THE FINANCIAL STATEMENT AUDITING ENVIRONMENT

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Chapter 02 - The Financial Statement Auditing Environment 2-1 © 2017 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—Auditors who are referred to as “external” or “independent” because they are not employees of the entity being audited. Audit financial statements for publicly traded and private companies, partnerships, municipalities, individuals, and other types of entities. May also conduct compliance, operational, and forensic audits for such entities (2) Internal auditors—Auditors who are employees of individual companies, government agencies, and other entities. Often conduct financial, internal control, compliance, operational, and forensic audits within their organizations. In some cases they may assist the external auditors with the annual financial statement audit. Internal auditors also often are involved in assurance and consulting engagements for their entities.(3) Government auditors—Auditors employed by federal, state, and local agencies.Government auditors are usually considered to be a type of internal auditor. Conduct audits of activities, financial transactions, and accounts of the federal government. They also assist Congress by performing special audits, surveys, and investigations. The majority of the audits are compliance and operational audits. May also investigate for fraud in government agencies and other organizations subject to federal laws.(4) Forensic auditors—Auditors employed by corporations, government agencies, public accounting firms, and consulting and investigative services firms. They are specially trained in detecting, investigating, and deterring fraud and white-collar crime.

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

Chapter 02 - The Financial Statement Auditing Environment 2-2 © 2017 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.

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

Chapter 02 - The Financial Statement Auditing Environment 2-3 © 2017 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