Solutions Manual, Chapter 6, Page 1 of 446
h h h h h h h
,CHAPTER 1 h
The Role of the h h h
Public Accountant in the
h h h h
American Economy h
Review Questions
h
1-1 The ―crisis of credibility‖ largely arose from the number of companies that restated their previously
h h h h h h h h h h h h h h
issued financial statements as a result of accounting irregularities and fraud. Especially responsible
h h h h h h h h h h h h h
were the very visible Enron and WorldCom fraud cases. Both companies filed for bankruptcy and
h h h h h h h h h h h h h h h
constituted the largest companies in American history to do so. The extent of the accounting
h h h h h h h h h h h h h h h
irregularities and fraud being investigated and disclosed brought into question the effectiveness of
h h h h h h h h h h h h h
financial statement audits. In addition, the criminal conviction of Arthur Andersen, LLP, one of the
h h h h h h h h h h h h h h h
then Big 5 accounting firms, on charges of destroying documents related to the Enron case brought into
h h h h h h h h h h h h h h h h h
question the ethics standards of the profession.
h h h h h h h
1-2 Assurance services are professional services that enhance the quality of information, or its context, for
h h h h h h h h h h h h h h
decision-making. The two types are: (a) those that increase the reliability of information and (b)
h h h h h h h h h h h h h h h
those that involve putting information in a form or context that facilitates decision-making.
h h h h h h h h h h h h h
1-3 A financial statement audit is, by far, the most common type of attest engagement. The overall
h h h h h h h h h h h h h h h
assertion, made by management, most frequently is that the financial statements follow generally
h h h h h h h h h h h h h
accepted accounting principles.
h h h
1-4 A large corporation with securities listed on a stock exchange is required by the rules of the stock
h h h h h h h h h h h h h h h h h
exchange and by the rules of the Securities and Exchange Commission to provide an audit report with
h h h h h h h h h h h h h h h h h
the annual financial statements furnished to its stockholders. It also is required to engage the auditors to
h h h h h h h h h h h h h h h h h
provide an opinion on its internal control. Apart from legal requirements, however, a large listed
h h h h h h h h h h h h h h h
corporation recognizes that it must maintain investor confidence in the reliability of its financial
h h h h h h h h h h h h h h
hstatements and internal control over financial reporting if it is to continue to be able to secure
h h h h h h h h h h h h h h h h
capital from the public. The report by a firm of certified public accountants adds credibility to the
h h h h h h h h h h h h h h h h h
financial statements prepared by the corporation. When a small family-owned enterprise elects to
h h h h h h h h h h h h h
have an audit, the purpose usually is to use the auditors' report to support an application for a bank loan.
h h h h h h h h h h h h h h h h h h h h
Solutions Manual, Chapter 6, Page 2 of 446 h h h h h h h
,1-5 A report by an independent public accountant concerning the fairness of a company's financial
h h h h h h h h h h h h h
statements is commonly required in the following situations:
h h h h h h h h
(1) Application for a bank loan. h h h h
(2) Establishing credit for purchase of merchandise, equipment, or other assets. h h h h h h h h h
(3) Reporting operating results, financial position, and cash flows to absentee owners (stockholders
h h h h h h h h h h h
hor partners). h
(4) Issuance of securities by a corporation. h h h h h
(5) Annual financial statements by a corporation with securities listed on a stock exchange or traded
h h h h h h h h h h h h h h
hover the counter. h h
(6) Sale of an ongoing business.h h h h
(7) Termination of a partnership. h h h
1-6 To add credibility to financial statements is to increase the likelihood that they have been prepared
h h h h h h h h h h h h h h h
following the appropriate criteria, usually generally accepted accounting principles. As such, an
h h h h h h h h h h h h
increase in credibility results in financial statements that can be believed and relied upon by third
h h h h h h h h h h h h h h h h
parties.
h
1-7 Business risk is the risk that the investment will be impaired because a company invested in is unable
h h h h h h h h h h h h h h h h h
to meet its financial obligations due to economic conditions or poor management decisions.
h h h h h h h h h h h h h
hInformation risk is the risk that the information used to assess business risk is not accurate. Auditors
h h h h h h h h h h h h h h h h
can directly reduce information risk, but have only limited effect on business risk.
h h h h h h h h h h h h h
1-8 At the beginning of the century, the principal objective of auditing was the prevention and detection of
h h h h h h h h h h h h h h h h
fraud. Audit work centered on the balance sheet, because the income statement was regarded as highly
h h h h h h h h h h h h h h h h
confidential and not for public disclosure. Today, the principal objective of auditing is to form an
h h h h h h h h h h h h h h h h
opinion on the fairness of financial statements and their conformity with generally accepted accounting
h h h h h h h h h h h h h h
principles. But the professional standards also require that an audit be designed to provide reasonable
h h h h h h h h h h h h h h h
assurance of detecting material misstatements, due to errors or fraud. Particular emphasis is placed
h h h h h h h h h h h h h h
on the income statement which is of great importance to investors. Auditing today also has the
h h h h h h h h h h h h h h h h
objectives of meeting the requirements of the Securities and Exchange Commission (SEC) and the
h h h h h h h h h h h h h h
Public Company Accounting Oversight Board for public companies.
h h h h h h h h
1-9 The statement is incorrect. The increasing integrated databases of today, along with available audit
h h h h h h h h h h h h h
procedures make audited entire populations a possibility in many situations.
h h h h h h h h h h
1-10 An operational audit attempts to measure the effectiveness and efficiency of a specific unit of an
h h h h h h h h h h h h h h h
organization. It involves more subjective judgments than a compliance audit or an audit of financial
h h h h h h h h h h h h h h h
statements because the criteria of effectiveness and efficiency of departmental performance are not
h h h h h h h h h h h h h
as clearly established as are many laws and regulations or generally accepted accounting principles.
h h h h h h h h h h h h h h
The report prepared after completion of an operational audit is usually directed to management
h h h h h h h h h h h h h
of the organization in which the audit work was done.
h h h h h h h h h h
1-11 A compliance audit is an audit to determine whether financial reports or other assertions are in
h h h h h h h h h h h h h h h
compliance with established criteria. The necessary ingredients are verifiable data and the existence of
h h h h h h h h h h h h h h
standards established by an authoritative body. An operational audit, on the other hand, is a review of
h h h h h h h h h h h h h h h h h
a department or other unit of a business or governmental organization to measure the effectiveness and
h h h h h h h h h h h h h h h h
efficiency of operations. Internal auditors often perform operational audits as do auditors employed by
h h h h h h h h h h h h h h
the Government Accountability Office (GAO) of the federal government.
h h h h h h h h h
1-12 Internal auditors must be independent of the department heads and other line executives whose work
h h h h h h h h h h h h h h
hthey review. However, internal auditors are not independent in the same sense as a public accounting
h h h h h h h h h h h h h h h
Solutions Manual, Chapter 6, Page 3 of 446 h h h h h h h
, firm.
h
Solutions Manual, Chapter 6, Page 4 of 446
h h h h h h h
h h h h h h h
,CHAPTER 1 h
The Role of the h h h
Public Accountant in the
h h h h
American Economy h
Review Questions
h
1-1 The ―crisis of credibility‖ largely arose from the number of companies that restated their previously
h h h h h h h h h h h h h h
issued financial statements as a result of accounting irregularities and fraud. Especially responsible
h h h h h h h h h h h h h
were the very visible Enron and WorldCom fraud cases. Both companies filed for bankruptcy and
h h h h h h h h h h h h h h h
constituted the largest companies in American history to do so. The extent of the accounting
h h h h h h h h h h h h h h h
irregularities and fraud being investigated and disclosed brought into question the effectiveness of
h h h h h h h h h h h h h
financial statement audits. In addition, the criminal conviction of Arthur Andersen, LLP, one of the
h h h h h h h h h h h h h h h
then Big 5 accounting firms, on charges of destroying documents related to the Enron case brought into
h h h h h h h h h h h h h h h h h
question the ethics standards of the profession.
h h h h h h h
1-2 Assurance services are professional services that enhance the quality of information, or its context, for
h h h h h h h h h h h h h h
decision-making. The two types are: (a) those that increase the reliability of information and (b)
h h h h h h h h h h h h h h h
those that involve putting information in a form or context that facilitates decision-making.
h h h h h h h h h h h h h
1-3 A financial statement audit is, by far, the most common type of attest engagement. The overall
h h h h h h h h h h h h h h h
assertion, made by management, most frequently is that the financial statements follow generally
h h h h h h h h h h h h h
accepted accounting principles.
h h h
1-4 A large corporation with securities listed on a stock exchange is required by the rules of the stock
h h h h h h h h h h h h h h h h h
exchange and by the rules of the Securities and Exchange Commission to provide an audit report with
h h h h h h h h h h h h h h h h h
the annual financial statements furnished to its stockholders. It also is required to engage the auditors to
h h h h h h h h h h h h h h h h h
provide an opinion on its internal control. Apart from legal requirements, however, a large listed
h h h h h h h h h h h h h h h
corporation recognizes that it must maintain investor confidence in the reliability of its financial
h h h h h h h h h h h h h h
hstatements and internal control over financial reporting if it is to continue to be able to secure
h h h h h h h h h h h h h h h h
capital from the public. The report by a firm of certified public accountants adds credibility to the
h h h h h h h h h h h h h h h h h
financial statements prepared by the corporation. When a small family-owned enterprise elects to
h h h h h h h h h h h h h
have an audit, the purpose usually is to use the auditors' report to support an application for a bank loan.
h h h h h h h h h h h h h h h h h h h h
Solutions Manual, Chapter 6, Page 2 of 446 h h h h h h h
,1-5 A report by an independent public accountant concerning the fairness of a company's financial
h h h h h h h h h h h h h
statements is commonly required in the following situations:
h h h h h h h h
(1) Application for a bank loan. h h h h
(2) Establishing credit for purchase of merchandise, equipment, or other assets. h h h h h h h h h
(3) Reporting operating results, financial position, and cash flows to absentee owners (stockholders
h h h h h h h h h h h
hor partners). h
(4) Issuance of securities by a corporation. h h h h h
(5) Annual financial statements by a corporation with securities listed on a stock exchange or traded
h h h h h h h h h h h h h h
hover the counter. h h
(6) Sale of an ongoing business.h h h h
(7) Termination of a partnership. h h h
1-6 To add credibility to financial statements is to increase the likelihood that they have been prepared
h h h h h h h h h h h h h h h
following the appropriate criteria, usually generally accepted accounting principles. As such, an
h h h h h h h h h h h h
increase in credibility results in financial statements that can be believed and relied upon by third
h h h h h h h h h h h h h h h h
parties.
h
1-7 Business risk is the risk that the investment will be impaired because a company invested in is unable
h h h h h h h h h h h h h h h h h
to meet its financial obligations due to economic conditions or poor management decisions.
h h h h h h h h h h h h h
hInformation risk is the risk that the information used to assess business risk is not accurate. Auditors
h h h h h h h h h h h h h h h h
can directly reduce information risk, but have only limited effect on business risk.
h h h h h h h h h h h h h
1-8 At the beginning of the century, the principal objective of auditing was the prevention and detection of
h h h h h h h h h h h h h h h h
fraud. Audit work centered on the balance sheet, because the income statement was regarded as highly
h h h h h h h h h h h h h h h h
confidential and not for public disclosure. Today, the principal objective of auditing is to form an
h h h h h h h h h h h h h h h h
opinion on the fairness of financial statements and their conformity with generally accepted accounting
h h h h h h h h h h h h h h
principles. But the professional standards also require that an audit be designed to provide reasonable
h h h h h h h h h h h h h h h
assurance of detecting material misstatements, due to errors or fraud. Particular emphasis is placed
h h h h h h h h h h h h h h
on the income statement which is of great importance to investors. Auditing today also has the
h h h h h h h h h h h h h h h h
objectives of meeting the requirements of the Securities and Exchange Commission (SEC) and the
h h h h h h h h h h h h h h
Public Company Accounting Oversight Board for public companies.
h h h h h h h h
1-9 The statement is incorrect. The increasing integrated databases of today, along with available audit
h h h h h h h h h h h h h
procedures make audited entire populations a possibility in many situations.
h h h h h h h h h h
1-10 An operational audit attempts to measure the effectiveness and efficiency of a specific unit of an
h h h h h h h h h h h h h h h
organization. It involves more subjective judgments than a compliance audit or an audit of financial
h h h h h h h h h h h h h h h
statements because the criteria of effectiveness and efficiency of departmental performance are not
h h h h h h h h h h h h h
as clearly established as are many laws and regulations or generally accepted accounting principles.
h h h h h h h h h h h h h h
The report prepared after completion of an operational audit is usually directed to management
h h h h h h h h h h h h h
of the organization in which the audit work was done.
h h h h h h h h h h
1-11 A compliance audit is an audit to determine whether financial reports or other assertions are in
h h h h h h h h h h h h h h h
compliance with established criteria. The necessary ingredients are verifiable data and the existence of
h h h h h h h h h h h h h h
standards established by an authoritative body. An operational audit, on the other hand, is a review of
h h h h h h h h h h h h h h h h h
a department or other unit of a business or governmental organization to measure the effectiveness and
h h h h h h h h h h h h h h h h
efficiency of operations. Internal auditors often perform operational audits as do auditors employed by
h h h h h h h h h h h h h h
the Government Accountability Office (GAO) of the federal government.
h h h h h h h h h
1-12 Internal auditors must be independent of the department heads and other line executives whose work
h h h h h h h h h h h h h h
hthey review. However, internal auditors are not independent in the same sense as a public accounting
h h h h h h h h h h h h h h h
Solutions Manual, Chapter 6, Page 3 of 446 h h h h h h h
, firm.
h
Solutions Manual, Chapter 6, Page 4 of 446
h h h h h h h
