APPENDIX 1B
ALTERNATIVE THEORIES OF THE ROLE OF AUDITING IN SOCIETY
SOLUTIONS FOR REVIEW CHECKPOINTS
1B-1 Yes, many people feel that the most important reason auditors are demanded is due to the
conflict of interest between preparers of the financial statements and the 3rd party financial
statement users. Most 3rd party users are more interested in intentional errors rather than
unintentional errors because of these conflicts of interest. This also helps explain the importance
of professional skepticism in judgments—it is needed to offset the potential bias and unethical
reporting that results from the conflict of interest. No, assumes auditors do not place a high
importance on detecting fraud. Such a stance contradicts auditor’s responsibility under CAS 240
and contradicts what the auditor says in the report!
1B-2 Information risk is the risk that user decisions may be based on incorrect information. More
specifically, information risk is the risk that the financial statements fail to appropriately reflect
the economic substance of a reporting entity’s business activities, and be misleading or
unethical. Information risk applies to the numbers on the face of the financial statements as well
as note disclosures. It needs to be reduced so that investor’s confidence will be increased to the
point they will trust the financial reporting sufficiently to use in their decision making.
1B-3 The 3 theories that have evolved to explain how audits reduce information risk are as follows:
1. Insurance hypothesis: auditors are demanded so that they can be sued and act as
insurers of the accuracy of the financial statements.
2. Information hypothesis: auditors are demanded by users to reduce information risk to
users of financial statements.
3. Monitoring hypothesis: auditors are demanded by management to reduce information
risk so that the managers can be compensated at higher levels because their audited
performance as reflected in the financial statements will be more trustworthy.
, Note that in all 3 theories, information risk will be reduced by the auditor.
APPENDIX 2B
IMPLEMENTATION OF QUALITY CONTROL STANDARDS IN CANADA
SOLUTIONS FOR REVIEW CHECKPOINTS
2B-1 This is an example of a policy statement related to consultation ("Establishing Quality
Control Policies and Procedures," QC 90.14).
2B-2 Practice Inspection is the evaluation of conformity of member’s work with the appropriate
standards of the member’s CPA Handbook and appropriate standards of member’s
organization. It provides self-monitoring by focusing on individual members performance
with an emphasis on providing educational feedback to the individual member.
2B-3 The PCAOB is harsher in terms of making the monitoring results more public (more readily
identifying problem PA firms individually) and appears to be more thorough. In addition
PCAOB is developing the quality control standards as well as the audit standards.
2B-4 While GAAS relate to the conduct of each audit engagement, quality control standards
govern the quality of a PA firm's audit practice as a whole (see CSQC-1 and CAS 220).
IFAC gives nine elements of quality control for a PA firm. When a peer review or quality
review is conducted, the reviewers "audit" the PA firm's statement of policies and
procedures designed to ensure compliance with the nine elements. These statements vary in
length and complexity, depending upon the size of the PA firm in Canada.
APPENDIX 3A
FRAMEWORK FOR CRITICAL THINKING
,SOLUTIONS FOR REVIEW CHECKPOINTS
3A-1 No, if the client fails to provide appropriate disclosure of going concern problems, it is the
auditor’s obligation to modify the opinion for inappropriate going concern disclosures.
Chapter 4 covers opinion modifications in more detail. High assurance means low risk of
material misstatement or low probability of being misleading. This means that not only
should disclosures be in conformity with GAAP but they should also result in fair
presentation in the circumstances. The purpose of the accounting risk concept is to help
guide auditors on fair presentation issues. Accounting risk here is the risk of failing to
disclose when an auditee actually fails within the next year. Accounting risk can be high but
audit risk can be low. Since assurance = 1 minus audit risk, there can be high assurance AND
high accounting risk.
3A-2 The self-fulfilling prophecy argument looks at the failure to disclose from management’s
point of view. A new investor would like to know the true risk of their investment and so the
self-fulfilling prophecy does not apply to them. The auditor should be aware of both
viewpoints but put primacy on 3rd party user needs.
3A-3 Management would not want stock options expensed since it reduces reported earnings and
thus any bonuses related to them (same incentives as for Nortel). But as Warren Buffet said,
if stock option compensation is not an expense, then what is it? He backed up his argument
by offering “free” insurance for stock options. In other words, the economic value of stock
options is the measure of the expense. Typically, a model such as a stock option pricing
model is used to estimate the expense.
3A-4 The auditor would need to identify an acceptably low level of probability of failure so that no
disclosure would not be considered misleading in the circumstances. Note this means setting
accounting risk at an acceptably low level.
3A-5 The accounting risk concept implies that the risk of material misstatement whether due to
factual misstatements (audit risk) or forecasts used in accounting estimates should also be
acceptably low. This is discussed in more detail in the application cases of later chapters.
SOLUTIONS FOR EXERCISES AND PROBLEMS
, EP 3A-1 This issue is discussed in more detail in Chapter 19. The problem here is the vagueness of
standards as discussed in this appendix. A 20% risk of reporting company failure suggests
required disclosure in the notes to the financial statements with an emphasis of matter
paragraph in the auditor’s report. This would avoid criticisms of auditors for failing to
provide timely disclosure of going concern risk and be consistent with Grice’s cooperative
communication principles.
A risk range of (0, 40%) would still mean going concern probability is 60% or higher and
suggests that the going concern numbers are more likely than not. This indicates that auditor
should have same response as in the 20% risk of failure situation. As we discuss in chapter
19 much also depends on how well calibrated the risk range is.
EP 3A-2 As discussed in this appendix the ideal logic is a principles-based framework consistent with
the logic of professional ethics discussed in the chapter. This means the conceptual
framework of FASB should be at the top of the hierarchy, not at the bottom. This would be
the simplest way of getting a reasoning process that is consistent with fair presentation
reporting concept of CAS 200.13 and CAS 700.10 that allows departures from the more
detailed standards if the departure results in fair presentation. Such a departure in
particular circumstances would be logically justified, for example, if application of the
detailed standard would result in not meeting the objectives of financial reporting in the
circumstances. Interestingly, the hierarchy given in the question results in more of a
compliance reporting framework of CAS 200.13.
EP 3A-3 SAMPLE RESPONSE
MEMO
to: Victoria Smyth
from: CPA
RE: Review of YLS’s working papers
Based on my review of the notes you prepared, I have noted the following:
General standard
The general standard may not have been met, although this is a grey area. The staff assigned
to the engagement had no experience with public companies or in this industry. However,
they were qualified in their knowledge of CAS.
ALTERNATIVE THEORIES OF THE ROLE OF AUDITING IN SOCIETY
SOLUTIONS FOR REVIEW CHECKPOINTS
1B-1 Yes, many people feel that the most important reason auditors are demanded is due to the
conflict of interest between preparers of the financial statements and the 3rd party financial
statement users. Most 3rd party users are more interested in intentional errors rather than
unintentional errors because of these conflicts of interest. This also helps explain the importance
of professional skepticism in judgments—it is needed to offset the potential bias and unethical
reporting that results from the conflict of interest. No, assumes auditors do not place a high
importance on detecting fraud. Such a stance contradicts auditor’s responsibility under CAS 240
and contradicts what the auditor says in the report!
1B-2 Information risk is the risk that user decisions may be based on incorrect information. More
specifically, information risk is the risk that the financial statements fail to appropriately reflect
the economic substance of a reporting entity’s business activities, and be misleading or
unethical. Information risk applies to the numbers on the face of the financial statements as well
as note disclosures. It needs to be reduced so that investor’s confidence will be increased to the
point they will trust the financial reporting sufficiently to use in their decision making.
1B-3 The 3 theories that have evolved to explain how audits reduce information risk are as follows:
1. Insurance hypothesis: auditors are demanded so that they can be sued and act as
insurers of the accuracy of the financial statements.
2. Information hypothesis: auditors are demanded by users to reduce information risk to
users of financial statements.
3. Monitoring hypothesis: auditors are demanded by management to reduce information
risk so that the managers can be compensated at higher levels because their audited
performance as reflected in the financial statements will be more trustworthy.
, Note that in all 3 theories, information risk will be reduced by the auditor.
APPENDIX 2B
IMPLEMENTATION OF QUALITY CONTROL STANDARDS IN CANADA
SOLUTIONS FOR REVIEW CHECKPOINTS
2B-1 This is an example of a policy statement related to consultation ("Establishing Quality
Control Policies and Procedures," QC 90.14).
2B-2 Practice Inspection is the evaluation of conformity of member’s work with the appropriate
standards of the member’s CPA Handbook and appropriate standards of member’s
organization. It provides self-monitoring by focusing on individual members performance
with an emphasis on providing educational feedback to the individual member.
2B-3 The PCAOB is harsher in terms of making the monitoring results more public (more readily
identifying problem PA firms individually) and appears to be more thorough. In addition
PCAOB is developing the quality control standards as well as the audit standards.
2B-4 While GAAS relate to the conduct of each audit engagement, quality control standards
govern the quality of a PA firm's audit practice as a whole (see CSQC-1 and CAS 220).
IFAC gives nine elements of quality control for a PA firm. When a peer review or quality
review is conducted, the reviewers "audit" the PA firm's statement of policies and
procedures designed to ensure compliance with the nine elements. These statements vary in
length and complexity, depending upon the size of the PA firm in Canada.
APPENDIX 3A
FRAMEWORK FOR CRITICAL THINKING
,SOLUTIONS FOR REVIEW CHECKPOINTS
3A-1 No, if the client fails to provide appropriate disclosure of going concern problems, it is the
auditor’s obligation to modify the opinion for inappropriate going concern disclosures.
Chapter 4 covers opinion modifications in more detail. High assurance means low risk of
material misstatement or low probability of being misleading. This means that not only
should disclosures be in conformity with GAAP but they should also result in fair
presentation in the circumstances. The purpose of the accounting risk concept is to help
guide auditors on fair presentation issues. Accounting risk here is the risk of failing to
disclose when an auditee actually fails within the next year. Accounting risk can be high but
audit risk can be low. Since assurance = 1 minus audit risk, there can be high assurance AND
high accounting risk.
3A-2 The self-fulfilling prophecy argument looks at the failure to disclose from management’s
point of view. A new investor would like to know the true risk of their investment and so the
self-fulfilling prophecy does not apply to them. The auditor should be aware of both
viewpoints but put primacy on 3rd party user needs.
3A-3 Management would not want stock options expensed since it reduces reported earnings and
thus any bonuses related to them (same incentives as for Nortel). But as Warren Buffet said,
if stock option compensation is not an expense, then what is it? He backed up his argument
by offering “free” insurance for stock options. In other words, the economic value of stock
options is the measure of the expense. Typically, a model such as a stock option pricing
model is used to estimate the expense.
3A-4 The auditor would need to identify an acceptably low level of probability of failure so that no
disclosure would not be considered misleading in the circumstances. Note this means setting
accounting risk at an acceptably low level.
3A-5 The accounting risk concept implies that the risk of material misstatement whether due to
factual misstatements (audit risk) or forecasts used in accounting estimates should also be
acceptably low. This is discussed in more detail in the application cases of later chapters.
SOLUTIONS FOR EXERCISES AND PROBLEMS
, EP 3A-1 This issue is discussed in more detail in Chapter 19. The problem here is the vagueness of
standards as discussed in this appendix. A 20% risk of reporting company failure suggests
required disclosure in the notes to the financial statements with an emphasis of matter
paragraph in the auditor’s report. This would avoid criticisms of auditors for failing to
provide timely disclosure of going concern risk and be consistent with Grice’s cooperative
communication principles.
A risk range of (0, 40%) would still mean going concern probability is 60% or higher and
suggests that the going concern numbers are more likely than not. This indicates that auditor
should have same response as in the 20% risk of failure situation. As we discuss in chapter
19 much also depends on how well calibrated the risk range is.
EP 3A-2 As discussed in this appendix the ideal logic is a principles-based framework consistent with
the logic of professional ethics discussed in the chapter. This means the conceptual
framework of FASB should be at the top of the hierarchy, not at the bottom. This would be
the simplest way of getting a reasoning process that is consistent with fair presentation
reporting concept of CAS 200.13 and CAS 700.10 that allows departures from the more
detailed standards if the departure results in fair presentation. Such a departure in
particular circumstances would be logically justified, for example, if application of the
detailed standard would result in not meeting the objectives of financial reporting in the
circumstances. Interestingly, the hierarchy given in the question results in more of a
compliance reporting framework of CAS 200.13.
EP 3A-3 SAMPLE RESPONSE
MEMO
to: Victoria Smyth
from: CPA
RE: Review of YLS’s working papers
Based on my review of the notes you prepared, I have noted the following:
General standard
The general standard may not have been met, although this is a grey area. The staff assigned
to the engagement had no experience with public companies or in this industry. However,
they were qualified in their knowledge of CAS.
