Chapter 1 Modern Auditing

CHAPTER 1 AUDITING AND THE PUBLIC ACCOUNTING PROFESSION INTEGRITY OF FINANCIAL REPORTING instruction CHECK 1. SEVERAL COMMON ATTRIBUTES OF ACTIVITIES DEFINED AS AUDITING ARE (A) positive 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) raise USERS. 2.A pecuniary pedagogy visit involves obtaining and evaluating order around an entitys monetary statements for the settle of expressing an opinion on whether the statements be presented fairly in form with launch criteriausu anyy GAAP. Thus, the nature of the attendants cogitation is an opinion on the legality of the fiscal statement presentation. A respect study involves obtaining and evaluating evidence to determine whether true monetary or operating activities of an entity conform to specified conditions, rules, or regulations.A report on a compliance visit take s the form of a clove pinky of decisions or toast regarding degree of compliance. An practicable scrutinise involves obtaining and evaluating evidence rough the efficiency and effectiveness of an entitys operating activities in relation to specified objectives. Reports on such size ups allow in an assessment of efficiency and effectiveness and recommendations for melioratements. 3. self-sufficing tenders be individual practitioners or members of open account statement theatres who render master auditing service to knobs. These run whitethorn involve financial statement audits, compliance audits, and operational audits.Internal auditors argon employees of the companies they audit. They argon involved in an independent appraisal activity, c eithered inborn auditing, as a service to the organic law. Internal auditors argon primarily relate with compliance and operational audits. brass auditors ar employed by various local, state, and national governmental ag encies. They whitethorn be involved in all triple types of audits. 4. a. The financial statement audit is a form of an exam interest in which the auditor turn ins fair effrontery that the financials statements ar plain of clobber misstatement.The certified public accountant might to a fault cause an encounter to psychoanalyze a forecast or a projection in which the auditor contributes clean assurance that the forecast or projection reflects the underlying assumptions and that on that point is support reasonable for the underlying assumptions. A CPA might also perform an usage 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 reassessment of financial statements is an engagement in which the CPA provides negative assurance that he or she is non aware of any material modifications that neediness to be do to the financial statements in order for them to be in conformity with GAAP. 5. be and compilation services provide financial statement holdrs and decisions puzzlers with pertinent discip pipeline. However, they are non designed to test the dependability of such development. The primary benefit true is information that may be relevant to a decision, even though evidence is not obtained about the re financial obligation of such information. . The avocation set back summarizes several assurance services provided by CPAs and explains the how they improve the relevance or reliability of information utilise by decision cast offrs. Assurance aid How the service improves the relevance or reliability of information used by decision sterilisers CPA Risk Advisory Provides relevant information to concern or the board of restrainors about duty adventures faced by an entity.It ma also provide information about the reliability of attentions dodge for identifying and supervise business risks. CPA Perfor mance 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 supervise the entitys performance. 7. a.The audit provides reasonable assurance that financial statement information is free of material misstatements. conclusiveness pick outrs dismiss 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 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 both the relevance and reliability of in formation 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 lose. c. The CPA risk advisory service may transform complex information into association by helping management better understand business risks. The CPA risk advisory service may also provide assurance about the reliability of information produced by managements system of evaluating business risks. . The origin of the ac fellow travelership audit as we go to bed it canful be linked to British legislation 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 auditing solids. The focus of these early audits was on finding errors in the balance sheet accounts and stemming the growth of takeoff associated with the increase phenomenon of pro managers and absentee owners.Several weighty milestones in the rise of the U. S. profession were (1) the march onage of legislation (2) the stock market crash of 1929 which drew attention to deficiencies in financial coverage and produced a challenge to the accounting profession to provide stronger leadership, (3) adoption of a requirement by the New York Stock substitute in 1933 that all listed corporations obtain an audit certificate from an independent CPA, and (4) passage of the Securities Act of 1933 and the Securities change Act of 1934 which added to the demand for audit services for publicly owned companies.Three important changes in audit course session that evolved by the 1040s were (1) a shift from fine verification of accounts to sampling or interrogatory as the basis for transformation an opinion on the frankness of financial statements, (2) development of the practice of linking the testing to be through with(p) to the auditors evaluation of a companys midland defys, and (3) deemphasis of the detection of boloney as an audit objective.In recent years, the profession has come under increasing pressure to reverse the deemphasis on detecting fraud as the publics prognosis that the auditor will detect fraud persists. The lumber of audits was questioned when a serial of restatements of earnings from public companies such as Sunbeam, Waste oversight, 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 Congress to pass the Sarbanes-Oxley Act of 2002. This act created the universal Companies Accounting Oversight senesce (PCAOB) and gave it accountability for cathode-ray oscilloscope auditing, ethics, independence, and pure tone view as standards for audits of public companies. 9. Four factors that contribute 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 moldiness be satisfied in order to gain plan of attack to chief city markets, (b) obtain debt and equity financing at a lower terms of capital, (c) deter inefficiency and errors in the accounting function and reduce the risk of fraud in the accounting and financial reporting process, and (d) make internal instruction 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 overwhelm the fact that an auditor works within fairly restrictive economic limits that impose clipping and cost constraints and necessitate the use of selective testing or sampling of the accounting records and support ing data. Also, the auditors report moldiness ordinarily be issued within three months of the balance sheet date, which affects the amount of evidence that can be obtained.The availability of alternative accounting principles permitted under GAAP, and the contact of accounting estimates and uncertainties on the financial statements represent additional inherent limitations on financial statement audits. 12. Six public sector organizations hold (1) the Securities and Exchange Commission, (2) state boards of method of accounting, (3) the U. S. General Accounting mapping, (4) the Internal Revenue Service, (5) state and national courts, and the U.S. Congress. Five private sector organizations associated with the public accounting profession hold (1) the Public Companies Accounting Oversight Board, (2) the American pioneer of Certified Public Accountants, (2) State Societies of Certified Public Accountants, (4) Practice Units (CPA wholes), and (5) Accounting Standard pose Bodi es principally the Financial Accounting Standards Board (FASB) and Governmental Accounting Standards Board (GASB). 3. The Securities and Exchange Commission regulates the distribution of securities offered for public sale and subsequent job of securities on stock exchanges and over-the-counter markets. The mo also has the authority to embed GAAP for companies under its jurisdiction, and it currently actualizes the pronouncements of the FASB as constituting GAAP in the register 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 effect 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 cinque major areas (1) registering public accounting warms that audit the financial statements of public companies, (2) tantrum persona control standards for mates review of auditors of public companies and conducting critical reviews of registered public accounting unanimouss, (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 wipe out a direct impact on auditors are (1) the AICPA Practice monitor Program is responsible for quality control standards and coadjutor 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 c ompanies, and (3) the Professional Ethics Division is responsible for setting and enforcing the AICPA command 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 oft sequences classified into the following four groups (1) Big Four, (2) Second Tier, (3) Regional, and (4) Local. 16. a. The innovation of the professions multilevel regulatory modelling 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. severally CPA firm adopts policies and procedures to assure that practicing accountants adhere to professional standards. Self-or peer regulation. The AICPA has utilise a comprehensive program of self-regulation including mandatory continuing professional knowledge, 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 flipper elements of quality control are (1) independence, integrity and objectivity, (2) violence management, (3) credence and duration of engagements, (4) engagement performance, and (5) monitoring. 18. a. The key elements of the PCAOB inspection program includes Inspecting and reviewing selected audit and review engagements of the firm. Evaluating the adequateness of the firms quality control systems and the firms bread and butter and communication of that system. Performing such other testing of the audit, superv isory, and quality control procedures of the firm as are necessary or appropriate in light of the purpose of the inspection and the responsibilities of the board. The PCAOB conducts annual 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 few 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 organism 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 engageme nts in accordance with professional standards, in all material respects. Comprehensive Questions 1. 19 (Estimated time 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 lighting of its responsibilities.External auditing is done by independent, external 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 different 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) nonparasitic(1) Stockholders, investors, regulatory agencies, and general public 2.Operational (3) Internal (2), Independent(1) Senior charge 3. conformation (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. Comp liance (2) Independent (1), Internal (2), Congress and Government 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 first 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 maturation 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 computer science of instrument turn days. Transforming complex information into knowledge involves understanding how the clients receivable collection expiration (58 days) compares with the rest of the industry.In this case the 75% of the industry collect their receivabl es faster than the client. Anticipating and creating the opportunity 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 specialized customers that are delinquent and considering how to take steps to speed collection. The final storey 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 qua lity 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 trim down 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 malversate company assets.The fact that financial statement assertions are to be verify 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 pass judgment managemen ts assessments of business risks, to recommend improved performance measures, and to make recommendations to achieve greater operational efficiencies within the clients organization.Your fellow business student is correct that these benefits are not achieved when an audit is not performed in accordance with professional standards. b. Even 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 aud it every transaction. Reasonable Length of Time. The auditors report on many public companies is usually issued three to five weeks by and by 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 last in first out 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 allo wance for doubtful accounts and an inventory obsolescence reserve to impairment tests for fixed assets and goodwill. An audit cannot add exactness and foregone conclusion 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 pu blic accounting firm done 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 monitor (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) pop the question of Policy / unconscious process Additional Policy/ Element (b) Procedure Procedure (a) (c) 1. military force Management Personnel should have the qualifications to Establish qualifications necessary for forgather responsibilities they may be called upon each level of responsibility in the firm. to admit in the future. 2. Engagement Performance prepar e at all levels should be supervised to ssure Establish procedures for reviewing working that it meets the firms standards of quality. papers and reports. 3. Personnel Management Work is assigned to people who have the technical Identify areas and specialized situations gentility for the assignment and personnel should for which consultation is required. seek assistance, when necessary, from persons having appropriate expertise, judgment, and authority 4. Independence, haleness andAll professionals should be independent of Monitor compliance with independence objectiveness clients. rules. 5. observe 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 want should be new hires at the entry le vel. hired. 7. Personnel Management Personnel should have the knowledge required to Provide Programs 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 Continuance 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 substantiative effect on members who are involved in audits that are subject to inspection or peer review and all individuals in a firm may receive cer tain types of continuing professional breeding based on the findings of these programs. . The PCAOB is responsible 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 systems 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 4 5 minutes) Research Situation communicating A student can perform the search of quality control standards 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 outline below. 1. apologize 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 con trol 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 actio ns necessary, including necessary modifications to the quality control system, are taken on a timely basis. 2) Preissuance or postissuance review of selected engagements. 3) compendium 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 chequer that any necessary modifications are made to the quality control policies and procedures on a timely basis.