Chapter 1 Modern Auditing

CHAPTER 1 AUDITING AND THE PUBLIC ACCOUNTING PROFESSION INTEGRITY OF FINANCIAL REPORTING LEARNING CHECK 1. SEVERAL COMMON ATTRIBUTES OF ACTIVITIES specify AS AUDITING ARE (A) SYSTEMATIC PROCESS, (B) OBJECTIVELY OBTAINING AND EVALUATING EVIDENCE, (C) ASSERTIONS ABOUT ECONOMIC ACTIONS AND EVENTS, (D) DEGREE OF CORRESPONDENCE, (E) ESTABLISHED CRITERIA, (F) COMMUNICATING THE RESULTS, AND (G) INTERESTED USERS. 2.A fiscal differentiatement audit involves get holding and evaluating evidence to the highest degree an entitys fiscal statements for the purpose of expressing an opinion on whether the statements atomic number 18 presented fairly in conformity with established criteriausually GAAP. Thus, the nature of the meeters discip disceptation is an opinion on the pallidity of the financial statement presentation. A compliance audit involves obtaining and evaluating evidence to determine whether certain financial or operating activities of an entity conform to specified condition s, rules, or regulations.A report on a compliance audit takes the form of a summary of findings or federal agency regarding degree of compliance. An in operation(p) audit involves obtaining and evaluating evidence about the talent and effectiveness of an entitys operating activities in relation to specified objectives. Reports on much(prenominal) audits include an sound judgement of efficiency and effectiveness and recommendations for changements. 3. Independent auditors are individual practitioners or members of universal explanation sures who render professional auditing services to customers. These services whitethorn involve financial statement audits, compliance audits, and operational audits.Internal auditors are employees of the companies they audit. They are knobbed in an free-living appraisal activity, called familiar auditing, as a service to the organization. Internal auditors are primarily concerned with compliance and operational audits. G every(prenominal )placenment auditors are employed by various local, state, and national governmental agencies. They may be involved in all three theatrical roles of audits. 4. a. The financial statement audit is a form of an examination work in which the auditor provides reasonable assurance that the financials statements are free of clobber misstatement.The CPA might also perform an engagement to examine a forecast or a projection in which the auditor provides reasonable assurance that the forecast or projection reflects the beneathlying assumptions and that thither is support reasonable for the underlying assumptions. A CPA might also perform an engagement to examine an assertion regarding compliance with laws or regulations in which the auditor provides reasonable assurance that the entity complied with laws or regulations. b.A limited review of financial statements is an engagement in which the CPA provides negative assurance that he or she is not aware of any(prenominal) material modif ications that learn to be made to the financial statements in order for them to be in conformity with GAAP. 5. Accounting and compilation services provide financial statement users and decisions makers with pertinent breeding. However, they are not knowing to test the dependability of such information. The primary benefit received is information that may be relevant to a decision, even though evidence is not obtained about the reliability of such information. . The following table summarizes several assurance services provided by CPAs and rationalises the how they improve the relevance or reliability of information utilise by decision makers. Assurance Service How the service improves the relevance or reliability of information utilize by decision makers CPA Risk Advisory Provides relevant information to focal point or the board of directors about business risks faced by an entity.It ma also provide information about the reliability of managements system for identifyin g and monitoring business risks. CPA slaying View Provides relevant financial and nonfinancial information to management or the board of directors about the entitys performance. It ma also provide information about the reliability of managements system for monitoring the entitys performance. 7. a.The audit provides reasonable assurance that financial statement information is free of material misstatements. Decision makers can uses financial information to anticipate business opportunities and to make business decisions based with reasonable assurance that the information set used to make decisions is reliable. b. A review of financial statements provides less(prenominal) assurance about the reliability of financial information than that provided by an audit. The CPA provides negative assurance that he or she is not aware of any material modifications that need to be made to the financial statements in order for them to be in conformity with GAAP.This service is focused on som e(prenominal) the relevance and reliability of information used by decision makers. A compilation does not provide assurance about the reliability of financial statement information used by decision makers. However, a compilation service may provide decision makers with relevant information that they would not otherwise have. c. The CPA risk consultative service may transform complex information into knowledge by helping management better understand business risks. The CPA risk informatory service may also provide assurance about the reliability of information produced by managements system of evaluating business risks. . The origin of the fraternity audit as we know it can be linked to British lawmaking during the industrial revolution in the mid-1800s. One or more stockholders designated by other stockholders initially performed company audits, but subsequent revisions in the legislation permitted the use of outside independent auditors, giving rise to the formation of auditin g blottos. The focus of these other(a) audits was on finding errors in the balance plane accounts and stemming the growth of fraud associated with the increasing phenomenon of professional managers and absentee owners.Several important milestones in the rise of the U. S. profession were (1) the passage of legislation (2) the stock market crash of 1929 which drew attention to deficiencies in financial reporting and produced a challenge to the account profession to provide stronger leadership, (3) adoption of a requirement by the New York Stock Exchange in 1933 that all listed corporations obtain an audit certificate from an independent CPA, and (4) passage of the Securities moment of 1933 and the Securities Exchange Act of 1934 which added to the demand for audit services for publicly owned companies.Three important changes in audit normal that evolved by the 1040s were (1) a shift from detailed verification of accounts to take in or testing as the basis for rendering an opinion on the fairness of financial statements, (2) development of the work out of linking the testing to be do to the auditors paygrade of a companys internal controls, and (3) deemphasis of the detection of fraud as an audit objective.In recent years, the profession has come under increasing pressure to reverse the deemphasis on discover fraud as the publics expectation that the auditor will detect fraud persists. The prize of audits was questioned when a series of restatements of earnings from public companies such as Sunbeam, surplus Management, Xerox, Adelphia, Enron and WorldCom brought about a crisis of confidence in the work of auditors.By 2002 the collapse of Enron and WorldCom led relation back to pass the Sarbanes-Oxley Act of 2002. This act created the Public Companies Accounting reversion mount (PCAOB) and gave it responsibility for setting auditing, ethics, independence, and graphic symbol control standards for audits of public companies. 9. Four factors that contr ibute to the need for independent audits are (a) conflict of interest, (b) consequence, (c) complexity, and (d) remoteness. Collectively these factors contribute to information risk. 0. financial statement audits enable companies to (a) meet statutory and other regulatory requirements that must be satisfied in order to gain access to capital markets, (b) obtain debt and equity financing at a lower appeal of capital, (c) deter inefficiency and errors in the report function and reduce the risk of fraud in the accounting and financial reporting cognitive operation, and (d) make internal control and operational improvements based on suggestions made by the auditor as a by-product of the audit. 1. The limitations of a financial statement audit include the fact that an auditor works at heart fairly restrictive economic limits that impose date and cost constraints and carry the use of selective testing or sampling of the accounting records and supporting data. Also, the auditors rep ort must usually be issued within three months of the balance sheet date, which affects the aggregate of evidence that can be obtained.The availability of alternative accounting principles permitted under GAAP, and the impact of accounting estimates and uncertainties on the financial statements represent additional intrinsical limitations on financial statement audits. 12. Six public sector organizations include (1) the Securities and Exchange citizens committee, (2) state boards of accountancy, (3) the U. S. General Accounting Office, (4) the Internal Revenue Service, (5) state and federal courts, and the U.S. Congress. Five buck secluded sector organizations associated with the public accounting profession include (1) the Public Companies Accounting Oversight Board, (2) the American Institute of Certified Public Accountants, (2) take Societies of Certified Public Accountants, (4) Practice Units (CPA squares), and (5) Accounting Standard Setting Bodies principally the Financ ial Accounting Standards Board (FASB) and organisational Accounting Standards Board (GASB). 3. The Securities and Exchange Commission regulates the distribution of securities offered for public sale and subsequent trading of securities on stock exchanges and over-the-counter markets. The SEC also has the authority to establish GAAP for companies under its jurisdiction, and it soon recognizes the pronouncements of the FASB as constituting GAAP in the filing of financial statements with the agency.In some instances, however, the SECs disclosure requirements exceed GAAP. Finally, the SEC also exerts considerable influence over auditing profession. The Sarbanes-Oxley Act of 2002 established a private sector, Public Companies Accounting Oversight Board to oversee the audit of public companies that are subject to securities laws. The PCAOBs rulemaking process results in proposals that do not take effect until the SEC approves them. 14. a.The PCAOB has authority in five major areas (1) r egistering public accounting theatres that audit the financial statements of public companies, (2) setting step control standards for peer review of auditors of public companies and conducting inspections of registered public accounting firms, (3) setting auditing standards for audits of public companies, (4) setting independence and ethics rules for auditors of public companies, (4) execute other duties or functions to promote high professional standards for public company audits, and enforce compliance with the Sarbanes-Oxley Act of 2002. . Three important AICPA divisions, or teams, that have a direct impact on auditors are (1) the AICPA Practice Monitoring Program is responsible for(p) for quality control standards and peer reviews of firms that provide assurance services to private companies, (2) the Auditing and Attest Standards Team sets auditing and attest standards for audit, accounting, and review services provided to private companies, and (3) the Professional Ethics D ivision is responsible for setting and enforcing the AICPA Code of Professional Conduct. 15. a.A CPA firm may be organized as a proprietorship, partnership, Professional Corporation, or any other form of organization permitted by state law or regulation (including limited liability partnerships (LLPs) and limited liability corporations (LLCs)). b. CPA firms are often classified into the following four groups (1) Big Four, (2) Second Tier, (3) Regional, and (4) Local. 16. a. The purpose of the professions multilevel regulatory framework is to help assure quality in the performance of audits and other professional services. b. The four components of the professions multilevel regulatory framework are Standard-setting. The private sector establishes standards for accounting, auditing, ethics, and quality control to govern the conduct of CPAs and CPA firms. Firm regulation. Each CPA firm adopts policies and procedures to assure that practicing accountants adhere to professional standar ds. Self-or peer regulation. The AICPA has utilize a comprehensive weapons platform of self-regulation including mandatory continuing professional education, peer review, audit failure inquiries, and public oversight. Government regulation. Only qualified professionals are licensed to practice, and auditor conduct is monitored and regulated by state boards of accountancy, the SEC, and the courts. 17. The five elements of quality control are (1) independence, integrity and objectivity, (2) forcefulness management, (3) acceptance and continuance of engagements, (4) engagement performance, and (5) monitoring. 18. a. The see elements of the PCAOB inspection program includes Inspecting and reviewing selected audit and review engagements of the firm. Evaluating the sufficiency of the firms quality control systems and the firms documentation and communication of that system. actioning such other testing of the audit, supervisory, and quality control procedures of the firm as are ne cessary or grab in light of the purpose of the inspection and the responsibilities of the board. The PCAOB conducts yearly inspections of firms that regularly provide audit reports for over 100 public companies.The PCAOB inspects the quality control activities of firms that provide audit reports for 100 or fewer public companies every three years. b. The purpose of the AICPA practice monitoring (peer review) program is to Determine that a firms system of quality control for its accounting and auditing practice has been designed in accordance with quality control standards established by the AICPA. Determine that a firms quality control policies and procedures were being complied with to provide the firm with reasonable assurance of conforming with professional standards. Determine that a firm has demonstrated the knowledge, skills, and abilities necessary to perform accounting, auditing, and attestation engagements in accordance with professional standards, in all material respec ts. Comprehensive Questions 1. 19 (Estimated clipping 20 minutes) a. Internal auditing is an independent appraisal activity performed by employees of the company being audited. The objective of internal auditing is to assist management in the effective discharge of its responsibilities.External auditing is done by independent, outdoor(a) auditors for the purpose of expressing an opinion on the fairness of the companys financial statements. Governmental auditing is done by government auditors to determine (1) fairness of financial reports, (2) compliance with applicable laws and regulations, (3) efficiency and economy of operations, and (4) effectiveness in achieving program results. b. The Public Companies Accounting Oversight Board and the American Institute of Certified Public Accountants, the Institute of Internal Auditors, and the U.S. General Accounting Office establish practice standards for independent, internal, and government auditors, respectively. c. The audits serve diametrical purposes and are made by different types of auditors. Auditing only by internal auditing will not satisfy the requirements of stock exchanges and the SEC for independent audits by external auditors. Moreover, internal audits will not satisfy all government requirements for audits, particularly in the area of compliance with applicable laws and regulations.In sum, each type of auditing is necessary. 1. 20 (Estimated time 30 minutes) a. Type of Audit b. Type of Auditor(s) c. Primary Recipient(s) 1. Financial statement (1) Independent(1) Stockholders, investors, regulatory agencies, and general public 2.Operational (3) Internal (2), Independent(1) Senior Management 3. Compliance (2) Government IRS (4) IRS 4. Operational (3) Government GAO (3) Congress 5. Financial statement (1) Independent (1) Creditors 6.Operational (3) Internal (2) Management 7. Compliance (2) Government GAO (3) Congress 8. Compliance (2) Independent (1), Internal (2), Congress and G overnment GAO (3) 9.Financial Statement (1) Independent (1) Citizens, taxpayers 10. Operational (3) Government GAO (3) Congress 11. Compliance (2) Independent (1), Internal (2) Bondholders 12. Compliance (2) Internal (2), Independents (1) Management 21. Estimated time 15 minutes) a. The source step in the accountants value chain involves capturing data about business events, such as data about sales and the collection of receivables. The second step involves developing an information set that communicates the total picture with integrity and objectivity. The relevant information set here might include information about sales, receivables and the calculation of inventory turn days. Transforming complex information into knowledge involves understanding how the clients receivable collection period (58 days) compares with the rest of the industry.In this casing the 75% of the industry collect their receivables faster than the client. Anticipating and creating the opportunit y involves recognizing that the client will improve its cash flow if it brings its collection days more in line with the industry median. This may further involve a study of specialised customers that are delinquent and considering how to take steps to speed collection. The final stage involves managements implementation of tighter credit policies, improved discounts for paying quickly, or charging interest for being delinquent. b.A financial statement audit is important as it provides reasonable assurance that the sales and receivables information that is being used to make business decisions is free of material misstatement. If the information supporting the calculation of accounts receivable turn days is materially understated, the company may not recognize that it needs to take steps to improve cash flows, and in turn, make poor business decisions. 22. (Estimated time 20 minutes) a. The benefits of a high quality audit include the following Access to Capital Markets.An audit allows companies access to public securities markets. In many cases, companies also need audits to support a lenders loan decisions. Lower Cost of Capital. An audit often allows companies to obtain capital at a lower cost of capital, because of the reduced information risk associated with audited financial statements. Deterrent to Inefficiency and Fraud. Research has demonstrated that when employees know that an independent audit is to be made, they take care to make fewer errors in performing accounting functions and are less likely to mis earmark company assets.The fact that financial statement assertions are to be verified reduces the likelihood that management will engage in fraudulent financial reporting. Control and Operational Improvements. Based on observations made during a financial statement audit, the independent auditor often makes suggestions to improve internal control, to evaluate managements assessments of business risks, to recommend improved performance measure s, and to make recommendations to achieve greater operational efficiencies within the clients organization.Your fellow business assimilator is correct that these benefits are not achieved when an audit is not performed in accordance with professional standards. b. eve an audit performed in accordance with professional standard may not detect every material misstatement in financial statements. The following inherent limitations explain why an audit can only provide reasonable assurance that financial statements are free of material misstatement, not a guarantee that the financial statements are accurate. Reasonable Cost. Audits must be performed at a reasonable cost.Auditors use selective testing, or sampling, of the accounting records and supporting data. In addition, the auditor may choose to test internal controls and may obtain assurance from a well-functioning system of internal controls. Audits cannot audit every transaction. Reasonable Length of Time. The auditors report on many public companies is usually issued three to five weeks after the balance sheet date. This time constraint may affect the amount of evidence that can be obtained concerning events and transactions after the balance sheet date that may have an effect on the financial statements.Moreover, there is a relatively short time period available for resolving uncertainties existing at the statement date. Alternative Accounting Principles. Alternative accounting principles are permitted under GAAP. Financial statement users must be knowledgeable about a companys accounting choices and their effect on financial statements. For example, there may be a material difference between the value of inventory using LIFO or FIFO. Accounting Estimates. Estimates are an inherent part of the accounting process, and no one, including auditors, can foresee the outcome of uncertainties.Estimates range from the allowance for doubtful accounts and an inventory obsolescence reserve to impairment tests fo r fixed assets and goodwill. An audit cannot add exactness and induction to financial statements when these factors do not exist. 1. 23(Estimated time 15 minutes) 1. State boards of accountancy 10. State societies of CPAs 2. FASB and GASB 11. SEC, state and federal courts 3. AICPA 12. GASB 4. SEC 13. AICPA 5. AICPA, state societies of CPAs, 14. State boards of accountancy and state boards of accountancy 6. FASB 15. AICPA 7. State boards of accountancy 16. Practice units 8. SEC 17. GAO 9. AICPA 18. IRS 1. 24(Estimated time 20 minutes) a. The four sets of standards in the private sector and the standard setting bodies are (1) accounting by the FASB and GASB, (2) auditing by the AICPA, (3) professional ethics by the AICPA, and (4) quality control by the PCAOB and the AICPA. The other components of the regulatory framework are (1) firm regulation that occurs within the public accounting firm through day-to-day monitoring of the actions of the firms professional staff by the firms management (2) inspections and peer reviews that relates to the activities of professional entities outside the firm such as the PCAOB and the AICPAs Practice Monitoring (Peer Review) program and (3) governmental regulation that occurs at both the state and federal levels through activities that range from positive enforcement programs to punitive actions.This type of regulation is done by state boards of accountancy, the SEC, and state and federal courts of law. 1. 25(Estimated time 30 minutes) Purpose of Policy / mathematical function Additional Policy/ Element (b) Procedure Procedure (a) (c) 1. Personnel Management Personnel should have the qualifications to Establish qualifications necessary for fulfill responsibilities they may be called upon each level of responsibility in the firm. to consume in the future. 2. Engagement Performance Work at all levels should be supervised to ssure Establish procedures for reviewing working that it meets the fi rms standards of quality. papers and reports. 3. Personnel Management Work is delegate to people who have the technical Identify areas and specialized situations training for the assignment and force out should for which consultation is required. seek assistance, when necessary, from persons having appropriate expertise, judgment, and authority 4. Independence, Integrity andAll professionals should be independent of Monitor compliance with independence Objectivity clients. rules. 5. Monitoring Determine that procedures relating to the other Provide for reporting inspection results elements are being effectively applied. to appropriate management levels in the firm. 6. Personnel Management Only individuals who possess the qualities of Maintain a recruiting program to obtain integrity, competency, and motivation should be new hires at the initiation level. hired. 7. Personnel Management Personnel should have the knowledge required to Provide Progr ams to develop expertise in fulfill assigned responsibilities. specialized areas and industries. 8. Engagement Performance Personnel should have the technical training and Permit partner in charge of engagement to proficiency required by the engagement. approve assignments. 9. Acceptance and duration The firm should not be associated with clients Establish review procedures for continuing of Clients and Engagements. whose management lacks integrity. a client. 1. 6(Estimated time 30 minutes) a. The PCAOBs inspection program and the AICPAs practice monitoring (peer review) program do not have a direct impact on individual members. They are focused on a firms quality control activities. However, these programs may have an indirect effect on members who are involved in audits that are subject to inspection or peer review and all individuals in a firm may receive certain types of continuing professional education based on the findings of these programs. . The PCAOB is respons ible for the inspection of audit firms that audit public companies. The AICPAs practice monitoring (peer review) program is focuses on audit firms that audit private companies. The objectives of both programs focus on a firms adherence to quality control practices. c. The following table compares the objectives of the PCAOBs inspection program and the AICPAs practice monitoring (peer review) program. They both focus on a firms adherence to quality control practices. PCAOBs inspection program AICPAs practice monitoring (peer review) program In conducting inspections, the Sarbanes-Oxley Act of 2002 states The purpose of a peer review is to determine whether that the PCAOB should The reviewed firms system of quality control for its accounting Inspect and review selected audit and review engagements of the and auditing practice has been designed in accordance with quality firm. control standards established by the AICPA. Evaluate the sufficiency of the firms quality control system s and The reviewed firms quality control policies and procedures were the firms documentation and communication of that system. being complied with to provide the firm with reasonable assurance Perform such other testing of the audit, supervisory, and quality of conforming to professional standards. control procedures of the firm as are necessary or appropriate in The reviewed firm has demonstrated the knowledge, skills, and light of the purpose of the inspection and the responsibilities of abilities necessary to perform accounting, auditing, and the board. attestation engagements in accordance with professional standards, in all material respects. d. The primary activities of the AICPA practice monitoring program include providing peer reviews and issuing reports on a firms compliance with quality control standards. Professional Simulation (Estimated time 30 to 45 minutes) Research Situation Communication A student can perform the search of quality control standa rds in two ways. First, the student can do a key words search on monitoring procedures. Second, if a student looks at the way the Quality Control Standards are organized, he or she will note that QC Section 30 addresses Monitoring a CPA Firms Accounting and Auditing Practice.The relevant paragraphs are abridgment below. 1. Explain the monitoring procedures that should be performed by the firm. QC Section QC 30. 03 -. 08 2. Explain the factors that should be considered by small firms with a limited number of management individuals. QC Section QC 30. 10 -. 11 Communication Situation Research To Tom Meyers and Kenny Vaughn Re Monitoring ProceduresFromCPA Candidate Based on a review of relevant quality control standards (QC 30. 03-. 09) the firms monitoring procedures should include the following 1) Inspection procedures evaluate the adequacy of the firms quality control policies and procedures, its personnels understanding of those policies and procedures, and the extent of the firms compliance with its quality control policies and procedures. These might include a) Review of selected administrative and personnel records pertaining to the quality control elements. ) Review of engagement working papers, reports, and clients financial statements. c) Discussions with the firms personnel. d) Summarization of the findings from the inspection procedures, at least annually, and consideration of the systemic causes of findings that indicate improvements are needed. e) Determination of any corrective actions to be taken or improvements to be made with respect to the specific engagements reviewed or the firms quality control policies and procedures. f) Communication of the identified findings to appropriate firm management personnel. ) Consideration of inspection findings by appropriate firm management personnel who should also determine that any actions necessary, including necessary modifications to the quality control system, are taken on a timely basis. 2) P reissuance or postissuance review of selected engagements. 3) Analysis and assessment of a) New professional pronouncements. b) Results of independence confirmations. c) Continuing professional education and other professional development activities undertaken by firm personnel. ) Decisions related to acceptance and continuance of client relationships and engagements. e) Interviews of firm personnel. 4) Determination of any corrective actions to be taken and improvements to be made in the quality control system. 5) Communication to appropriate firm personnel of any weaknesses identified in the quality control system or in the level of understanding or compliance therewith. 6) Follow-up by appropriate firm personnel to ensure that any necessary modifications are made to the quality control policies and procedures on a timely basis.