CHAPTER 1
AN INTRODUCTION TO ASSURANCE AND
FINANCIAL STATEMENT AUDITING
Answers to Review Questions
1-1 The study of auditing is more conceptual in nature as compared to other accounting courses.
Rather than focusing on learning the rules, techniques, and computations required to
prepare financial statements, auditing emphasizes learning a framework of analytical and
logical skills. This framework enables auditors to evaluate the relevance and reliability of the
systems and processes responsible for financial information as well as the information itself.
To be successful, students must learn the framework and then learn to use logic and common
sense in applying auditing concepts to various circumstances and situations. Understanding
auditing can improve the decision-making ability of consultants, business managers, and
accountants by providing a framework for evaluating the usefulness and reliability of
information—an important task in many different business contexts.
1-2 There is a demand for auditing in a free-market economy because the agency relationship
between an absentee owner and a manager produces a natural conflict of interest due to the
information asymmetry that exists between these two parties. As a result, the agent agrees to
be monitored as part of his/her employment contract. Auditing appears to be a cost-effective
form of monitoring. The empirical evidence suggests that auditing was demanded prior to
government regulation. In 1926, before it was required by law, independent auditors audited
82 percent of the companies on the New York Stock Exchange. Additionally, many private
companies and municipalities not subject to government regulations, such as the Securities
Act of 1933 and Securities Exchange Act of 1934, also purchase various forms of auditing and
assurance services. Many private companies seek out financial statement audits in order to
secure financing for their operations. Companies preparing to go public also benefit from
having an audit.
1-3 The agency relationship between an owner and manager produces a natural conflict of
interest because of differences in the two parties’ goals and because of the information
asymmetry that exists between them. That is, the manager likely has different goals than the
, owner, and generally has more information about the "true" financial position and results of
operations of the entity than the absentee owner does. If both parties seek to maximize their
own self-interest, the manager may not act in the best interest of the owner and may
manipulate the information provided to the owner accordingly.
1-4 Independence is a bedrock principle for auditors. If an auditor is not independent of the
client, users may lose confidence in the auditor’s ability to report objectively and truthfully
on the financial statements, and the auditor’s work loses its value. From an agency
perspective, if the principal (owner) knows that the auditor is not independent, the owner
will not trust the auditor’s work. Thus, the agent will not hire the auditor because the
auditor’s report will not be effective in reducing information risk from the perspective of the
owner. Auditor independence is also a regulatory requirement.
1-5 Auditing (broadly defined) is a systematic process of (1) objectively obtaining and
evaluating evidence regarding assertions about economic actions and events to ascertain the
degree of correspondence between those assertions and established criteria and (2)
communicating the results to interested users.
Attest services occur when a practitioner issues a report on subject matter, or an assertion
about subject matter, that is the responsibility of another party.
Assurance services are independent professional services that improve the quality of
information, or its context, for decision makers.
1-6 The phrase systematic process implies that there should be a well-planned, logical approach
for conducting an audit that involves objectively obtaining and evaluating evidence. It
requires organizing a plan for gathering evidence and documenting steps taken during the
audit to evaluate the relevance and validity of the evidence.
1-7 Audit risk is defined as the risk that the auditor may unknowingly fail to appropriately
modify his or her opinion on financial statements that are materially misstated (AS 1101).
Materiality is defined as "the magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the
judgment of a reasonable person relying on the information would have been changed or
influenced by the omission or misstatement" (FASB Statement of Financial Accounting
Concepts No. 8, Chapter 3: Qualitative Characteristics of Useful Accounting Information,
which is pending revision at the time of the writing of this book per the Board’s November
2017 decision to revert to a definition of materiality similar to the one found in superseded
Concept No. 2).
, The concept of materiality is reflected in the wording of the auditor's standard audit report
through the phrase "the financial statements present fairly in all material respects." This is
the manner in which the auditor communicates the notion of materiality to the users of the
auditor's report. The auditor's standard report states that the audit provides only reasonable
assurance that the financial statements do not contain material misstatements. The term
"reasonable assurance" implies that there is some risk that a material misstatement could be
present in the financial statements and the auditor will fail to detect it.
1-8 The major phases of the audit are:
Client acceptance/continuance
Preliminary engagement activities
Plan the audit
Consider and audit internal control
Audit business processes and related accounts
Complete the audit
Evaluate results and issue audit report
1-9 Plan the audit: During this phase of the audit, the auditor uses knowledge about the client
and any controls in place to plan the audit and perform preliminary analytical procedures.
The outcome of the planning process is a written audit plan that sets forth the nature, extent,
and timing of the audit procedures to be performed. The purpose of this phase is to plan an
effective and efficient audit.
1-10 The auditor's standard unqualified report for a public company client includes the following
sections: (1) opinion on the financial statements, (2) basis for opinion, and (3) critical audit
matters, as illustrated in this chapter.
1-11 The emergence of advanced audit technologies will help remove many of the tedious tasks
that are usually performed by junior auditors. Thus, auditors of all positions and experience
will be required to spend additional time reasoning through fundamental business,
accounting, and auditing concepts. An auditors’ knowledge in these areas will enable them to
provide greater benefit to clients by asking the right questions and identifying new, more
effective ways to collect, analyze, and interpret results. In using audit data analytics, for
example, auditors must understand the client and its industry, as well as the fundamentals of
, accounting and auditing, in order to ask the right questions in querying the data and in
interpreting the results obtained.
1-12 Auditors frequently face situations where no standard audit procedure exists, such as the
example from the text of verifying the inventory of cattle. Such circumstances require that
the auditor exercise creativity and innovation when planning and administering audit
procedures where little or no guidance or precedent exists. Every client is different, and
applying auditing concepts in different situations requires logic and common sense, and
frequently creativity and innovation.
Answers to Multiple-Choice Questions
1-13 b 1-19 a
1-14 b 1-20 d
1-15 c 1-21 d
1-16 c 1-22 d
1-17 c 1-23 b
1-18 c
Solutions to Problems
1-24 There are two major factors that may make an audit necessary for Greenbloom Garden
Centers. First, the company may require long-term financing for its expansion into other
cities in Florida. Entities such as banks or insurance companies are likely to be the sources of
the company's debt financing. These entities normally require audited financial statements
before lending significant funds and generally require audited financial statements during
the time period the debt is outstanding. There is information asymmetry between the lender
of funds and the owner of the business, and this asymmetry results in information risk to the
lender. Even if the business could get funding without an audit, a clean audit report by a
reputable auditor might very well reduce the lender’s information risk and make the terms
AN INTRODUCTION TO ASSURANCE AND
FINANCIAL STATEMENT AUDITING
Answers to Review Questions
1-1 The study of auditing is more conceptual in nature as compared to other accounting courses.
Rather than focusing on learning the rules, techniques, and computations required to
prepare financial statements, auditing emphasizes learning a framework of analytical and
logical skills. This framework enables auditors to evaluate the relevance and reliability of the
systems and processes responsible for financial information as well as the information itself.
To be successful, students must learn the framework and then learn to use logic and common
sense in applying auditing concepts to various circumstances and situations. Understanding
auditing can improve the decision-making ability of consultants, business managers, and
accountants by providing a framework for evaluating the usefulness and reliability of
information—an important task in many different business contexts.
1-2 There is a demand for auditing in a free-market economy because the agency relationship
between an absentee owner and a manager produces a natural conflict of interest due to the
information asymmetry that exists between these two parties. As a result, the agent agrees to
be monitored as part of his/her employment contract. Auditing appears to be a cost-effective
form of monitoring. The empirical evidence suggests that auditing was demanded prior to
government regulation. In 1926, before it was required by law, independent auditors audited
82 percent of the companies on the New York Stock Exchange. Additionally, many private
companies and municipalities not subject to government regulations, such as the Securities
Act of 1933 and Securities Exchange Act of 1934, also purchase various forms of auditing and
assurance services. Many private companies seek out financial statement audits in order to
secure financing for their operations. Companies preparing to go public also benefit from
having an audit.
1-3 The agency relationship between an owner and manager produces a natural conflict of
interest because of differences in the two parties’ goals and because of the information
asymmetry that exists between them. That is, the manager likely has different goals than the
, owner, and generally has more information about the "true" financial position and results of
operations of the entity than the absentee owner does. If both parties seek to maximize their
own self-interest, the manager may not act in the best interest of the owner and may
manipulate the information provided to the owner accordingly.
1-4 Independence is a bedrock principle for auditors. If an auditor is not independent of the
client, users may lose confidence in the auditor’s ability to report objectively and truthfully
on the financial statements, and the auditor’s work loses its value. From an agency
perspective, if the principal (owner) knows that the auditor is not independent, the owner
will not trust the auditor’s work. Thus, the agent will not hire the auditor because the
auditor’s report will not be effective in reducing information risk from the perspective of the
owner. Auditor independence is also a regulatory requirement.
1-5 Auditing (broadly defined) is a systematic process of (1) objectively obtaining and
evaluating evidence regarding assertions about economic actions and events to ascertain the
degree of correspondence between those assertions and established criteria and (2)
communicating the results to interested users.
Attest services occur when a practitioner issues a report on subject matter, or an assertion
about subject matter, that is the responsibility of another party.
Assurance services are independent professional services that improve the quality of
information, or its context, for decision makers.
1-6 The phrase systematic process implies that there should be a well-planned, logical approach
for conducting an audit that involves objectively obtaining and evaluating evidence. It
requires organizing a plan for gathering evidence and documenting steps taken during the
audit to evaluate the relevance and validity of the evidence.
1-7 Audit risk is defined as the risk that the auditor may unknowingly fail to appropriately
modify his or her opinion on financial statements that are materially misstated (AS 1101).
Materiality is defined as "the magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the
judgment of a reasonable person relying on the information would have been changed or
influenced by the omission or misstatement" (FASB Statement of Financial Accounting
Concepts No. 8, Chapter 3: Qualitative Characteristics of Useful Accounting Information,
which is pending revision at the time of the writing of this book per the Board’s November
2017 decision to revert to a definition of materiality similar to the one found in superseded
Concept No. 2).
, The concept of materiality is reflected in the wording of the auditor's standard audit report
through the phrase "the financial statements present fairly in all material respects." This is
the manner in which the auditor communicates the notion of materiality to the users of the
auditor's report. The auditor's standard report states that the audit provides only reasonable
assurance that the financial statements do not contain material misstatements. The term
"reasonable assurance" implies that there is some risk that a material misstatement could be
present in the financial statements and the auditor will fail to detect it.
1-8 The major phases of the audit are:
Client acceptance/continuance
Preliminary engagement activities
Plan the audit
Consider and audit internal control
Audit business processes and related accounts
Complete the audit
Evaluate results and issue audit report
1-9 Plan the audit: During this phase of the audit, the auditor uses knowledge about the client
and any controls in place to plan the audit and perform preliminary analytical procedures.
The outcome of the planning process is a written audit plan that sets forth the nature, extent,
and timing of the audit procedures to be performed. The purpose of this phase is to plan an
effective and efficient audit.
1-10 The auditor's standard unqualified report for a public company client includes the following
sections: (1) opinion on the financial statements, (2) basis for opinion, and (3) critical audit
matters, as illustrated in this chapter.
1-11 The emergence of advanced audit technologies will help remove many of the tedious tasks
that are usually performed by junior auditors. Thus, auditors of all positions and experience
will be required to spend additional time reasoning through fundamental business,
accounting, and auditing concepts. An auditors’ knowledge in these areas will enable them to
provide greater benefit to clients by asking the right questions and identifying new, more
effective ways to collect, analyze, and interpret results. In using audit data analytics, for
example, auditors must understand the client and its industry, as well as the fundamentals of
, accounting and auditing, in order to ask the right questions in querying the data and in
interpreting the results obtained.
1-12 Auditors frequently face situations where no standard audit procedure exists, such as the
example from the text of verifying the inventory of cattle. Such circumstances require that
the auditor exercise creativity and innovation when planning and administering audit
procedures where little or no guidance or precedent exists. Every client is different, and
applying auditing concepts in different situations requires logic and common sense, and
frequently creativity and innovation.
Answers to Multiple-Choice Questions
1-13 b 1-19 a
1-14 b 1-20 d
1-15 c 1-21 d
1-16 c 1-22 d
1-17 c 1-23 b
1-18 c
Solutions to Problems
1-24 There are two major factors that may make an audit necessary for Greenbloom Garden
Centers. First, the company may require long-term financing for its expansion into other
cities in Florida. Entities such as banks or insurance companies are likely to be the sources of
the company's debt financing. These entities normally require audited financial statements
before lending significant funds and generally require audited financial statements during
the time period the debt is outstanding. There is information asymmetry between the lender
of funds and the owner of the business, and this asymmetry results in information risk to the
lender. Even if the business could get funding without an audit, a clean audit report by a
reputable auditor might very well reduce the lender’s information risk and make the terms
