Solution manual auditing theory by cabrera chapter 02

CHAPTER 2
OVERVIEW OF AUDITING
I. Review 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 generally accepted accounting principles (GAAP), as well as
generally accepted auditing standards (GAAS).
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.


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3.

Audits of Financial
Statements

Compliance
Audits

Operational
Audits

Purpose

To determine whether
the financial statements
are presented in
accordance with GAAP.

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

To evaluate whether
operating procedures
are efficient and
effective.

Users of
Audit
Report

Different groups for
different purposes –
many outside entities.

Authority setting down
procedures, internal or
external

Management of
organization

Nature

Highly standardized

Not standardized, but
very specific and
usually objective

Highly nonstandard;
often very subjective

Performed by:
CPAs
COA Auditors
BIR Auditors
Internal Auditors

Almost universally
Occasionally

Never
Frequently

Occasionally
Frequently
Universally
Frequently

Frequently
Frequently
Never
Frequently

4. The major differences in the scope of audit responsibilities are:
1. 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.
2. 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.
3. BIR agents perform compliance audits to enforce the tax laws as defined by
Congress, interpreted by the courts, and regulated by the BIR law.
4. 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.
5. 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


Overview of Auditing

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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
computerized systems
b. multiple product lines
c. multiple transaction locations

processed

daily

via

sophisticated

4. 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

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

Users share
information risk
with
management

1. No audit costs incurred.

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

Audited financial
statements are
prepared

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.

7. 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,

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•
•

voluminous data, and
complex exchange transactions.

8. 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 45 and 46 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
SFAS. 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 generally accepted accounting principles.


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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. A compliance audit is an audit to determine whether financial reports or other assertions
are in compliance with established criteria. The necessary ingredients are verifiable
data and the existence of standards established by an authoritative body. An
operational audit, on the other hand, is a review of a department or other unit of a

business or governmental organization to measure the effectiveness and efficiency of
operations. Internal auditors often perform operational audits as do auditors employed
by the Commission on Audit (COA) of the national government and public practitioners
as part of their consultancy services.
16. 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.”
17. (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.
II. Multiple Choice Questions
1.

2.
3.
4.
5.

d
a
a
d (PSAs)
b

6.
7.
8.
9.
10.

c
b
c
b
d

III. Comprehensive Cases

11.
12.
13.
14.
15.

b
a
c
c
a

16.
17.
18.
19.
20.

d
a
a
d
c

21. d


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Case 1.

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

Employment

Advantages

Disadvantages

BIR agent

1. Extensive training in
individual, corporate, gift,
trust, and other taxes is
available with concentration
in area chosen.
2. On-hand experience with
sophisticated selection
techniques.

1. Experience limited to
taxes.
2. No experience with
operational or financial
statement auditing.
3. Training is not extensive
with any business
enterprise.

CPA

1. Extensive training in audit of
financial statements,

compliance auditing and
operational auditing.
2. Opportunity for experience in
auditing, tax counseling, and
management consulting
practices.
3. Experience in a diversity of
enterprises and industries
with the opportunity to
specialize in a particular
industry.

1. Exposure to taxes and to
the business enterprise
may not be as in-depth as
the BIR agent or the
internal auditor.
2. Likely to be less exposed
to operational auditing
than is likely for internal
auditors.

Internal
Auditor

1. Extensive exposure to all
segments of the enterprise
with which employed.
2. Constant exposure to one
industry presenting

opportunity for expertise in
that industry.
3. Likely to have exposure to
compliance, financial and
operational auditing.

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


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b. Other auditing careers that are available are:
1. COA auditor
2. Auditors within many of the branches of the government
3. Auditors for many local government units
Case 2.

The most likely type of auditor and the type of audit for each of the examples are:

Example
1.
2.
3.

4.
5.
6.
7.
8.
9.
10.
11.
12.
Case 3.

Type of Auditor
COA
CPA; Internal Auditor
Internal auditor; CPA
CPA
CPA
COA
CPA
COA
CPA; Internal Auditor
Internal auditor or CPA
CPA or COA
CPA; BIR

Type of Audit
Compliance
Operational
Compliance
Financial statements

Tax audit; FS audit
Financial statements
Financial statements
Operational audit
Financial statements
Operational audit
Operational audit
Compliance

a. The overriding objective of an independent audit is to provide reasonable
assurance that the financial statements fairly reflect the economic substance of the
transactions and events reflected in those statements. To this end, the auditor tests
management’s assertions as embodied in the financial statements, and renders an
opinion concerning fairness. Testing involves gathering and evaluating evidence
relating to the assertions. The opinion assumes the form of an audit report
formulated and issued at the conclusion of the examination.
b. An independent audit may be beneficial to Lyn Cruz in the following ways:
1. Correction of identified weaknesses in the accounting system may improve
the quality of financial reporting;
2. The independent auditor may be able to assist Lyn in improving physical
safeguards over assets;
3. An independent audit may facilitate Lyn’s efforts in raising new capital;
4. The audit may identify a need for improved budgeting and performance
reporting, thus improving control over costs and revenues;
5. Although not designed for this purpose, the audit may disclose defalcations
by employees;
6. To determine amounts receivable or payable under bonus, profit sharing, and
pension plans; lease agreements; royalty agreements; and other contracts
and agreements;
7. To serve as an error and/or irregularity prevention device by making

employees aware of audit coverage.

Case 4.

Types of Auditors and Services Performed


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Topic
1
2
3
4
5
6
7
8
9
10

Type of Auditor
CPA
CPA
Internal auditor; CPA
COA
Bank examiner
CPA

CPA
Internal auditor; CPA
BIR; CPA
CPA; COA

Class of Work
Audit of financial statements
Audit of financial statements
Operational audit
Operational audit
Compliance audit
Mngt. advisory services
Audit of financial statements
Operational audit
Compliance audit
Compliance audit