest to, and report
on, the assessment made by the management of the issuer.
Section 404 indicates that the attestation should not be a separate
engagement, which means that it is to be integrated with the audit
of the financial statements.

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1-13


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Chapter 2
The CPA Profession
 Review Questions

2-1

The four major services that CPAs provide are:
1.

2.

3.
4.

Audit and assurance services Assurance services are independent
professional services that improve the quality of information for
decision makers. Assurance services include attestation services,
which are any services in which the CPA firm issues a report that
expresses a conclusion about the reliability of an assertion that is
the responsibility of another party. The four categories of attestation
services are audits of historical financial statements, attestation on
the effectiveness of internal control over financial reporting, reviews
of historical financial statements, and other attestation services.
Accounting and bookkeeping services Accounting services involve
preparing the client's financial statements from the client's records.
Bookkeeping services include the preparation of the client's
journals and ledgers as well as financial statements.
Tax services Tax services include preparation of corporate,
individual, and estate returns as well as tax planning assistance.
Management consulting services These services range from
suggestions to improve the client's accounting system to computer
installations.

2-2
The major characteristics of CPA firms that permit them to fulfill their
social function competently and independently are:
1.

2.

3.

Organizational form A CPA firm exists as a separate entity to avoid
an employer-employee relationship with its clients. The CPA firm
employs a professional staff of sufficient size to prevent one client
from constituting a significant portion of total income and thereby
endangering the firm's independence.
Conduct A CPA firm employs a professional staff of sufficient size
to provide a broad range of expertise, continuing education, and
promotion of a professional independent attitude and competence.
Peer review This practice evaluates the performance of CPA firms
in an attempt to keep competence high.

2-3
The Public Company Accounting Oversight Board provides oversight for
auditors of public companies, including establishing auditing and quality control
standards for public company audits, and performing inspections of the quality
controls at audit firms performing those audits.

2-1


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2-4
The purpose of the Securities and Exchange Commission is to assist in
providing investors with reliable information upon which to make investment
decisions. Since most reasonably large CPA firms have clients that must file
reports with the SEC each year (all companies filing registration statements
under the securities acts of l933 and l934 must file audited financial statements

and other reports with the SEC at least once each year), the profession is highly
involved with the SEC requirements.
The SEC has considerable influence in setting generally accepted accounting
principles and disclosure requirements for financial statements because of its
authority for specifying reporting requirements considered necessary for fair
disclosure to investors. In addition, the SEC has power to establish rules for any
CPA associated with audited financial statements submitted to the Commission.
2-5
The AICPA is the organization that sets professional requirements for
CPAs. The AICPA also conducts research and publishes materials on many
different subjects related to accounting, auditing, management advisory services,
and taxes. The organization also prepares and grades the CPA examinations,
provides continuing education to its members, and develops specialty designations
to help market and assure the quality of services in specialized practice areas.
2-6
Statements on Standards for Attestation Engagements provide a
framework for attest engagements, including detailed standards for specific types
of attestation engagements.
2-7
The PCAOB has responsibility for establishing auditing standards for
public companies, while the Auditing Standards Board (ASB) of the AICPA
establishes auditing standards for private companies. The ASB previously had
responsibility for establishing auditing standards for both public and private
companies. Existing auditing standards were adopted by the PCAOB as interim
auditing standards for public company audits.
2-8
Generally accepted auditing standards are ten general guidelines to aid
auditors in fulfilling their professional responsibilities. These guidelines include
three general standards concerned with competence, independence, and due
professional care; three standards of field work including planning and supervision,

understanding the entity and its environment, including its internal control, and
the gathering of sufficient appropriate evidence; and four standards of reporting,
which require a statement as to presentation in accordance with generally
accepted accounting principles, inconsistency observed in the current period in
relation to the preceding period, adequate disclosure, and the expression of an
opinion as to the fairness of the presentation of the financial statements.
Generally accepted accounting principles are specific rules for accounting
for transactions occurring in a business enterprise. Examples may be any of the
opinions of the FASB.

2-2


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2-9
Auditors can obtain adequate technical training and proficiency through
formal education in auditing and accounting, adequate practical experience, and
continuing professional education. Auditors can demonstrate their proficiency by
becoming licensed to practice as CPAs, which requires successful completion of
the Uniform CPA Examination. The specific requirements for licensure vary from
state to state.
2-10 For the most part, generally accepted auditing standards are general
rather than specific. Many practitioners along with critics of the profession believe
the standards should provide more clearly defined guidelines as an aid in
determining the extent of evidence to be accumulated. This would eliminate
some of the difficult audit decisions and provide a source of defense if the CPA is
charged with conducting an inadequate audit. On the other hand, highly specific
requirements could turn auditing into mechanical evidence gathering, void of
professional judgment. From the point of view of both the profession and the

users of auditing services, there is probably a greater harm from defining
authoritative guidelines too specifically than too broadly.
2-11 International Standards on Auditing (ISAs) are issued by the International
Auditing and Assurance Standards Board (IAASB) of the International Federation
of Accountants (IFAC). ISAs are designed to improve the uniformity of auditing
practices and related services throughout the world by issuing pronouncements
on a variety of audit and attest functions and promoting their acceptance
worldwide. A CPA who conducts an audit in accordance with GAAS may not
comply with ISAs because there may be additional ISA requirements that extend
beyond GAAS requirements.
2-12 Quality controls are the procedures used by a CPA firm that help it meet
its professional responsibilities to clients. Quality controls are therefore established
for the entire CPA firm as opposed to individual engagements.
2-13 The element of quality control is personnel management. The purpose of
the requirement is to help assure CPA firms that all new personnel are qualified
to perform their work competently. A CPA firm must have competent employees
conducting the audits if quality audits are to occur.
2-14 A peer review is a review, by CPAs, of a CPA firm's compliance with its
quality control system. A mandatory peer review means that such a review is
required periodically. AICPA member firms are required to have a peer review
every three years. Registered firms with the PCAOB are subject to quality
inspections. These are different than peer reviews because they are performed
by independent inspection teams rather than another CPA firm.
Peer reviews can be beneficial to the profession and to individual firms. By
helping firms meet quality control standards, the profession gains if reviews result
in practitioners doing higher quality audits. A firm having a peer review can also
gain if it improves the firm's practices and thereby enhances its reputation and
effectiveness, and reduces the likelihood of lawsuits. Of course peer reviews are
costly. There is always a trade-off between cost and benefits.

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2-15 Firms may belong to Center for Audit Quality and the Private Companies
Practice Section (PCPS) Firm Practice Center. The mission of the Center for
Audit Quality is to foster confidence in the audit process and to aid investors and
the capital markets by advancing constructive suggestions for change rooted in
the profession’s core values of integrity, objectivity, honesty and trust. The PCPS
Firm Practice Center provides practice management resources for firms of all sizes.
In addition to these resource centers, the AICPA also provides the
Governmental Audit Quality Center and Employee Benefit Plan Audit Quality
Center to provide resources for performing quality audits in these unique and
complex audit areas.

 Multiple Choice Questions From CPA Examinations

2-16

a.

(1)

b.

(2)

c.

(3)

d.

(3)

2-17

a.

(2)

b.

(1)

c.

(2)

d.

(3)

 Discussion Questions And Problems

2-18

a.

The comments summarize the beliefs of many practitioners about
the Sarbanes–Oxley Act and the PCAOB. The arguments against
the Act can be summarized as four arguments:
1.

2.
3.
4.

Costs of complying with the Act are excessively high, especially
the requirement to report on internal control over financial
reporting, and will discourage companies from becoming public
companies.
Relative cost for local audit firms is excessively high.
Additional oversight is not needed because sufficient quality
controls have already been implemented by most audit firms.
Three other things already provide assurance of adequate
quality: a competitive economic environment, legal liability,
and auditing standards.

To support these comments, it can be argued that the
profession has generally functioned well with relatively little
controversy and criticism.
The arguments against these comments are primarily as follows:
1.

2.

Reporting on the effectiveness of internal control over financial
reporting will provide benefits in improved controls, resulting

in higher quality financial reporting and reduced losses from
fraud.
The increased confidence in financial reporting will increase
access to capital and lower the cost of capital by reducing
information risk.
2-4


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2-18 (continued)
3.
4.

b.

Changes in the scope of CPA practices and other threats to
audit quality required government regulation.
Regulation of public company audits will not affect most audit
firms that do not have public company audit clients.

There is no correct answer to this question. Different people reach
different conclusions, depending on the weights put on the various
arguments. Time is needed to effectively assess both the costs and
benefits of the Act.

2-19 a.
b.
c.
d.

e.
f.
g.
h.
i.
j.

Engagement performance
Human resources
Engagement performance
Engagement performance
Relevant ethical requirements
Monitoring
Acceptance and continuation of clients and engagements
Human resources
Human resources
Leadership responsibilities

2-20

Rossi and Montgomery's primary ethical consideration is their
professional competence to perform all of the audit work for filing
with the SEC. In addition, if Rossi and Montgomery have performed
bookkeeping services or certain consulting services for Mobile Home,
they will not be independent under PCAOB and SEC independence
requirements. The firm must also be a registered firm with the
PCAOB.
The filing with the SEC, in addition to normal audited financial
statements, will require completion and registration with the SEC of
Form S-1 which includes an audited summary of operations for the

last five fiscal years as well as many additional schedules and
descriptions of the business. Each quarter subsequent to the filing,
Form 10-Q must be filed; and within 90 days of the end of each
fiscal year Form 10-K must be filed with the SEC.
In addition, Form 8-K must be filed whenever significant
events have occurred which are of interest to public investors.
These forms must be filed in conformity with Regulation S-X, which
requires considerable disclosures in addition to those normally
required in audited financial statements.

a.

b.

2-5


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2-21
a. The auditor’s primary ethical consideration is their
professional competence to perform all of the audit work for filing
with the SEC. In addition, another ethical consideration is independence
both in fact and appearance. For example, if the auditor’s have performed
bookkeeping services or certain consulting services for Al-Abdullah
Trading Company, they will not be independent under PCAOB and SEC
independence requirements. The firm must also be a registered firm with
the PCAOB.
b. The filing with the SEC, in addition to normal audited financial statements,
will require completion and registration with the SEC of Form S-1 which

includes an audited summary of operations for the last five fiscal years as
well as many additional schedules and descriptions of the business. Each
quarter subsequent to the filing, Form 10-Q must be filed; and within 90
days of the end of each fiscal year Form 10-K must be filed with the SEC.
In addition, Form 8-K must be filed whenever significant events
have occurred which are of interest to public investors. These forms must
be filed in conformity with Regulation S-X, which requires considerable
disclosures in addition to those normally required in audited financial
statements.
Considerations with the ISA are the understanding (competence) of
international standards. Also international standards do not trump laws of
the country in which the audit is performed, so the auditor must also have
an understanding of the laws of the country.
2-22 a.
b.
c.
d.
e.
f.

International auditing standards.
PCAOB auditing standards.
PCAOB auditing standards (reporting in the U.K. will be under
international auditing standards).
Generally accepted auditing standards.
International auditing standards.
PCAOB auditing standards (due to the publicly-traded debt).

 Internet Problem Solution: International Auditing and Assurance Standards

Board
2-1
International Standards on Auditing (ISAs) are issued by the International
Auditing and Assurance Standards Board (IAASB ( />Visit the IAASB’s website to answer the following questions:
1.

What is the primary objective of the IAASB?
Answer:
The objective of the IAASB is to serve the public interest by setting
high-quality auditing and assurance standards and by facilitating
the convergence of international and national standards, thereby
2-6


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enhancing the quality and uniformity of practice throughout the
world and strengthening public confidence in the global auditing
and assurance profession. International Standards on Auditing (ISA)
are used by auditors in countries that have adopted ISAs as their
auditing standards.
2.

What is the IAASB’s due process that it follows when setting
standards?
Answer:
The IAASB follows a due process in setting standards.
•

The standards-setting Public Interest Activity Committees

(PIAC) identify new projects based on review of international
developments and consultation with the Public Interest
Oversight Board.
•
The project may be assigned to a task force, which considers
whether to hold a public forum or roundtable.
•
Draft pronouncements are exposed for a minimum of 90 days.
•
The task force considers all comments and whether reexposure is needed.
•
The PIAC votes on the approval or withdrawal of the
pronouncement. Affirmative vote of at least two-thirds of the
members, but not less than 12, is required to approve an
exposure draft.
Internet Problem 2-1 (continued)
3.

The IAASB is committed to transparency. How does the IAASB
make public information related to standards setting activities?
Answer:
The IAASB is committed to transparency. Where practicable,
meetings are broadcast over the Internet or recorded. Meeting
agendas and minutes are published on the International Federation
of Accountants (IFAC) website. All exposure drafts are subject to
public exposure for a minimum of 90 days.

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Internet sites are subject to change, Internet problems and solutions may change. Current
information on Internet problems is available at www.pearsonglobaleditions.com/arens).

2-7


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Chapter 3
Audit Reports
 Review Questions

3-1
Auditor's reports are important to users of financial statements because
they inform users of the auditor's opinion as to whether or not the statements are
fairly stated or whether no conclusion can be made with regard to the fairness of
their presentation. Users especially look for any deviation from the wording of the
standard unqualified report and the reasons and implications of such deviations.
Having standard wording improves communications for the benefit of users of the
auditor’s report. When there are departures from the standard wording, users are
more likely to recognize and consider situations requiring a modification or
qualification to the auditor’s report or opinion.
3-2

The unqualified audit report consists of:
1.
2.
3.

4.

5.

6.
7.

Report title Auditing standards require that the report be titled and
that the title includes the word independent.
Audit report address The report is usually addressed to the company,
its stockholders, or the board of directors.
Introductory paragraph The first paragraph of the report does three
things: first, it makes the simple statement that the CPA firm has
done an audit. Second, it lists the financial statements that were
audited, including the balance sheet dates and the accounting
periods for the income statement and statement of cash flows.
Third, it states that the statements are the responsibility of
management and that the auditor's responsibility is to express an
opinion on the statements based on an audit.
Scope paragraph. The scope paragraph is a factual statement about
what the auditor did in the audit. The remainder briefly describes
important aspects of an audit.
Opinion paragraph. The final paragraph in the standard report
states the auditor's conclusions based on the results of the audit.
Name of CPA firm. The name identifies the CPA firm or practitioner
who performed the audit.
Audit report date. The appropriate date for the report is the end of
fieldwork, when the auditor has gathered sufficient appropriate
evidence to support the opinion.

The same seven parts are found in a qualified report as in an unqualified
report. There are also often one or more additional paragraphs explaining reasons
for the qualifications.

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3-3
The purposes of the scope paragraph in the auditor's report are to inform
the financial statement users that the audit was conducted in accordance with
generally accepted auditing standards, in general terms what those standards
mean, and whether the audit provides a reasonable basis for an opinion.
The information in the scope paragraph includes:
1.
2.
3.
4.

The auditor followed generally accepted auditing standards.
The audit is designed to obtain reasonable assurance about whether
the statements are free of material misstatement.
Discussion of the audit evidence accumulated.
Statement that the auditor believes the evidence accumulated was
appropriate for the circumstances to express the opinion presented.

3-4
The purpose of the opinion paragraph is to state the auditor's conclusions
based upon the results of the audit evidence. The most important information in
the opinion paragraph includes:
1.
2.
3.

The words "in our opinion" which indicate that the conclusions are
based on professional judgment.
A restatement of the financial statements that have been audited
and the dates thereof or a reference to the introductory paragraph.
A statement about whether the financial statements were presented
fairly and in accordance with generally accepted accounting
principles.

3-5
The auditor's report should be dated February 17, 2010, the date on which
the auditor concluded that he or she had sufficient appropriate evidence to support
the auditor’s opinion.
3-6

An unqualified report may be issued under the following five circumstances:
1.

2.
3.

4.

5.

All statements—balance sheet, income statement, statement of
retained earnings, and statement of cash flows—are included in the
financial statements.
The three general standards have been followed in all respects on
the engagement.

Sufficient evidence has been accumulated and the auditor has
conducted the engagement in a manner that enables him or her to
conclude that the three standards of field work have been met.
The financial statements are presented in accordance with generally
accepted accounting principles. This also means that adequate
disclosures have been included in the footnotes and other parts of
the financial statements.
There are no circumstances requiring the addition of an explanatory
paragraph or modification of the wording of the report.

3-2