THE FINANCIAL STATEMENT AUDITING ENVIRONMENT

Chapter 02 - The Financial Statement Auditing Environment 2-1 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

CHAPTER 2

THE FINANCIAL STATEMENT AUDITING ENVIRONMENT

Answers to Review Questions

2-1 Auditors can be classified under four types: (1) external auditors, (2) internal auditors, (3) government auditors, and (4) forensic auditors.

2-2 Examples of compliance audits include (1) internal auditors determining whether corporate rules and policies are being followed by departments within the organization, (2) an examination of tax returns of individuals and companies by the Internal Revenue Service for compliance with the tax laws, and (3) an audit under the Single Audit Act of 1984 to determine whether an entity receiving federal assistance is in compliance with applicable laws and regulations.

Examples of operational audits include (1) an audit by the GAO of the Food and Drug Administration to determine the efficiency and effectiveness of procedures for introducing new drugs to the market, (2) internal auditors examining the effectiveness and efficiency of funds being spent on the entity’s computer resources, and (3) a university hiring an external auditor to examine the effectiveness and efficiency of student advisory services.

Examples of forensic audits include (1) an examination by an external auditor of cash disbursements for payments to unauthorized vendors, (2) assistance by an auditor to a law enforcement agency in tracing laundered monies by organized criminals, and (3) an independent auditor helping identify hidden assets as part of a divorce settlement.

Student answers will likely be less detailed but should capture the general idea of each type of audit.

2-3 During the late 1990s and early 2000s, accounting firms aggressively sought opportunities to expand their business in nonaudit services such as consulting. This expansion from their core audit practice, combined with allegations of auditors refusing to challenge management’s actions, resulted in conflict between regulators and the accounting profession. Subsequent financial fiascos such as those at Enron, WorldCom, Tyco, and many others caused investors to doubt the fundamental integrity of the financial reporting system. Under pressure to restore the public’s confidence, Congress passed the Sarbanes- Oxley Act and created the PCAOB in 2002.

2-4 The accounting profession’s expansion into new areas, combined with changes in the overall business environment, resulted in new regulations and guidelines. The scandals of the late 1990s and early 2000s brought into question the profession’s ability to self- regulate, resulting in new legislation. While these changes have caused pain and turmoil, they highlight the essential importance of auditing in our economic system. Ultimately, the “back to basics” emphasis, along with auditing firms’ renewed focus on thorough and effective financial statement audits, will likely prove healthy for the U.S. financial Auditing and Assurance Services A Systematic Approach 9th Edition Messier Solutions Manual Visit TestBankDeal.com to get complete for all chapters

Chapter 02 - The Financial Statement Auditing Environment 2-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

reporting system and for the profession. Further, somewhat ironically, the SOX-mandated audit of internal control over financial reporting has brought significant new revenues to accounting firms.

2-5 Management is responsible to prepare financial statements that fairly present the company’s financial condition and operations in accordance with established accounting standards. Note that the auditor’s opinion explicitly states that the financial statements are the responsibility of management. The auditor is responsible to issue an opinion in regards to the financial statements prepared by management. In order to issue this opinion, the auditor must plan and perform the audit in accordance with established standards to obtain reasonable assurance that the financial statements are free of material misstatement, whether caused by error or fraud. However, it is important to note that an auditor’s unqualified opinion does not mean that errors or fraud do not exist but rather that there is reasonable assurance that they do not exist in material amounts.

2-6 The essential components of the high-level model of business offered in the chapter are: corporate governance, objectives, strategies, processes, controls, transactions, and financial statements. Corporate governance is carried out by management and the board of directors in order to ensure that business objectives are carried out and that company assets are safeguarded. To achieve its objectives, management must formulate strategies and implement various processes which are in turn carried out through business transactions. The entity’s information and internal control systems must be designed to ensure that these transactions are properly executed, captured, and processed in order to produce accurate financial statements. It is important that the auditor obtain a firm understanding of these components in order to understand relevant risks and to plan the nature, timing, and extent of the audit so that it is efficient and effective.

2-7 The information system must maintain a record of all businesses transactions. It should be capable of producing accurate financial reports to summarize the effects of the entity’s transactions. Among other things, internal control is required to ensure that a proper environment is established and that transactions are appropriately conducted and recorded by the information system and company employees. Effective internal control provides safeguards to ensure the (1) reliability of financial reporting, (2) compliance with laws and regulations, and (3) the effectiveness and efficiency of operations. Auditing standards require that the auditor obtain an understanding of the client’s environment, including its internal control, in planning the nature, timing, and extent of testing.

2-8 The AICPA issues the following standards:

 Statements on Auditing Standards  Statements on Standards for Attestation Engagements  Statements on Standards for Accounting and Review Services  Statements on Quality Control Standards  Standards for Performing and Reporting on Peer Reviews  Statements on Standards for Consulting Services  Statements on Standards for Tax Services

Chapter 02 - The Financial Statement Auditing Environment 2-3 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

2-9 The PCAOB is a quasi-governmental organization overseen by the SEC. It was formed to provide governmental regulation of the standards used in conducting public company audits because of a perceived failure of the profession to adequately regulate itself.

2-10 The SEC has congressional authority from the original Securities Acts of 1933 and 1934 to establish accounting and auditing standards for publicly traded companies; however, in the past the SEC has largely delegated this authority to other bodies, including the FASB and the AICPA’s Auditing Standards Board. The Sarbanes-Oxley Act of 2002 gave the SEC the mandate to actively regulate the public accounting profession by establishing and overseeing the PCAOB and its standard-setting process relating to the audits of public companies. The SEC has authority to implement and oversee standards relating to all aspects of the audits of public companies, including standards relating to auditor independence (such as the requirement for audit firms to rotate audit partners off audit engagements every five years).

2-11 The documents most frequently encountered by auditors under the Securities Exchange Act of 1934 are forms 10-K, 10-Q, and 8-K. Forms 10-K and 10-Q are, respectively, annual and quarterly reports, which include the audited financial statements periodically filed with the SEC by a publicly traded entity. An 8-K is filed whenever a significant event occurs which may be of interest to investors, such as a change of independent auditors.

2-12 The four categories of Principles Underlying an Audit Conducted in Accordance with GAAS are the purpose and premise of an audit, personal responsibilities of the auditor, auditor actions in performing the audit, and reporting. The Principles Underlying an Audit include all of the key concepts conveyed in the 10 GAAS, but do so in a more organized and coherent manner. They also address other key concepts that are not addressed in the 10 GAAS, such as explicitly identifying the fundamental purpose of an audit and management’s responsibilities.

2-13 GAAS is composed of three categories of standards: general standards, standards of field work, and standards of reporting. The ten GAAS and the SAS are minimum standards of performance because circumstances of individual engagements may require the auditor to perform audit work beyond that specified in GAAS and the SAS in order to appropriately issue an opinion that a set of financial statements is fairly presented. As a result, the auditor needs to use professional judgment in following all standards.

2-14 Independence is a fundamental 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.

Chapter 02 - The Financial Statement Auditing Environment 2-4 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Answers to Multiple-Choice Questions

2-15 b 2-20 a 2-16 a 2-21 a 2-17 a 2-22 c 2-18 d 2-23 c 2-19 c

Solutions to Problems

2-24

Item Number

Type of Audit

Type of Auditor

a.

Operational

Government

b.

Financial statement

External

c.

Compliance or operational or possibly internal control

Internal or external

• Forensic Internal, external, or forensic

e.

Operational

Government, external, or internal

f.

Operational

Internal or external

g.

Compliance

Government

h.

Compliance or forensic

Government, external, or forensic

2-25 a.

Brief Description of Generally Accepted Auditing Standards

Sally Jones' Actions Resulting in Failure to Comply with Generally Accepted Auditing Standards

General Standards:

• The auditor must have adequate

technical training and proficiency to perform the audit.

• It was inappropriate for Jones to hire

the two students to conduct the audit. The examination must be conducted by persons with proper