ACCT 102 Auditing Answer Solutions-Chapters 1-9 Full and Revised ANSWERS NEWEST 2023.

ACCT 102 Auditing Answer Solutions-Chapters 1-9 Full and Revised ANSWERS NEWEST 2023. HAPTER 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 ethical 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. 9-1 Chapter 09 - Audit Sampling 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 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. 1-10 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. 9-2 Chapter 09 - Audit Sampling 1-11 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. 1-12 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. 1-13 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. 1-14 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, Statements on Standards for Accounting and Review Services (SSARSs), Auditing Practice Releases (formally Auditing Procedure Studies), Industry Risk Alerts, and the Code of Professional Conduct (only two required). 1-15 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. 1-16 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. 9-3 Chapter 09 - Audit Sampling 1-17 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 writeup 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. 1-18 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. 1-19 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. 1-20 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. 1-21 The various levels of accounting personnel in a large public accounting firm are staff assistants, senior auditors, managers or supervisors, and partners (and principals). 9-4 Chapter 09 - Audit Sampling The staff assistant 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. 1-22 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 Questions Requiring Analysis 1-23 (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 ethic 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. The AICPA through the PCPS: the AICPA Alliance for Public Accounting Firms Section of the Division for Public Accounting Firms administers the peer and quality review programs for such firms. Ethical violations are investigated and enforced by the AICPA and the state boards of accountancy. 9-5 Chapter 09 - Audit Sampling 1-24 (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. 1-25 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 ethic 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. 1-26 (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.