Solution manual for
principles of auditing and other assurance services
22nd edition
by ray whittington kurt
,CHAPTER 1
The Role of the
Public Accountant in the
American Economy
Review Questions
1-1 The ―crisis of credibility‖ largely arose from the number of companies that restated their previously
issued financial statements as a result of accounting irregularities and fraud. Especially responsible were
the very visible Enron and WorldCom fraud cases. Both companies filed for bankruptcy and constituted
the largest companies in American history to do so. The extent of the accounting irregularities and fraud
being investigated and disclosed brought into question the effectiveness of financial statement audits. In
addition, the criminal conviction of Arthur Andersen, LLP, one of the then Big 5 accounting firms, on
charges of destroying documents related to the Enron case brought into question the ethics standards of
the profession.
1-2 Assurance services are professional services that enhance the quality of information, or its context, for
decision-making. The two types are: (a) those that increase the reliability of information and (b) those
that involve putting information in a form or context that facilitates decision-making.
1-3 A financial statement audit is, by far, the most common type of attest engagement. The overall assertion,
made by management, most frequently is that the financial statements follow generally accepted
accounting principles.
1-4 A large corporation with securities listed on a stock exchange is required by the rules of the stock
exchange and by the rules of the Securities and Exchange Commission to provide an audit report with the
annual financial statements furnished to its stockholders. It also is required to engage the auditors to
provide an opinion on its internal control. Apart from legal requirements, however, a large listed
corporation recognizes that it must maintain investor confidence in the reliability of its financial
statements and internal control over financial reporting if it is to continue to be able to secure capital
from the public. The report by a firm of certified public accountants adds credibility to the financial
statements prepared by the corporation. When a small family-owned enterprise elects to have an audit,
the purpose usually is to use the auditors' report to support an application for a bank loan.
,1-5 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.
1-6 To add credibility to financial statements is to increase the likelihood that they have been prepared
following the appropriate criteria, usually generally accepted accounting principles. As such, an increase
in credibility results in financial statements that can be believed and relied upon by third parties.
1-7 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.
1-8 At the beginning of the century, the principal objective of auditing was the prevention and detection of
fraud. Audit work centered on the balance sheet, because the income statement was regarded as highly
confidential and not for public disclosure. Today, the principal objective of auditing is to form an
opinion on the fairness of financial statements and their conformity with generally accepted accounting
principles. But the professional standards also require that an audit be designed to provide reasonable
assurance of detecting material misstatements, due to errors or fraud. Particular emphasis is placed on
the income statement which is of great importance to investors. Auditing today also has the objectives of
meeting the requirements of the Securities and Exchange Commission (SEC) and the Public Company
Accounting Oversight Board for public companies.
1-9 The statement is incorrect. The increasing integrated databases of today, along with available audit
procedures make audited entire populations a possibility in many situations.
1-10 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.
The report prepared after completion of an operational audit is usually directed to management
of the organization in which the audit work was done.
1-11 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 Government Accountability Office (GAO) of the federal government.
1-12 Internal auditors must be independent of the department heads and other line executives whose work they
review. However, internal auditors are not independent in the same sense as a public accounting firm.
, The public accounting firm serves many clients and the revenue obtained from any one client is only a
small part of the revenue of the firm. Internal auditors, on the other hand, are employees of one company,
and are subject to the restraints inherent in the employer-employee relationship. Internal auditors can
achieve a great deal of independence by reporting to the audit committee of the board of directors, but
they cannot achieve the same degree of independence as is possessed by the external public accounting
firm.
1-13 The internal auditors are employees of Spacecraft, Inc., and may be influenced by corporate management.
The public accounting firm is independent of the company and is in a better position to take positions
opposed to those of company management. The work of the internal audit staff emphasizes measurement
of the efficiency and effectiveness of various operating units of the company and compliance with all
types of controls, whereas the public accounting firm is primarily concerned with determining the fairness
of Spacecraft's financial statements.
1-14 The Government Accountability Office (GAO) is a staff of professional auditors which reports to
Congress. Its function is to determine that programs carried out by federal agencies conform to the
financial authorization of the Congress. It is also concerned with the cost-effectiveness of government
programs. The audit activities include investigation of the costs and performance of corporations holding
government contracts.
1-15 Among the many important contributions to auditing literature by the AICPA are the series of Statements
on Auditing Standards (SASs), Statements on Standards for Attestation Engagements (SSAEs), Industry
Audit and Accounting Guides, Audit Guides, Audit Risk Alerts, Statements on Standards for Accounting
and Review Services (SSARSs), , and the Code of Professional Conduct (only two required).
1-16 A peer review is a critical review of a public accounting firm's practices by another public accounting
firm (or other CPAs functioning as a peer review team). The purpose of a peer review is to encourage
adherence to quality control standards established by the accounting firm and the profession.
1-17 The Securities and Exchange Commission (SEC) is an agency of the federal government and is
responsible for administering a number of acts, including the Securities Act of 1933 and the Securities
Exchange Act of 1934. In meeting this responsibility, the SEC reviews financial statements of
companies offering securities for sale to the public. It is particularly concerned with requiring full
disclosure of financial information and with preventing misrepresentation. Through the Public Company
Accounting Oversight Board, the SEC now oversees public accounting firms that audit public companies.
Included in this oversight process includes development of auditing, independence, and quality control
standards; inspection of performance; and enforcement of the standards.
The AICPA is the national organization of certified public accountants. It has long been a leader
in accounting and auditing research, in publication of authoritative accounting and auditing
pronouncements and studies, and in promoting high professional standards of practice.
1-18 Services offered by public accounting firms in addition to auditing include other forms of attestation, tax
work, consulting services, litigation support services, fraud investigation services, personal financial
planning and accounting services. This last category includes preparation of financial statements for
smaller companies that have limited accounting personnel and various types of write-up work. Public
accounting firms also perform a variety of other services. Consulting services include aiding clients in
the design of accounting systems, conversion to Information Technology (IT) systems, preparation of
budgets, planning business combinations with other companies, executive search, and numerous other
projects. Public accounting firms are restricted as to the consulting services that they may provide to
audit clients that are public companies.
,1-19 The partnership form of organization for a public accounting firm offers several advantages over a sole
proprietorship. A partnership offers the opportunity for specialization by the partners in areas such as
taxation, auditing, and consulting services. Partners can discuss difficult technical problems among
themselves, and benefit from different perspectives. Also, the partnership may be better able to attract
and retain high quality professional staff, because they may be rewarded by acceptance into the
partnership.
1-20 The following characteristics of a professional corporation distinguish it from the traditional corporation:
(1) All shareholders must be engaged in the practice of public accounting.
(2) To the extent possible, directors and officers should be certified public accountants.
(3) Shares of a professional corporation may be transferred only to those engaged in public
accounting or to the corporation itself.
(4) The corporation's shareholders and employees have liability equivalent to other forms of
organizations (i.e., the corporate form of organization does not reduce liability). Note, however,
that CPAs may choose to purchase liability insurance to limit potential liability.
1-21 Local firms usually have only one or two offices, are headed by a single CPA or have a few CPAs as
partners, and serve clients in a single city or area. The services provided are mostly income tax work,
consulting services, and accounting services. Auditing is often only a small part of the practice.
Regional firms often arise from the merger and expansion of local firms. They typically maintain
several offices in neighboring cities and states. Auditing is a more important function for regional firms
than for the local firms, because larger businesses are included among the clients.
National firms have offices in most major cities in the United States and some operate in other
countries as well. These firms offer a full range of services, with auditing often representing the largest
single portion of the practice.
International firms have offices in most of the world’s major cities. These firms offer a full range
of services, with auditing often representing the largest single portion of the practice.
1-22 The various levels of accounting personnel in a large public accounting firm are staff auditors, senior
auditors, managers or supervisors, and partners (and principals).
The staff auditor performs audit procedures such as the observation of physical inventories and
confirmation of receivables under the supervision of a senior. The senior auditor plans and coordinates
the audit and drafts the audit report. The senior also reviews working papers, controls the allocation of
audit time, and trains assistants on the job. The manager or supervisor usually is responsible for
supervising and reviewing several audit engagements concurrently, and resolving significant problems
with the client. The partners maintain contacts with clients, develop new business, establish policies of
the firm, review the adequacy of audit work, and sign audit reports. The engagement partner is
responsible for performance of the audit in accordance with professional standards. A partner also
devotes time to the recruitment and development of staff, to AICPA and other professional group
activities, to educational and other civic activities, and generally to promoting an environment in which
the firm can prosper. The position of principal, which is often held by top-ranking consulting personnel
who do not hold the CPA certificate, has responsibilities similar to those of a partner.
1-23 The most significant responsibilities of a partner in a public accounting firm include (only three required:
Assume ultimate responsibility for the audits assigned to him or her
Sign audit reports
Review the audit work for compliance with firm and professional standards
Maintain relations with audit clients
, Establishing firm policies
Staff recruitment and development
1-24 An accounting association becomes an accounting network when member firms share one or more of the
following with other member firms: (1) common brand name; (2) common control; (3) profits;
(4) common business strategy; (5) significant professional resources; (6) common quality
control policies and procedures.
1-25 The International Auditing and Assurance Standards Board establishes International Standards on
Auditing (ISAs) International Standards on Quality Control (ISQC) and standards for other assurance
and related services. Its pronouncements are meant to foster the development of consistent worldwide
professional standards. Its standards do not to override the national auditing standards of its members.
Questions Requiring Analysis
1-26 (a) The Sarbanes-Oxley Act of 2002 made significant reforms in the regulation system for public
accounting firms that audit public companies. It contains provisions toughening penalties for
corporate fraud, restricting the types of consulting CPAs may perform for audit clients, and
creating the Public Company Accounting Oversight Board (PCAOB) to oversee the accounting
profession.
(b) Primary regulation of public accounting firms that audit public companies is provided by the
PCAOB and the Securities and Exchange Commission (SEC). With respect to the practices of
these firms, the PCAOB has the responsibility for:
(1) Establishing or adopting auditing, quality control, and ethics standards,
(2) Registering public accounting firms,
(3) Performing inspections of the practices of registered,
(4) Conducting investigations and disciplinary proceedings of registered firms, and
(5) Sanctioning registered firms.
The SEC investigates violations of the securities laws, including allegations of fraudulent
financial reporting and public accounting firm audit deficiencies. In addition, the state boards of
accountancy may revoke any public accounting firm’s license to practice.
(c) Primary regulation of public accounting firms that are not under the PCAOB’s inspection
program rests with the AICPA and the state boards of accountancy. Members of the AICPA in
public practice must practice with a firm that participates in a practice review program. Firms
can meet this requirement by enrolling the AICPA Peer Review Program, which requires the firm
to have a peer review every three years. Ethical violations are investigated and enforced by the
AICPA and the state boards of accountancy.
,1-27 (a) Audits of financial statements of a corporation contemplating issuing debenture bonds may
facilitate the transaction through reducing information risk—the risk that the information used to
make the investment decision is materially misstated. Misstatements of the financial statements
may occur due to accidental errors, lack of knowledge of accounting principles, unintentional
bias, or by deliberate falsification of the statements.
(b) When financial statements have not been audited a "credibility gap" may exist in that
management can hardly be expected to be impartial and unbiased in their preparation. This
credibility gap may lead to a situation in which investors find the information risk too great and
they decide not to invest in the bonds. If they do decide to invest in the bonds, the investors will
likely demand a higher rate of return.
1-28 The Public Company Accounting Oversight Board was created because of the concerns about the
credibility of the public accounting profession that occurred in the later part of 2001 and the early part of
2002. The large number of public company restatements due to accounting irregularities and fraud
caused the investing public and Congress to question the effectiveness of audits. In addition, the
conviction of Arthur Andersen LLP of destruction of evidence related to the Enron case caused Congress
to question the profession’s ethical principles. The Public Company Accounting Oversight Board has the
responsibility to oversee and discipline public accounting firms that audit public companies. Specifically,
the PCAOB has the responsibility for:
(1) Establishing or adopting auditing, quality control, and ethics standards,
(2) Registering public accounting firms,
(3) Performing inspections of the practices of registered,
(4) Conducting investigations and disciplinary proceedings of registered firms, and
(5) Sanctioning registered firms.
1-29 (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.
Objective Questions
1-30 Multiple Choice Questions
(a) (3) Both sets of standards require independence.
(b) (1) The client's management is primarily responsible for representations contained in the
financial statements. The independent auditors are responsible for performing their
audit in accordance with generally accepted auditing standards.
(c) (1) The most important benefit of having an annual audit by a public accounting firm is to
provide assurance to investors and other outsiders that the financial statements are
dependable. The expansion of the securities markets has tremendously increased the
need for verification of financial statements performed by competent, independent
, persons. Answer (2) is incorrect because management cannot avoid responsibility for
the financial statements by retaining independent auditors. Answer (3) gives no
recognition to the fact that many nonpublic corporations and other business entities have
no obligation to file audited financial statements with governmental agencies. It also
disregards the fact that large corporations which secure capital from the general public
would continue to provide audited statements even though there were no such
requirements by governmental agencies. Answer (4) is unacceptable because it implies
that an audit is designed to detect illegal acts without regard to type or size.
(d) (2) The PCAOB ordinarily does not review financial reports filed with the Securities and
Exchange Commission—although, if they so desire, they may review such reports to
accomplish their other responsibilities. The other three replies are all explicit
responsibilities of the PCAOB.
(e) (4) The Public Company Accounting Oversight Board was given the authority by the
Sarbanes-Oxley Act of 2002 to establish or adopt auditing standards for audits of public
companies.
(f) (4) Governmental auditing often extends to audits of efficiency, effectiveness, and
compliance (with laws, regulations, etc.). The other responses, adequacy, evaluation,
and accuracy, are terms not typically used to summarize the scope of governmental
auditing.
(g) (3) Normally, the higher in an organization an internal auditor reports, the greater the degree
of independence. Accordingly, reporting to the audit committee of the board of directors
increases the likelihood that the internal auditor will be able to act independently of
those being audited. Answers (1) and (2) may lead to a lesser degree of independence
because when an internal auditor reports to the financial vice-president or the controller
they cannot objectively review their work. Answer (4) is incorrect because it is generally
not practical or effective for the internal auditor to report to stockholders on a timely
basis.
(h) (4) Ethical scandals at the AICPA was not one of the causes of the passage of the Sarbanes-
Oxley Act of 2002. All of the other responses contributed to passage of the Act.
(i) (3) The Federal Accounting Standards Advisory Board establishes accounting standards for
United States governmental agencies. The Governmental Accounting Standards Board
establishes accounting standards for state and local government entities.
(j) (4) Forensic audits are usually performed when fraud has been found or is suspected.
Answer (1) is incorrect because it overstates the nature of most audits by suggesting that
all audits are forensic in nature. Answer (2) is wrong in that CPA firms (or law firms)
may perform forensic audits. Answer (3) is incorrect because while compliance audits
may find fraud, they are not directed at fraud as are forensic audits.
(k) (1) Because the auditors’ purposes for considering internal control are to (a) plan the audit
and (b) to determine the nature, timing, and extent of the tests to be performed, answer
(1) is correct.
, (l) (2) A compliance audit measures the compliance of an organization with established criteria
such as laws and regulations. Answer (2) is correct because it addresses policies and
procedures on environmental laws and regulations.
1-31 (1) Phrases more applicable to an audit performed in 1900:
(a) Complete review of all transactions.
(c) Auditors' attention concentrated on balance sheet.
(f) Auditing procedures to prevent or detect fraud on the part of all employees and
managers.
(l) Bankers and short-term creditors as principal users of audit reports.
(2) Phrases more applicable to an audit performed today:
(b) Assessment of internal control.
(d) Emphasis upon use of sampling techniques.
(e) Determination of fairness of financial statements.
(g) Registration statement.
(h) Fairness of reported earnings per share.
(i) Influence of stock exchanges and the investing public upon the use of independent
auditors.
(j) Concern about fraudulent financial reporting.
(k) Generally accepted auditing standards.
(m) Pressure for more disclosure.
(n) Auditing for compliance with laws and regulations.
1-32
Publication Sponsor
1. Statements on Auditing Standards (SASs) c. AICPA
2. The Journal of Accountancy c. AICPA
3. Regulation S-X b. SEC
4. Statements on Standards for Accounting and Review Services (SSARS) c. AICPA
5. Financial Reporting Releases (FRRs) b. SEC
6. Accounting and Reporting Standards for Corporate Financial Statements d. FASB
7. Accounting and Reporting Standards for Governmental Entities g. GASB
8. Industry Accounting and Auditing Guides c. AICPA
9. Audit Risk Alerts c. AICPA
10. The Tax Advisor c. AICPA
11. Auditing Standards h. PCAOB
1-33 Definitions
Column One Column Two
1. Quality control e. Peer Review
2. Operational audit h. Measurement of effectiveness and efficiency
of a unit of an organization
3. Internal control i. Basis for sampling and testing
4. General Accountability Office j. Auditing staff reporting to Congress
5. Disclosure c. Material information
6. Critical characteristic that must be maintained by the d. Credibility
accounting profession
, 7. Public Company Accounting Oversight a. Regulation of auditors of public companies
Board
8. Securities and Exchange Commission f. Registration statement
9. Audited financial Statements b. Opinion
10. Compilation of financial statements g. Accounting service
1-34
Statement Type of
Engagement
a. When financial statements are involved this is referred to as an audit. E
b. The term ―we are not aware of any material modifications that should be made‖ is R
often included in the report.
c. The report issued provides a summary of procedures followed and findings. A
d. The report issued provides ―reasonable assurance.‖ E
e. The procedures involved are generally limited to inquiry and analytical R
procedures.
f. The report issued provides ―absolute assurance.‖ N
g. The report provides ―limited assurance.‖ R
h. The procedures followed are agreed upon with the specified user or users. A
i. This type of engagement provides more assurance than a review. E
j. The CPA need not be independent to perform this service. N
1-35 Definitions
a. 1 Agreed-upon procedures engagement
b. 9 Review
c. 3 Attest engagement
d. 4 Audit of financial statements
e. 7 Integrated audit
f. 2 Assurance services
g. 6 Examination
1-36 Definitions
a. 8 Securities and Exchange Commission
b. 2 Assertion
c. 9 Statements on Auditing Standards
d. 4 Financial reporting framework.
e. 7 Sarbanes-Oxley Act of 2002
f. 6 Public Company Accounting Oversight Board
g. 1 American Institute of Certified Public Accountants
h. 11 Suitable criteria.
1-37 Topic Type of Auditor Class of Work
1 CPA Audit of financial statements
2 CPA Audit of financial statements
3 Internal auditor Operational audit
4 GAO Operational audit
5 Bank examiner Compliance audit
6 CPA Consulting services
7 CPA Audit of financial statements
8 Internal auditor Operational audit
9 IRS Compliance audit
