AN INTRODUCTION TO ASSURANCE AND FINANCIAL

1-1 Copyright ©2023 McGraw Hill Limited. All rights reserved.

CHAPTER 1

AN INTRODUCTION TO ASSURANCE AND FINANCIAL

STATEMENT AUDITING

Answers to Review Questions 1-1The study of auditing is more conceptual in nature as compared to financial accounting.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. This framework enables auditors 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 accountants, business managers, consultants, and other business decision makers by providing a framework for evaluating the usefulness and reliability of information—an important task in many different business contexts.1-2There is a demand for auditing in a free-market economy because the agency relationship between an absentee owner (principle) and a manager (agent) produces a natural conflict of interest due to the information asymmetry that exists between these two parties. 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 that 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. Furthermore, many private companies seek out financial statement audits in order to secure financing for their operations. Companies preparing to go public also benefit from having an audit.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 likely has different goals than the owner. For instance, the owner is interested in maximizing the company’s value, whereas the manager may seek to maximize their remuneration. Generally, the manager 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, the manager may 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, it is also a regulatory requirement. 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 client’s financial statements, and the auditor’s work loses its value. From an agency perspective, if the principal (owner) knows that the auditor Auditing & Assurance Services 4th Canadian Edition, 4e Messier, Glover, Prawitt, Paisley, Springate (Solutions Manual All Chapters) Supplement files download link at the end of this file. 1 / 4

Chapter 01 - An Introduction to Assurance and Financial Statement Auditing 1-2 Copyright ©2023 McGraw Hill Limited. All rights reserved.

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.

1-5 Auditing (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 a subject matter, or an assertion about a 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.

1-6 The phrase systematic process implies that there should be a well-planned, logical approach for conducting an audit that involves objectively obtaining and evaluating evidence. It requires organizing a plan for gathering evidence and documenting steps taken during the audit to evaluate the relevance and reliability of the evidence.

1-7 Audit risk is defined as the risk that the auditor fails to appropriately modify their opinion on financial statements that are materially misstated (AS 1101). Materiality 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" (FASB Statement of Financial Accounting Concepts No. 8, Chapter 3: Qualitative Characteristics of Useful Accounting Information,).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 way 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 and/or report it.

1-8 The major phases of the audit are:

• Client acceptance/continuance • 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

1-9 Plan the audit: During this phase of the audit, the auditor uses knowledge about the client and any controls in place to perform preliminary analytical procedures and plan the audit.The outcome of the planning process is a written audit plan that sets forth the nature, extent, and timing of the audit procedures to be performed in the remaining phases of the audit. The 2 / 4

Chapter 01 - An Introduction to Assurance and Financial Statement Auditing 1-3 Copyright ©2023 McGraw Hill Limited. All rights reserved.

purpose of this phase is to plan an effective and efficient audit.

1-10 The auditor's standard unqualified report for a public company client includes the following sections: (1) opinion on the financial statements, (2) basis for opinion, (3) critical audit matters, (4) Responsibilities of Management and Those Charged with Governance for the Financial Statements, and (5) Auditor’s Responsibilities for the Audit of the Financial Statements, as illustrated in this chapter.

1-11 The emergence of advanced audit technologies will help remove many of the tedious tasks that are usually performed by junior auditors. Thus, auditors of all positions and experience will be able to spend more time reasoning through fundamental business, accounting, and auditing concepts, and exercising professional judgment. An auditor’s knowledge in these advanced audit technologies areas will enable them to provide greater value to clients by identifying new, more effective and efficient ways to collect, analyze, and interpret results.In using audit data analytics, for example, auditors must understand the client and its industry, as well as the fundamentals of accounting and auditing, to ask the right questions in querying the data and in interpreting the results obtained.

1-12 Every client is different and applying auditing concepts in different situations requires logic and common sense, and frequently creativity and innovation. Auditors frequently face situations where no standard audit procedure exists, such as the example from the chapter’s conclusion 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.

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

1-24 There are two major factors that may make an audit necessary for Greenbloom Garden Centers. First, the company may require long-term financing for its expansion into other cities in Ontario. Entities such as banks or insurance companies are likely to be the sources of the company's debt financing. There is information asymmetry between the lender of funds and the owner of the business, and this asymmetry results in information risk to the lender. For this reason, these entities normally require audited financial statements before lending significant funds and generally require audited financial statements during the time period the debt is outstanding. Even if the business could get funding without an audit, a clean audit report by a reputable auditor might very well reduce the lender’s information 3 / 4

Chapter 01 - An Introduction to Assurance and Financial Statement Auditing 1-4 Copyright ©2023 McGraw Hill Limited. All rights reserved.

risk and make the terms of the loan more favorable to the owner. Second, as the company grows, the family will lose control over the day-to-day operations of the stores. An audit will be potentially valuable for the company as it can provide an additional monitoring activity for the family in controlling the expanded operations of the company.

1-25 a. Audit evidence is defined as any evidence that assists the auditor in evaluating financial statement assertions. It consists of the underlying accounting data and any additional information available to the auditor, whether originating from the client or externally.

• 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. In short, the assertions are a conceptual tool to help the auditor ensure that she or he has “covered all the bases.” Audit evidence collected and evaluated by the auditor during the audit help her or him 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 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.

1-26 a. The major phases of the audit and their descriptions are:

• Client acceptance/continuance. The auditor decides to accept a new client or

to retain an existing client.

• Preliminary engagement activities. This phase involves (1) determining the

audit engagement team requirements, (2) ensuring the independence of the audit team and audit firm, and (3) establishing an understanding with the client regarding the services to be performed and the other terms of the engagement.

• Plan the audit. During this phase of the audit, the auditor uses the knowledge

of the client to perform preliminary analytical procedures and plan the audit.The purpose of this phase is to plan an effective and efficient audit.

• Consider and audit internal control. The auditor understands and evaluates

the client’s internal controls to assess the risk that they will not prevent or detect a material misstatement.

• Audit business processes and related accounts. The auditor conducts

substantive tests, including analytical procedures and the details of the account balances, searching for material misstatements.

• Complete the audit. The auditor searches for contingent liabilities and

subsequent events and performs a final review of the evidence gathered.

• Evaluate results and issue the audit report. Based on the collection and

evaluation of evidence, the auditor issues a report on whether the financial

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