Auditing and

Assurance Services Fourteenth Edition

Alvin A. Arens

Randal J. Elder

Mark S. Beasley

Prentice Hall

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ISBN-13: 978-0-13-257607-9

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CONTENTS

I. THE AUDITING PROFESSION

1 The Demand for Audit and Other Assurance Services .. . . . . . . . . . . . . . . . 1-1

2 The CPA Profession.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-1

3 Audit Reports.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-1

4 Professional Ethics .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-1

5 Legal Liability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-1

II. THE AUDIT PROCESS

6 Audit Responsibilities and Objectives.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-1

7 Audit Evidence ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-1

8 Audit Planning and Analytical Procedures.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-1

9 Materiality and Risk .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9-1

10 Section 404 Audits of Internal Control and Control Risk.. . . . . . . . . . . . . . . 10-1

11 Fraud Auditing .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11-1

12 The Impact of Information Technology on the Audit Process .. . . . . . . . . 12-1

13 Overall Audit Plan and Audit Program ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13-1

III. APPLICATION OF THE AUDIT PROCESS TO THE SALES AND

COLLECTION CYCLE

14 Audit of the Sales and Collection Cycle: Tests of Controls

and Substantive Tests of Transactions .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14-1

15 Auditing Sampling for Tests of Controls

and Substantive Tests of Transactions .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15-1

16 Completing the Tests in the Sales and Collection Cycle:

Accounts Receivable .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16-1

17 Audit Sampling for Tests of Details of Balances.. . . . . . . . . . . . . . . . . . . . . . . . 17-1

IV. APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES

18 Audit of the Acquisition and Payment Cycle:

Tests of Controls, Substantive Tests of Transactions,

and Accounts Payable .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18-1

19 Completing the Tests in the Acquisition and Payment Cycle:

Verification of Selected Accounts.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19-1

20 Audit of the Payroll and Personnel Cycle.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20-1

21 Audit of the Inventory and Warehousing Cycle .. . . . . . . . . . . . . . . . . . . . . . . . . 21-1

22 Audit of the Capital Acquisition and Repayment Cycle .. . . . . . . . . . . . . . . . 22-1

23 Audit of Cash Balances .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23-1

V. COMPLETING THE AUDIT

24 Completing the Audit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24-1

VI. OTHER ASSURANCE AND NONASSURANCE SERVICES

25 Other Assurance Services.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25-1

26 Internal and Governmental Financial Auditing

and Operational Auditing .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26-1

1-1

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 12 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 accordance with an applicable financial reporting framework such as U.S. GAAP or IFRS. 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. 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. 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.

3. Voluminous data a. Possibly millions of transactions processed daily via

sophisticated computerized systems b. Multiple product lines c. Multiple transaction locations

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

1-2

1-3 1. 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.

2. 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.

3. 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. User verifies the information. 2. User shares the information risk with management. 3. 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.

1-3

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 and electronic funds transfers, 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 accounting standards, 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.

1-4

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. Examine employee time records and personnel records to determine if sufficient information is available to maximize the effective use of personnel.

2. Review the processing of sales invoices to determine if it could be done more efficiently.

3. Review the acquisitions of goods, including costs, to determine if they are being purchased at the lowest possible cost considering the quality needed.

1-5

1-9 (continued)

4. Review and evaluate the efficiency of the manufacturing process. 5. 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. CPAs perform audits in accordance with auditing standards of published financial statements prepared in accordance with U.S. GAAP or IFRS.

2. 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.

3. IRS agents perform compliance audits to enforce the federal tax laws as defined by Congress, interpreted by the courts, and regulated by the IRS.

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.

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 information technology, including e-commerce, because many of their clients rely extensively on these technologies. 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.

1-6

� 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 a. The relationship among audit services, attestation services and

assurance services is reflected in Figure 1-3 on page 12 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) An attestation service other than an audit service

2. (1) An audit of historical financial statements 3. (2) An attestation service other than an audit service 4. (2) An attestation service other than an audit service; or

(3) 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.)

5. (2) An attestation service other than an audit service 6. (2) An attestation service other than an audit service 7. (2) 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.)

8. (2) An attestation service other than an audit service 9. (2) An attestation service other than an audit service 10. (3) An assurance service that is not an attestation service

1-17 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, Busch should select the loan from First

City 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:

1-7

1-17 (continued)

LENDER CPA

SERVICECOST OF CPA

SERVICES ANNUAL

INTEREST ANNUAL

LOAN COST

Existing loan None 0 $ 247,500 $ 247,500

United National Bank Review $ 20,000 $ 202,500 $ 222,500

First City Bank Audit $ 45,000 $ 157,500 $ 202,500

c. Busch should select the loan from United National Bank due to the

higher cost of the audit and the reduced interest rate for the loan from United National Bank. The following is the calculation of total costs for each loan:

LENDER CPA

SERVICECOST OF CPA

SERVICES ANNUAL

INTEREST ANNUAL

LOAN COST

Existing loan None 0 $ 247,500 $ 247,500

United National Bank Review $ 20,000 $ 180,000 $ 200,000

First City Bank Audit $ 55,000 $ 157,500 $ 212,500

d. Busch may desire to have an audit because of the many other

benefits that an audit provides. The audit will provide Busch’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.

1-18 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.

1-8

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.

1-9

1-19 a. The following parts of the definition of auditing are related to the narrative: (1) Altman 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 Altman: existence of the trucks on the night of June 30, 2011, ownership of each truck by Regional Delivery Service, physical condition of each truck and fair market value of each truck.

(3) Samantha Altman will accumulate and evaluate four types of evidence: (a) Count the trucks to determine their existence. (b) Use registrations documents held by Burrow 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) Samantha Altman, 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 25 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 Altman 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.

1-10

1-20 a. The major advantages and disadvantages of a career as an IRS agent, CPA, GAO auditor, or an internal auditor are:

EMPLOYMENT ADVANTAGES DISADVANTAGES

INTERNAL REVENUE 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. 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 consulting, and management consulting practices.

3. Experience in a diversity of enterprises and industries with the opportunity to specialize in a specific industry.

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.

GAO AUDITOR 1. Increasing opportunity for experience in operational auditing.

2. Exposure to highly sophisticated statistical sampling and computer auditing techniques.

1. Little exposure to diversity of enterprises and industries.

2. Bureaucracy of federal government.

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 of taxes.

2. Experience is limited to one enterprise, usually within one or a limited number of industries.

(b) Other auditing careers that are available are: � Auditors within many of the branches of the federal government

(e.g., Atomic Energy Commission) � Auditors for many state and local government units (e.g.,

state insurance or bank auditors)

1-11

1-21 The most likely type of auditor and the type of audit for each of the examples are:

EXAMPLE TYPE OF AUDITOR TYPE OF AUDIT

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

IRS GAO Internal auditor or CPA CPA or Internal auditor GAO CPA GAO IRS CPA Internal auditor or CPA Internal auditor or CPA GAO

Compliance Operational Operational Financial statements Operational Financial statements Financial statements Compliance Financial statements Compliance Financial statements or operational Compliance

1-22 a. Financial statement audits reduce information risk, which lowers

borrowing costs. An audit also provides assurances to management about information used for decision-making purposes, and may also provide recommendations to improve efficiency or effectiveness of operations.

b. Hogan and Czarnecki likely provide tax services, accounting

services, and management advisory services. They may also provide additional assurance and attestation services other than audits of financial statements.

c. Student answers will vary. They may identify new types of information

that require assurance, such as environmental or corporate responsibility reporting. Students may also identify opportunities for consulting or management advisory services, such as assistance with the adoption of international financial reporting standards.

� Internet Problem Solution: CPA Requirements Internet Problem 1-1

a. Answers will vary by state. Most states require 150 hours of education, with specific requirements for number of accounting hours and credit hours in other subject areas.

b. Most states have frequently addressed questions. Many of these

address education requirements, as well as information on how to prepare for the exam, as well as information on applying for licensure.

1-12

Internet Problem 1-1 (continued) c. The Elijah Watt Sells award program was established in 1923

by the American Institute of Certified Public Accountants (AICPA) to recognize outstanding performance on the Uniform CPA Examination. The Sells award is presented annually to ten candidates with the highest cumulative scores who completed testing during the previous calendar year and passed all four sections of the Uniform CPA Examination on their first attempt.

d. Passing information is available on the CPA Examination portion of

the AICPA web site. Recent passing rates have been approximately 45% for each section.

(Note: Internet problems address current issues using Internet sources. Because Internet sites are subject to change, Internet problems and solutions may change. Current information on Internet problems is available at www.pearsonhighered.com/arens.)

2-1

Chapter 2

The CPA Profession � Review Questions 2-1 The four major services that CPAs provide are:

1. 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.

2. 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.

3. Tax services Tax services include preparation of corporate, individual, and estate returns as well as tax planning assistance.

4. 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. 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.

2. 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.

3. 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.

2-2

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 U.S. public companies, while the Auditing Standards Board (ASB) of the AICPA establishes auditing standards for U.S. private companies. Prior to the creation of the PCAOB, the ASB had responsibility for establishing auditing standards for both public and private companies. Because existing auditing standards were adopted by the PCAOB as interim auditing standards for public company audits, there is considerable overlap in the two sets of auditing standards. 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, such as accounting for leases, pensions, or fair value assets.

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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) and are designed to improve the uniformity of auditing practices and related services throughout the world. The IAASB issues pronouncements on a variety of audit and attest functions and promotes their acceptance worldwide. As a results of efforts by the Auditing Standards Board to converge U.S. GAAS with international standards, U.S. GAAS and International Standards on Auditing are similar in most respects. 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 Center for Audit Quality is dedicated to enhancing investor confidence and public trust in global capital markets, including fostering high quality performance by public company auditors and promoting policies and standards that promote public company auditors’ objectivity, effectiveness and responsiveness to dynamic market conditions. 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. (2) 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. 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.

2. Relative cost for local audit firms is excessively high. 3. Additional oversight is not needed because sufficient quality

controls have already been implemented by most audit firms. 4. 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. 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.

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2-18 (continued)

2. Increased confidence in financial reporting will increase access to capital and lower the cost of capital by reducing information risk.

3. Changes in the scope of CPA practices and other threats to audit quality required government regulation.

4. Regulation of public company audits will not affect most audit firms that do not have public company audit clients.

b. 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. Engagement performance b. Monitoring c. Acceptance and continuation of clients and engagements d. Engagement performance e. Engagement performance f. Engagement performance g. Relevant ethical requirement h. Human resources i. Human resources j. Leadership responsibilities 2-20 a. Olson and Riley should first evaluate whether they have the

professional competence to perform all of the audit work for filing with the SEC, and whether they wish to accept the risk associated with such an engagement. In addition, if Olson and Riley have performed bookkeeping services or certain consulting services for Howard Mobile Home, 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.

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BRIEF DESCRIPTION OF GAAS HOLMES' ACTIONS RESULTING IN FAILURE TO COMPLY WITH GAAS

GENERAL STANDARDS

1. The auditor must have adequate technical training and proficiency to perform the audit.

1. It was inappropriate for Holmes to hire the two students to conduct the audit. The audit must be conducted by persons with proper education and experience in the field of auditing. Although a junior assistant has not completed his formal education, he may help in the conduct of the audit as long as there is proper supervision and review.

2. The auditor must maintain independence in mental attitude in all matters relating to the audit.

2. To satisfy the second general standard, Holmes must be without bias with respect to the client under audit. Holmes has an obligation for fairness to the owners, management, and creditors who may rely on the report. Because of the financial interest in whether the bank loan is granted to Ray, Holmes is independent in neither fact nor appearance with respect to the assignment undertaken.

3. The auditor must exercise due professional care in the performance of the audit and the preparation of the report.

3. This standard requires Holmes to perform the audit with due care, which imposes on Holmes and everyone in Holmes' organization a responsibility to observe the standards of field work and reporting. Exercise of due care requires critical review at every level of supervision of the work done and the judgments exercised by those assisting in the audit. Holmes did not review the work or the judgments of the assistants and clearly failed to adhere to this standard.

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2-21 (continued)

BRIEF DESCRIPTION OF GAAS HOLMES' ACTIONS RESULTING IN FAILURE TO COMPLY WITH GAAS

STANDARDS OF FIELD WORK

1. The auditor must adequately plan the work and must properly supervise any assistants.

1. This standard recognizes that early appointment of the auditor has advantages for the auditor and the client. Holmes accepted the engagement without considering the availability of competent staff. In addition, Holmes failed to supervise the assistants. The work performed was not adequately planned.

2. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures.

2. Holmes did not obtain an understanding of the entity or its internal control, nor did the assistants obtain such an understanding. There appears to have been no audit at all. The work performed was more an accounting service than it was an auditing service.

3. The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit.

3. Holmes acquired no evidence that would support the financial statements. Holmes merely checked the mathematical accuracy of the records and summarized the accounts. Standard audit procedures and techniques were not performed.

STANDARDS OF REPORTING

1. The auditor must state in the auditor’s report whether the financial statements are presented in accordance with generally accepted accounting principles (GAAP).

1. Holmes' report made no reference to generally accepted accounting principles. Because Holmes did not conduct a proper audit, the report should state that no opinion can be expressed as to the fair presentation of the financial statements in accordance with generally accepted accounting principles.

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2-21 (continued)

BRIEF DESCRIPTION OF GAAS HOLMES' ACTIONS RESULTING IN FAILURE TO COMPLY WITH GAAS

2. The auditor must identify in the auditor’s report those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.

2. Holmes' improper audit would not enable him to determine whether generally accepted accounting principles were consistently applied. Holmes' report should make no reference to the consistent application of accounting principles.

3. When the auditor determines that informative disclosures are not reasonably adequate, the auditor must so state in the auditor’s report.

3. Management is primarily responsible for adequate disclosures in the financial statements, but when the statements do not contain adequate disclosures the auditor should make such disclosures in the auditor's report. In this case both the statements and the auditor's report lack adequate disclosures.

4. The auditor must either express an opinion regarding the financial statements, taken as a whole, or state that an opinion cannot be expressed, in the auditor’s report. When the auditor cannot express an overall opinion, the auditor should state the reasons therefor in the auditor’s report. In all cases where an auditor's name is associated with financial statements, the auditor should clearly indicate the character of the auditor's work, if any, and the degree of responsibility the auditor is taking, in the auditor’s report.

4. Although the Holmes report contains an expression of opinion, such opinion is not based on the results of a proper audit. Holmes should disclaim an opinion because he failed to conduct an audit in accordance with generally accepted auditing standards.

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2-22 a. Generally accepted auditing standards. b. International auditing standards. c. PCAOB auditing standards. d. PCAOB auditing standards (reporting in the U.K. will be under

international auditing standards). e. Generally accepted auditing standards. f. Generally accepted auditing standards. g. International auditing standards. h. PCAOB auditing standards (due to the publicly-traded debt). � Internet Problem Solution: International Auditing and Assurance Standards

Board Internet Problem 2-1

a. 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 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.

b. 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 re-exposure 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.

c. 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.

(Note: Internet problems address current issues using Internet sources. Because Internet sites are subject to change, Internet problems and solutions may change. Current information on Internet problems is available at www.pearsonhighered.com/arens).