CHAPTER 1
PROFESSIONAL PRACTICE OF ACCOUNTANCY
Questions and Answers:
1. Role of the professional accountant in the economy?
Answer:
The credibility added to the information by an independent auditor
actually reduces the decision maker’s risk.
2. How does one become a CPA?
Answer:
Generally, to be a CPA one must meet certain education requirements,
and pass the CPA exam.
The CPA examination is prepared and graded twice each year. It is
generally recognized as an academic examination. Before the effectivity
of PRC-BOA Resolution No. 262, series of 2015 on May 2016, it includes
multiple-choice questions in the following subjects namely, Theory of
Accounts, Practical Accounting I, Practical Accounting II, Auditing Theory,
Auditing Problems, Management Services, Business Law and Taxation. So
starting May 2016, it covers, but are not limited to, the following six (6)
subjects: Financial Accounting and Reporting, Advanced Financial
Accounting and Reporting; Management Advisory Services, Auditing,
Taxation and, Regulatory Framework for Business Transaction.
3.What are the qualification requirements that a prospective examinee must
satisfy before taking the CPA Licensure Examination? Refer to page 11 of the
textbook.
Answer:
The “Philippine Accountancy Act of 2004” (RA 9298) Article II, Section 13 to 18
provides for the requirements for the Examination, (Registration and Licensure)
for the Practice of Accountancy as follows:
Any person applying for examination shall establish the following pre-requisites
to the satisfaction of the Board that he/she:
a) Is a Filipino citizen;
b) Is of good moral character;
c) Is a holder of the degree of BSA conferred by a school, college,
academy or institute duly recognized and/or accredited by the CHED
or other authorized government offices; and
d) Has not been convicted of any criminal offense involving moral
turpitude.
4. What are the requirements that a CPA in public practice must comply with
before he is issued a certificate of accreditation by the Board of Accountancy?
Answer: Refer to page 110 (Section 28 of the Philippine Accountancy Act of 2004)
of the textbook.
5. Name the core competencies required in the public accounting practice?
Answer:
Competencies include both what individual auditors know and what
individual auditors and audit teams do. Competencies are evidenced by
auditors applying their skills in the delivery of services to clients or supporting
the delivery of those services.
Refer to page 24 of text.
1.
2.
3.
4.
5.
6.
Communication Skills
Leadership Skills
Critical-/Thinking and Problem-Solving Skill
Anticipating and Serving Evolving Needs
Synthesizing Intelligence to Insight
Integration and Collaboration
These competencies categorized as “High Opportunity Competencies” and
“Low Opportunity Competencies” are as follows:
a) High Opportunity Competencies have a high likelihood of being building
blocks for selling or delivering new assurance services.

Analytical Skills

Business Advisory Skills

Business Knowledge

Capacity for Work

Comprehension of Client’s Business Processes

Communication Skills

Efficiency

Intellectual Capability

Learning and Rejuvenation

Marketing and Selling

Model Building

People Development

Relationship Management

Responsiveness and Timeliness

Technology

Verification
b) Low Opportunity Competencies, while important to the delivery of current
assurance services, are less likely to be exploited in the development of
future services.

Accounting and Auditing Standards

Administrative Capability

Managing Audit Risk
6. Why is the practice of accountancy considered practice of profession?
Answer: Refer to page 4 of the textbook.
7. Describe briefly the scope of practice of a professional accountant?
Answer:
The Philippine Accountancy Act of 2004 (R.A. 9298) Article I, Section 4,
paragraphs (a) to (d) spell out the scope of the practice of accountancy
as follows:

Practice of Public Accountancy

Practice in Commerce and Industry

Practice in Education/Academe

Practice in the Government
8. What are the major components of the BSA Curriculum?
Answer: Refer to pages 8 to 10 of the textbook.
9. What are the qualification requirements that an individual must meet to be
able to take the CPA Licensure examination?
Answer: Refer to page 11 of the textbook.
10. How may a professional accountant develop and sustain the required
capabilities and competence after admission to the profession?
Answer: Refer to pages 13 to 14 of the textbook.
11. Explain briefly the competency requirements for professional accountants
in public practice?
Answer: Refer to pages 14 to 15 of the textbook.
12.Explain briefly the competency requirements for professional accountants
in business?
Answer: Refer to pages 16 to 17 of the textbook.
13.Explain why the practice of accountancy is currently considered more
globalized?
Answer:
This is brought about by the nature of accounting standards and the demand
for accounting-related information which have changed in several
significant ways. These changes include:

Global Harmonization of Accounting Standards

Expanded Accountability

More Detailed Reporting

Increased Risk Reporting

Global Audit Standards
14.Comment upon each of the following statements you heard in a
conversation between two newly hired staff auditors?
Answer:
(a) While university-level training is important, it is also necessary that
professionals continue their education throughout their careers, as
accounting and auditing standards will change. In this particular case,
the staff member would need to stay abreast of current developments
in order to meet the competence and capabilities element of the
responsibilities principle.
(b) Auditors need to be both independent in fact and independent in
appearance. While a small financial investment might not impair the
auditors’ actual state of mind (independence in fact), it is unlikely that
financial statement users will perceive the auditor to be independent
(independence in appearance). Professional standards would not
consider the auditor independent in this case, as no direct financial
interests in clients are permitted.
Additional Questions:
15. What are the 5 different areas that a professional accountant’s mindset
needs to embrace? Page 17 of the Text.
Answer:
1.
2.
3.
4.
5.
Professional and Ethical Behavior
Professional Judgment
Organizational and Environmental Awareness
An Investor and Wider Stakeholder Focus
Change, Uncertainty and Complexity
16. What should Professional Ethics include, as a minimum program?
Answer: Page 10 of the text.
17. What should professional skills for professional accountants in general
include?
Answer: Page 16 of the text.
18. What are the 10 Insights and Directions that the research project
conducted by AICPA in 2011 entitled “CPA Horizons 2025”, cited?
Answer: Pages 20-23.
Multiple Choice Questions
Answer
1.
2.
3.
4.
D
C
B
B
CHAPTER 2
PRACTICE OF PUBLIC ACCOUNTANCY
Questions and Answers:
1. Describe briefly the practice of public accountancy as provided for in the
Philippine Accountancy Act of 2004?
Answer: Refer to page 29 of the textbook.
2. Describe the role of the various organizations that affect the practice of the
accounting professionals in the Philippines?
Answer: Refer to pages 30 to 35 of the textbook.
3. What is meant by an assurance engagement?
Answer: Refer to pages 36-37 of the textbook.
4. What is the basic objective of an assurance engagement?
Answer: Refer to page 37 of the textbook.
5. Give and explain briefly the most sought-after assurance services among
professional accountants.
Answer: Page 36 of the textbook
The following are the most sought - after services among professional
accountants.
A. Assurance Services. Examples are:
1. Independent financial statement audit
2. Reviews
3. Other assurance services (e.g., CPA Web Trust, Business Performance
Measurement Service)
B. Non-Assurance Services. Examples are:
1. Agreed-upon procedures
2. Compilation
3. Tax
4. Management consultancy/advisory services
5. Accounting and data processing
6. Other non-assurance services (e.g., Information Technology System
Services)
6. Distinguish between consulting and assurance services?
Answer:
In an assurance engagement, a practitioner aims to provide a high or
moderate level of assurance that an assertion being made by one party
for use by another party can be relied upon while in a consulting
engagement, the practitioner aims to provide professional advice on how
the limited resources of an enterprise can be put into optimal use in order
to attain the company’s objectives.
7. Give examples of assurance services on information technology?
Answers:
Examples of assurance engagements on information technology are:
a) CPA Web Trust Service
b) Information System Reliability Service
Refer to page 41 of the textbook for a brief discussion of these services.
8. Give and explain briefly three examples of non-assurance services by
professional accountants?
Answer: Refer to pages 52-54 of the textbook.
9. Explain the elements of an assurance engagement?
Answer: Refer to pages 44 to 52 of the textbook.
10. Differentiate between assertion-based engagements and direct reporting
engagements?
Answer: Refer to page 38 of the textbook.
11. What is meant by “criteria” in the context of assurance engagements?
What characteristics must professional accountants possess for them to be
considered suitable?
Answer: Refer to page 47 of the textbook.
12. Describe briefly four (4) non-assurance engagements performed frequently
by professional accountants?
Answer: Refer to pages 52 to 54 of the textbook.
13. Describe three (3) emerging consultancy services being offered by
professional accountants?
Answer: Refer to page 36/54 of the textbook.
14.Give and explain briefly at least five (5) initiatives to address the credibility
crisis in the accountancy profession?
Answer: Refer to pages 56 and 57 of the textbook.
15. What are the 2 types of assurance engagements under the Philippine
Framework for assurance engagements? Explain Each?
Answer: Page 38 of the text.
Multiple Choice Questions
Answers
1.
2.
3.
4.
5.
C
A
D
D
D
6.
7.
8.
9.
10
C
D
D
D
C
11.
12.
13.
14.
D
C
D
C
Cases
1. (a) The purpose of CPA reporting on internal control is to provide assurance
about whether management’s assertion about internal control is fairly
stated in all material respects, based on the control criteria being
followed. Thus, for example, an examination provides the highest
degree of assurance that information produced by the system will be
reliable.
(b) When involved in performing an examination on the effectiveness of
internal control a practitioner should:



Plan the engagement.
Obtain an understanding of internal control.
Evaluate the design and operating effectiveness of internal
control.
 Form an opinion about the fairness of management’s assertion on
internal control.
2. (a) PSA 100, Assurance Engagements, provide guidance for an
engagement such as one on customer satisfaction. They provide
guidelines on audits and related services such as examinations and
reviews.
(b) Suitable criteria are those that are objective and permit reasonably
consistent measurements. In addition, the criteria must be sufficiently
complete such that no relevant factors are omitted that would affect a
conclusion about the subject matter. Finally, the criteria must measure
some characteristic of the subject matter that is relevant to a user’s
decision.
(c)
INDEPENDENT ACCOUNTANTS’ REPORT
We have examined the accompanying Schedule of Customer
Satisfaction Measures for the three years ended December 31, 2013. This
schedule is the responsibility of Gonzales, Inc.’s management. Our
responsibility is to express an opinion on this schedule based on our
examination.
Our examination was conducted in accordance with standards on
assurance engagements adopted in the Philippines and, accordingly,
included examining, on a test basis, evidence supporting the schedule
and performing such other procedures as we considered necessary in
the circumstances. We believe that our examination provides a
reasonable basis for our opinion.
In our opinion, the Schedule of Customer Satisfaction Measures referred
to above presents fairly, in all material respects, the levels of customer
satisfaction for the three years ended December 31, 2013, in conformity
with the measurement and disclosure criteria set forth in Note 1.
Santos & Lopez, LLP
March 1, 2014
NOTE TO INSTRUCTOR: If the CPAs believe that the criteria are not
understandable by users other than management a paragraph must be
added to the report restricting its use.
CHAPTER 3
OVERVIEW OF AUDITING
Questions and Answers:
1. Define Auditing? Explain the basic objective of auditing as provided for in
PSA 120 “Framework of Philippine Standards on Auditing?”
Answer: 65/67
One definition of auditing is that it is a systematic process by which a
competent, independent person objectively obtains and evaluates
evidence regarding assertions about economic actions and events to
ascertain the degree of correspondence between those assertions and
established criteria and communicating the results to interested users.
The Philippine Standards on Auditing (PSA) 120 “Framework of Philippine
Standards on Auditing” states the objective of an audit as follows:
“The objective of an audit of financial statements is to enable the auditor
to express an opinion whether the financial statements are prepared in all
material respects, in accordance with an identified financial reporting
framework.”
2. In the conduct of audits of financial statements it would be a serious
breach of responsibility if the auditor did not thoroughly understand
accounting. However, many competent accountants do not have an
understanding of the auditing process. What causes the difference?
Answer:
This apparent paradox arises from the distinction between the
function of auditing and the function of accounting.
The accounting function is the process of analyzing, recording, classifying,
summarizing and communicating economic events to provide relevant
information to decision makers.
The rules of accounting are the criteria used by the auditor for evaluating
the presentation of economic events for financial statements and he or she
must therefore have an understanding of Philippine Financial Reporting
Standards (PFRS), as well as Philippine Standards on Auditing (PSA).
The accountant need not, and frequently does not, understand what
auditors do, unless he or she is involved in doing audits, or has been trained
as an auditor.
3.What are the differences and similarities in audits of financial
compliance audits and operational audits?
statements,
Answer:
Purpose
Users of
Audit
Report
Nature
Performed
by:
CPAs
COA
Auditors
BIR
Auditors
Internal
Auditors
Audits of
Financial
Statements
To determine
whether the
financial
statements
are
presented in
accordance
with PFRS.
Audits of
Financial
Statements
Different
groups for
different
purposes –
many outside
entities.
Highly
standardized
Compliance
Audits
Operational
Audits
To determine
whether the
client is
following
specific
procedures
set by higher
authority.
To evaluate
whether
operating
procedures
are efficient
and
effective.
Compliance
Audits
Operational
Audits
Authority
setting down
procedures,
internal or
external
Management of
organization
Not
standardized
, but very
specific and
usually
objective
Highly
nonstandard; often
very
subjective
Almost
universally
Occasionally
Occasionally
Frequently
Frequently
Frequently
Never
Universally
Never
Frequently
Frequently
Frequently
4. What are major differences in the scope of audit responsibilities for CPAs,
COA auditors, BIR agents, and internal auditors?
Answer:
The major differences in the scope of audit responsibilities are:
1. CPAs perform audits in accordance with Philippine Standards on
Auditing of published financial statements prepared in accordance
with identified and applicable Statements of Financial Accounting
Standards.
2. COA auditors perform compliance, financial or operational audits in
order to assure the Congress of the expenditure of public funds in
accordance with its directives and the law.
3. BIR agents perform compliance audits to enforce the tax laws as
defined by Congress, interpreted by the courts, and regulated by the
BIR law.
4. Internal auditors perform compliance, management or operational
audits in order to assure management or the board of directors that
controls and policies are properly and consistently developed,
applied and evaluated.
5. Discuss the major factors in today’s society that have made the need for
independent audits much greater than it was fifty years ago?
Answer:
An independent audit is a means of satisfying the need for reliable
information on the part of decision makers. Factors of a complex society
which contribute to this need are:
1. remoteness of information
a. owners (stockholders) divorced from management
b. directors not involved in day-to-day operations or decisions
c. dispersion of the business among numerous geographic locations
and complex corporate structures
2. bias and motives of provider
a. information will be biased in favor of the provider when his goals
are inconsistent with the decision maker.
3. voluminous data
a. possibly millions of transactions processed daily via sophisticated
computerized systems
b. multiple product lines
c. multiple transaction locations
4. complex exchange transactions
a. new and changing business relationships lead to innovative
accounting and reporting problems
b. potential impact of transactions not quantifiable, leading to
increased disclosures
6. Identify the major causes of information risk and identify the three main
ways information risk can be reduced. What are the advantages and
disadvantages of each?
Answer:
The four primary causes of information risk are remoteness of information,
bias in motives of the provider, voluminous data, and existence of complex
exchange transactions.
The three main ways to reduce information risk are:
1. User verifies the information itself.
2. The users share the information risk with management.
3. Have audited financial statements provided.
The advantages and disadvantages of each are as follows:
User verifies
information
Users share
information
risk with
management
Audited
financial
statements
are prepared
Advantages
Disadvantages
1. User obtains
1. High cost of
information
obtaining
desired.
information.
2. User can be
2. Inconvenience
more confident
to the person
of the
providing the
qualifications
information
and activities of
because large
the person
number of users
getting the
would be on
information.
premises.
1. No audit costs
1. Users may not be
incurred.
able to collect
on losses.
1. Multiple users
obtain the
information.
2. Information risk
can usually be
reduced
sufficiently to
satisfy users at
reasonable
cost.
3. Minimal
inconve-nience
to
management
by having only
one auditor.
1. May not meet
needs of certain
users.
2. Cost may be
higher than the
benefits in some
situations, such
as for a small
company.
7. Explain what is meant by information risk and discuss the four causes of this
risk?
Answer:
Information risk is the possibility that information upon which a business
decision is made is inaccurate. Four causes of information risk are:
 remoteness of information,
 biases and motives of the provider,
 voluminous data, and
 complex exchange transactions.
8. Discuss the three primary ways users of information can reduce risk? Same
as question number 6.
Answer:
Three primary ways users of information can reduce information risk are:
 users can verify the information themselves,
 users can share information risk with management, and
 users can obtain audited financial statements.
9. Discuss four factors that are likely to significantly reduce information risk in
the next five to ten years?
Answer:
Four factors that are likely to significantly reduce information risk in the next
five to ten years are:
 technological advances,
 more companies will go on–line, reducing the risk of investors
obtaining outdated information,
 new accounting and auditing standards, and
 auditors will find more efficient and effective audit techniques.
10. Explain the relationship between accounting and auditing?
Answer:
Refer to pages 84 and 85 of the textbook.
11. Describe several business situations that would create a need for a report
by an independent public accountant concerning the fairness of a
company’s financial statements
Answer
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.
12. Explain the following statement: One contribution of the independent
auditor is to lend credibility to financial statements
Answer:
To add credibility to financial statements is to increase the likelihood that
they have been prepared following the appropriate criteria, usually the
relevant and applicable PAS. As such, an increase in credibility results in
financial statements that can be believed and relied upon by third parties.
13. The overall risk of the investment in a business includes both business risk
and information risk. Contrast these two types of risk. Which one is most
directly affected by the auditors?
Answer:
Business risk is the risk that the investment will be impaired because a
company invested in and 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.
14. What does an operational audit attempt to measure? Does an operational
audit involve more or fewer subjective judgments than a compliance audit
or an audit of financial statements? Explain. To whom is the report usually
directed after completion of an operational audit?
Answer:
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 financial
reporting standards.
The report prepared after completion of an operational audit is usually
directed to management of the organization in which the audit work was
done.
15. Evaluate the following quotation: “Every business, large or small, should
have an annual audit of a CPA firm. To forgo an audit because of its cost
is false economy:
Answer:
The first quoted sentence overstates the case. Although annual audits by
CPA firms are universal practice for large corporations, they are not
essential to many small businesses. The financial statements of large
corporations go to many stockholders (often hundreds of thousands) who
demand the assurance of reliability supplied through independent audits
by CPA firms. Moreover the SEC and the stock exchanges require that listed
companies have annual audits.
For a small business concern, the primary need for annual financial
statements is to support an application for a bank loan. If a small business
does not need to borrow, or can obtain borrowed funds without providing
audited statements, the cost of an audit may not be justified.
Often a small business can obtain from a CPA firm specialized services other
than an audit, which are more useful and may cost less. Examples are the
review or compilation of financial statements, installation of a computer
based accounting system, or a study of internal control. Thus, the second
quoted sentence, as well as the first, is too sweeping to be correct. A
decision not to have an audit is not always “false economy.”
16.The self-interest of the provider of financial information (whether
an individual or a business entity) often runs directly counter to
the interests of the user of the information.
Required:
a) Give an example of such opposing interest.
b) What may be done to compensate for the possible bias existing
because of the self-interest of the individual or business entity providing
the financial information?
Answer:
(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.
17. Discuss the similarities between financial statement audits, operational
audits and compliance audits. Give an example of each type.
Answer:
Financial statements audits, operational audits, and compliance audits are
similar in that each type of audit involves accumulating and evaluating
evidence about information to ascertain and report on the degree of
correspondence between the information and established criteria. The
differences between each type of audit are the information being
examined and the criteria used to evaluate the information. 1) An example
of a financial statement audit would be the annual audit of ABS-CBN
Corporation, in which the external auditors examine ABS-CBN’s financial
statements to determine the degree of correspondence between those
financial statements and generally accepted accounting principles. 2) An
example of an operational audit would be an internal auditor’s evaluation
of whether the company’s computerized payroll-processing system is
operating efficiently and effectively. 3) An example of a compliance audit
would be a BIR auditor’s examination of an entity’s tax return to determine
the degree of compliance with the National Internal Revenue Code.
18. Discuss the similarities and differences between the roles of independent
COA auditors, BIR agents and internal auditors?
Answer: Refer to pages 83 to 84 of the textbook.
19. Define internal auditing by describing its nature and objectives?
Answer:
The text defines internal auditing as an independent appraisal activity in an
entity. Internal auditing is itself a control that operates by examining and
evaluating the adequacy and effectiveness of other controls.
Independence is such an important aspect of internal auditing that the
fourth section of the Statement of Responsibilities of Internal Auditing is
devoted to independence. Organizations create internal auditing to serve
or benefit the organization.
The broad objective of internal auditing is to provide assistance to members
of the organization to enable the members to meet their responsibilities
effectively.
Assistance
may
involve
providing
counsel
or
recommendations, analysis, or information. One goal of internal auditing
should be to achieve effective control that is worth the cost.
In describing the nature of internal auditing, the Statement of
Responsibilities of Internal Auditing indicates that internal auditing functions
by examining controls. The scope limits internal auditing’s responsibility for
examining and evaluating performance to specific responsibilities that are
assigned to individuals or units. Internal auditing examines and evaluates
performance to compare the actual performance with plans, specified
activities, standards, objectives, policies, and goals. Such evaluations are
really evaluations of controls because plans, specified activities, standards,
objectives, policies and goals are controls. Internal auditors may be called
on to examine areas for which performance criteria have not been
specified. When this occurs, internal auditors may select measurable
criteria and report their findings in terms of those measurable criteria. For
example, if internal auditors were called on to evaluate a credit
department, they might present historical information as well as industry
information to management as a basis for evaluating the credit
department.
20. How can internal auditors establish independence?
Answer:
Independence is the essence of auditing and enables auditors to render
impartial and unbiased judgments. The two conditions that contribute to
an internal auditor’s independence are 1) organizational status and 2)
auditor objectivity. The internal auditors’ status must be such that they are
respected throughout the organization. Generally, the more respect
management gives to the internal audit function, the greater the attention
the whole organization pays to their findings and recommendations.
Giving the highest-level person in internal auditing the status of vice
president and having that person report to the board of directors’ audit
committee give sufficient status to the internal audit function. Objectivity
requires that internal auditors have an independent mental attitude and
an honest belief in their work product.
21. What types of audits do COA auditors perform?
Answer:
COA auditors perform operational or performance audits,
compliance audits, and financial audits.
22. Contrast independent, internal and governmental auditors?
Answer:
An independent auditor is usually a CPA who has received a license to
perform the attest function. To be a CPA, one generally must meet certain
educational requirements and pass an examination.
Internal auditors are employees of the organization for which they do
audits. They may perform financial auditing (business), compliance
auditing, or operational auditing. They are not independent in the sense
that external auditors are, although they may attain a degree of
independence by their position in the organization.
Types of Audit in Government Internal Auditing (Reference PGIAM
(Philippine Government Internal Audit Manual)
1) Compliance Audit
Compliance audit is the evaluation of the degree of compliance with laws,
regulations and managerial policies and operating procedures in the
agency, including compliance with accountability measures, ethical
standards and contractual obligations. This type of audit is a necessary first
step to, and part of, management and operations audits.
2) Management audit:
Management Audit is a separate evaluation of the effectiveness of
internal controls adapted in the operating and support services
units/systems to determine whether they achieve the control objectives
over a period of time or as of a specific date. It includes the
determination of the degree of compliance with laws, regulations,
managerial policies, accountability measures, ethical standards and
contractual obligations covering specific timeframes.
It is a review and appraisal of the systems and processes, organizational
and staffing structures, operations and management practices, records,
reports and performance standards of the agencies/units covered.
It may encompass a comprehensive and thorough examination of an
organization or a specific operating or support system or work process.
Management Audit should be distinguished from Management Review.
Management review is usually conducted by the Management
Committee of a department/agency or delegated to the Management
Division of the FMS. Management audit is conducted by the
Management Audit Division of the IAS/IAU.
Under a management review, the operating or functional unit assesses
existing methods, systems and processes, and implements
recommendations for improvement. In a management audit, the IAS/IAU
appraises the management controls of the operating or support units to
determine if the control objectives are being achieved, conducts root
cause analysis in case the controls are weak, and recommends courses
of action to address the control weakness. Management audit is
conducted after a system/process has been implemented or over a
specific period of time or as of a given date.
Management Reviews are conducted any time prior to, during or after
the implementation of the processes.
Distinction Between Management Review and Management Audit
Focus
Management Review
Assess
existing
organizational structure,
methods,
measures,
systems and processes to
Management Audit
Evaluate management
control
effectiveness
and
determine
the
probable/root cause of
Scope
Timing
Action to be taken
ensure
continuing
suitability,
adequacy
and effectiveness and
identify
and
assess
opportunities
for
improvement
Existing
management
system and practices,
procedures
and
processes, organizational
structure,
staffing
standards
and
manpower requirements
Conducted
anytime
prior to, during or even
after the implementation
of a system or process
To improve or develop
new
management
system and practices,
procedures
and
processes,
staffing
standards
and
manpower requirements
control
any
deficiencies,
if
Appraise
whether
internal
control
components are well
designed and properly
implemented; evaluate
whether internal control
objectives are achieved;
evaluate
control
effectiveness
of
operating systems and
support systems for a
specific period or date
Takes place “after the
fact” and covers a
complete
cycle
of
operations
To advise/report to the
DS/ HoA or GB/Audit
Com all matters relating
to management control,
and recommend courses
of action to address
inadequacy in internal
control
3.Operations Audit:
Operations audit is a separate evaluation of the outcome, output, process
and input to determine whether government operations, programs and
projects are effective, efficient, ethical and economical, including
compliance with laws, regulations, managerial policies, accountability
measures and contractual obligations.
Operations audit of organizations, programs, and projects involves an
evaluation of whether or not performance targets and expected results
were achieved.
The importance of assessing the effectiveness, efficiency, ethicality and
economy of government operations is to contribute to better public
services, accountability and governance. The matter of outcomes, outputs,
processes, and inputs, as well as their correlation with the goals of
effectiveness, efficiency, ethicality and economy of operations are the
focus in the evaluation.
Before conducting an operations audit, the IAS/IAU must have a good
understanding of the organization, and its program and project processes.
This will give a clear grasp of the processes and the key areas involved, and
accordingly help the IAS/IAU determine the appropriate audit objectives,
scope, criteria and evidence. Information gathered during the strategic
and annual work planning is useful in understanding the organization and
the program and project processes.
In undertaking operations audit, the auditor seeks to:
a. Evaluate the outcome, which includes the evaluation of the
benefits/impact of the program or the change in the condition of the
beneficiaries;
b. Evaluate the output, which are products/goods and services produced
or delivered;
c. Evaluate the process. The process is the transformation of an input to an
output. There must be value added to the inputs. There is a need to
evaluate whether or not processes have been properly implemented and
there is proper conduct of risk response, performance and compliance
reviews; and
d. Evaluate the inputs (i.e., statutory policy, mandate, program,
organization, staff, system, resources, managerial policies, and citizens‟
needs).
Evaluation can be done on the outcome-output-process-input (or Work
Back Approach), as it relates to the 4Es or effectiveness, efficiency,
ethicality, and economy (see Figure 4). This approach, in particular, starts
with a set of objectives (e.g., statutory policy objectives), that the DS/HoA
or GB/AuditCom wants to achieve (expected outputs and outcomes)
which have been formulated in SMART terms (i.e., Specific, Measurable,
Attainable, Realistic and Time-bound).
Work Back Approach
Essential to the conduct of operations audit is the assessment of progress
with respect to processes, projects and programs, and their respective
outputs and outcomes or impact/change towards improving the condition
of intended beneficiaries. This is the work back approach of operations
audit.
Input
Evaluation
Process
Evaluation
Quality Input
Law,
mandate,
program,
organization,
Quality Process
Implementation,
risk response,
performance and
Output
Evaluation
Quality
Outputs
Products
and
services
Outcome
Evaluation
Quality
Outcomes
Benefits
and
Impact or
change
staff, system,
resources and
managerial
policies
Citizens‟
Needs
compliance
reviews
Serving Citizens‟
Needs
Satisfied
Citizens‟
Needs
Figure 4 – Work back Approach Flow Diagram
Improved
Quality of
Life
Governmental Auditors are employees of various government agencies
who perform financial (COA Auditors), compliance, and operational
auditing. For example, local governments employ auditors to verify that
businesses collect and remit sales tax as required by law.
Multiple Choice Questions
Answers
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
D
A
A
D
B
C
B
C
B
D
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
B
A
C
C
A
D
A
A
D
C
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
D
B
C
B
B
C
D
C
A
A
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
D
B
A
D
C
D
B
C
A
B
CHAPTER 4
REGULATION OF THE PRACTICE
OF PUBLIC ACCOUNTANCY
Questions and Answers:
1.
Answer: Refer to pages 110 (Section 28 of the Philippine Accountancy Act of
2004) of the textbook.
2.
Answer: Refer to pages 112 (Sections 34 & 35 of the Philippine Accountancy
Act of 2004) of the textbook.
3.
Answer:
Competencies include both what individual auditors know and what
individual auditors and audit teams do. Competencies are evidenced by
auditors applying their skills in the delivery of services to clients or supporting
the delivery of those services. These competencies categorized as “High
Opportunity Competencies” and “Low Opportunity Competencies” are as
follows:
High Opportunity Competencies have a high likelihood of being building
blocks for selling or delivering new assurance services.

Analytical Skills

Business Advisory Skills

Business Knowledge

Capacity for Work

Comprehension of Client’s Business Processes

Communication Skills

Efficiency

Intellectual Capability

Learning and Rejuvenation

Marketing and Selling

Model Building

People Development

Relationship Management

Responsiveness and Timeliness

Technology

Verification
Low Opportunity Competencies, while important to the delivery of current
assurance services, are less likely to be exploited in the development of
future services.

Accounting and Auditing Standards

Administrative Capability

Managing Audit Risk
4.
Answer:
Examples of typical lawsuits against CPAs are
a) Alleged misstatements that the auditor did not detect in the financial
statements involving
1) improper or inadequate disclosure
2) inappropriate valuations
b) Alleged failure to detect defalcation as a result of negligence in the
conduct of the audit
c) Alleged failure to complete the audit on the agreed-on date
d) Alleged inappropriate withdrawal from an audit
5.
Answer:
Indications That Noncompliance May Have Occurred
Examples of the type of information that may come to the auditor’s
attention that may indicate that noncompliance with laws or regulations
has occurred are listed below:
• Investigation by government departments or payment of fines or
penalties.
• Payments for unspecified services or loans to consultants, related
parties, employees or government employees.
• Sales commissions or agent’s fees that appear excessive in relation
to those ordinarily paid by the entity or in its industry or to the services
actually received.
• Purchasing at prices significantly above or below market price.
• Unusual payments in cash, purchases in the form of cashiers’ checks
payable to bearer or transfers to numbered bank accounts.
• Unusual transactions with companies registered in tax havens.
• Payments for goods or services made other than to the country from
which the goods or services originated.
• Payments without proper exchange control documentation.
• Existence of an accounting system which fails, whether by design or
by accident, to provide an adequate audit trail or sufficient
evidence.
• Unauthorized transactions or improperly recorded transactions.
• Adverse media comment.
6.
Answer: Refer to page 119 of the textbook.
7.
Answer:
PSA 260 (Clarified), “Communication with Those Charged with
Governance” deals with the auditor’s responsibility to communicate with
those charged with governance in relation to an audit of financial
statements. Although this PSA applies irrespective of an entity’s
governance structure or size, particular considerations apply where all of
those charged with governance are involved in managing an entity, and
for listed entities. This PSA does not establish requirements regarding the
auditor’s communication with an entity’s management or owners unless
they are also charged with a governance role.
8.
Answer:
The increase in litigation against auditors seems to be happening for two
reasons: a general increase in litigation in society, and the fact that
investors and creditors who suffer losses will look for “deep pockets” to pay
for those losses. Most accounting firms appear to have “deep pockets.”
9.
Answer:
Due (professional) care is the standard by which the courts and the
profession expect a CPA to practice. A CPA who is found to have
exercised due professional care in an engagement should not have any
liability to others.
10.
Answer:
The four gradations are none, negligence, gross negligence (sometimes
referred to as constructive fraud), and fraud. At one extreme is the auditor
who performs an appropriate audit and issues an appropriate report. This
auditor’s degree of wrongdoing is “none.” An auditor who commits fraud
is at the other extreme, since he or she knows that the financial statements
are misstated and yet issues an unqualified opinion. An auditor is negligent
if he or she does not do what a reasonably prudent auditor should do in the
circumstances. An auditor is grossly negligent if he or she consistently fails
to follow the standards of the profession on an engagement.
11.
Answer: Auditors are responsible to clients for negligence, gross negligence, or
fraud.
12.
Answer: Refer to page 126 of the textbook.
13.
Answer: Most courts have held that an auditor has a higher responsibility to
communicate information beyond that required by PFRSs and PSAs. Courts
have held that compliance with PFRSs is persuasive but not conclusive
evidence.
14.
Answer:
An auditor should (a) follow the Philippine Standards on Auditing, the Code
of Ethics for Professional Accountants in the Philippines, and where
appropriate, PFRSs; (b) establish and follow appropriate quality control
procedures; (c) evaluate whether a client has the necessary integrity and
appropriate reputation in the community; (d) evaluate carefully why a
client wants an audit; (e) conduct the audit with appropriate professional
skepticism; (f) provide for appropriate levels of consultation for issues; and
(g) provide for appropriate review of the audit.
15.
Answer: The prudent man concept states that a man is responsible for
conducting a job in good faith and with integrity, but is not infallible.
Therefore, the auditor is expected to conduct an audit using due care, but
does not claim to be a guarantor or insurer of financial statements.
Multiple Choice Questions
Answers
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
B
C
A
B
A
C
A
C
A
B
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
A
D
C
D
C
A
A
D
B
D
21.
22.
23.
24.
25.
26.
27.
28.
29.
30.
CHAPTER 5
B
C
A
A
A
C
C
A
A
C
31.
B
CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS
IN THE PHILIPPINES
Questions and Answers:
1. Why is there a need for ethical behavior for professionals? Why do the
ethical requirements of the CPA differ from other professionals?
Answer:
There is a special need for ethical behavior by professionals to maintain
public confidence in the profession, and in the services provided by
members of that profession. The ethical requirements for CPAs are similar
to the ethical requirements of other professions. All professionals are
expected to be competent, perform services with due professional care,
and recognize their responsibility to clients. The major difference between
other professional groups and CPAs is independence. Because CPAs have
a responsibility to financial statement users, it is essential that auditors be
independent in fact and appearance. Most other professionals, such as
attorneys, are expected to be an advocate for their clients.
2. Distinguish between independence in fact and independence in
appearance. State three activities that may not affect independence in
fact but are likely to affect independence in appearance:
Answer:
Independence in fact exists when the auditor is actually able to maintain
an unbiased attitude throughout the audit, whereas independence in
appearance is dependent on others’ interpretation of this independence
and hence their faith in the auditor.
Activities which may not affect independence in fact, but which are likely
to affect independence in appearance are: (Notice that the first two are
violations of the Code of Ethics.)
1. Ownership of a financial interest in the audited client.
2. Directorship or officer of an audit client.
3. Performance of management advisory or bookkeeping
accounting services and audits for the same company.
or
4. Dependence upon a client for a large percentage of audit fees.
5. Engagement of the CPA and payment of audit fees by
management.
3. What do the principles of the Code imply about a CPA’s obligation toward
the public interest?
Answer:
In return for the faith placed in CPAs by the public, CPAs should continually
seek to demonstrate their dedication to professional excellence. The
public interest is defined as the community’s collective well-being. CPAs
handle ethical conflicts best by acting with integrity, objectivity, and due
professional care and by having a genuine interest in serving the public.
4. Describe an ethical dilemma. “How does a person resolve an ethical
dilemma?”
Answer:
An ethical dilemma is a situation that a person faces in which a decision
must be made about the appropriate behavior. There are many possible
ethical dilemmas that one can face, such as 1) finding a wallet containing
money, or 2) dealing with a supervisor who asks you to work hours without
recording them.
An ethical dilemma can be resolved using the six-step approach outlined
below:
1. Obtain the relevant facts.
2. Identify the ethical issues from the facts.
3. Determine who is affected by the outcome of the dilemma and how
each person or group is affected.
4. Identify the alternatives available to the person who must resolve the
dilemma.
5. Identify the likely consequence of each alternative.
6. Decide the appropriate action.
5. Why might the rule “Let conscience be your guide” not be sufficient basis
for your personal ethics decision?
Answer:
Apparently, in ethical philosophy, the word “conscience” is used to
describe the “undefinable mental process that yields moral decisions.” A
close kin in the political science terms would be “anarchy.”
Conscience might not be a sufficient guide for personal ethics decisions
because the individual’s undefinable mental processes may be based on
caprice, immaturity, ignorance, stubbornness, or misunderstanding.
Conscience may fail to show the consistency, clarity, practicability,
impartiality, and adequacy preferred in ethical standards and behavior.
Exactly the same can be said about professional ethics decisions because
a non-hypocritical individual can no more split his behavior between
personal life and professional life than he can voluntarily split his own
personality.
6. What roles must a professional accountant be prepared to occupy in
regard to ethical decision problems?
Answer: A professional accountant must be prepared to be an agent,
spectator, advisor, instructor, judge, and critic.
7. What ethical responsibilities do CPAs have for acts of non-CPAs who are
under their supervision (e.g. recent college graduates who are not yet
CPAs)?
Answer:
Ethical responsibility for acts of non-CPAs under a CPA’s supervision falls
under the latter’s jurisdiction. A CPA shall not permit others to carry out on
his behalf, either with or without compensation, acts which, if carried out
by the CPA, would place him in violation of the Code of Ethics.
8. What benefit does an independent auditor gain when a client corporation
has an audit committee of the board of directors?
Answer: The auditor’s gain from having an audit committee is a direct
communication pipeline to the board of directors.
9. Ben Santos works as a manager in the Manila office of an international CPA
firm. His father has just taken a position as a purchasing agent for one of
the CPA firm’s Manila clients. Has Ben’s independence been impaired with
respect to this audit client? Has the CPA firm’s independence been
impaired if Ben does not work on the audit?
Answer:
Serving as a purchasing agent places Ben Santos’ father in an “audit
sensitive position.” Accordingly, Santos’ independence is impaired. Also,
since Santos is a managerial employee, he can no longer work in the
Manila office of the CPA firm. The CPA firm may retain its independence if
Santos transfers to another office (or resigns).
10. Three months ago, a national CPA firm hired Gary Angeles to work as a
staff auditor in its Cebu office. Yesterday Angeles’ father was hired to be
the chief financial officer of one of the CPA firm’s Cebu clients. Has the
independence of the CPA firm with respect to this client been impaired?
Answer:
The CPA firm’s independence would not be impaired as long as Gary
Angeles did not personally participate in the audit of this particular client.
Once Gary rises to the position in which he becomes a “managerial
employee” of the CPA firm, however, he must be transferred to an office
which does not participate in this audit if the firm is to remain independent.
11. Alex Ybanez is a CPA who often serves as an expert witness in court cases.
Is it proper for Ybanez to receive compensation in a damage suit based on
the amount awarded to the plaintiff? Discuss
Answer:
Historically, compensation for CPAs serving as expert witnesses had to be
based on a standard per diem rate or a fixed sum. However, under certain
situations, such contingent fees are allowed only from clients for which the
CPA does not also provide to the client financial statement audits, reviews
or certain compilations, or prospective financial information
examinations.
12. Lea Sanchez, wife of Juan Sanchez, CPA, is a life insurance agent. May
Juan Sanchez refer audit clients needing officer life insurance to Lea
Sanchez or to another life insurance agent who will share a commission with
Lea Sanchez? Explain.
Answer: Sanchez may only refer certain clients to his wife or to another life
insurance agent who will share such a commission with his wife provided
that he does not perform assurance as well as nonassurance services.
Multiple Choice Questions
Answers
1.
2.
3.
4.
5.
6.
7.
8.
9.
10
D
B
D
A
A
C
A*
A*
A*
A
11.
12.
13.
14.
15.
16.
17.
18.
19.
20
A
A
A
C
C
D
A
C
A
A
21.
22.
23.
24.
25.
26.
27.
A
B
D
C
C
B
D
*7.A fee for audit clients which is dependent upon the results achieved by the
CPA’s efforts is a contingent fee and is prohibited for audit clients.
*8.An auditor’s independence would not be considered to be impaired with
respect to a financial institution in which the auditor maintains a checking
account which is fully insured.
*9.The declaration requires the preparer to acknowledge that the return is
“true, correct, and complete...based on all information of which the
preparer has any knowledge.”
Cases
Answers:
1. a. Interpretation – Honorary Directorships and Trusteeships
Ela will not be considered independent unless:
1.
2.
3.
4.
the position is in fact purely honorary, and
listings of directors show she is an honorary director, and
she restricts participation strictly to the use of her name, and
she does not vote or participate in management functions.
b. Interpretation – Retired Partners and Firm
Independence: Since Monte is still active with the firm as an ex-officio
member of the income tax advisory committee, meeting monthly, his
situation would impair the appearance of the firm’s independence.
Monte should either resign from the Palm board or cease his association
with the accounting firm.
c. Interpretation – Accounting Services
CPA Benitez must be careful to know whether outsiders would perceive
relationships that would indicate status as an employee, hence
impairing the appearance of independence. In particular, CPA Benitez
must
1. Not have any business connection with Hernan Corporation or with
Mike Hernan that would in fact impair independence, objectivity
and integrity, and
2. Impress Mike Hernan (and the board of directors) that they must be
able and willing to accept primary responsibility for the financial
statements as their own, and
3. Not take managerial responsibility for conducting operations of the
Hernan Corporation (although Benitez’s supervision of the
bookkeeper seems to have this characteristics), and
4. Conduct the audit in conformity with PSA and not fail to audit records
simply because they were processed under Benitez’s supervision.
d. Interpretation – Effect of Family Relationships on Independence
Jack’s wife’s interest is attributed to him, and he would not be
independent. The financial interest is considered direct.
e. Interpretation
Jack is still not independent, so long as the daughter is a dependent
child. The financial interest is considered direct.
f. Interpretation
Still not enough. The grandfather (either Jack’s father or his father-inlaw) is considered a nondependent close relative, but the appearance
of independence is impaired. The grandfather’s investment is material
(50 percent) in relation to his net financial resources.
Answers:
2. a. Pee and Co. / United Furniture, Inc.: This is a judgment call. In this case,
the services can be considered temporary, mechanical in nature and
performed on a one-time emergency basis. For these reasons, the SEC
would probably not consider independence impaired.
b. Renson & Co. / Spectrum Corporation Laser Division: The SEC would
consider independence impaired because of the extent of the
bookkeeping services and the relative size of the Division. The only
solution that might work is to have another accounting firm audit the
Laser Division financials so that Renson & Co. can write a report “in
reliance on the work of other independent auditors.”
c. Reyes & Co. / Valley Bank: The SEC would consider independence
impaired because of the family relation of Annabelle, her connection
with Valley’s financial statements and the fact that Kris is a “member”
(partner) in the audit firm. (The PICPA would probably also consider
independence impaired because of the apparent closeness of the two
sisters and the “audit sensitivity” of Annabelle’s job).
d. Cruz & Reyes / Jonas Tomas / Starex Money Market Fund: Jonas is a
“member” since he is a manager and will provide audit services to
SMMF. Cruz & Reyes’ independence is impaired since Jonas holds a
direct financial interest.
Answer:
3. Violation of Code of Professional Ethics?
Yes
No
Since Bella had an employment relationship with the client during part of
the period covered by the financial statements, her independence is
impaired.
Answer:
4. Violation of Code of Professional Ethics?
Yes
This is a violation. It is a contingent fee agreement.
Answer:
No
5. Although her decision will not be popular with the audit staff, Tracy Ong
should thank the client but decline the offer, both for her and for the staff.
She should explain that an outsider who had knowledge of all of the
relevant facts might view the free use of a condominium as a sizable “gift”
to the auditors, which might influence their independent mental attitude.
Thus, we believe that to maintain an appearance of independence, the
auditors should not accept this offer.
Answer
6. No. CPAs may refuse client access to their working papers for any valid
business purpose. Therefore, a CPA may require that fees be paid before
working papers including such adjusting entries and supporting analysis are
provided to the client.
Answers:
7. The answers provided in this section are based on the assumption that the
traditional legal relationship exists between the CPA firm and the third party
user. That is, there is no privity of contract, the known versus unknown third
party user is not a significant issue, and high levels of negligence are
required before there is liability.
a. False. There was no privity of contract between Tan and Cañada,
therefore, ordinary negligence will usually not be sufficient for a
recovery.
b. True. If gross negligence is proven, the CPA firm can and probably
will be held liable for losses to third parties.
c. True. See a.
d. False. Gross negligence (constructive fraud) is treated as actual
fraud in determining who may recover from the CPA.
e. False. JC is an unknown third party and will probably be able to
recover damages only in the case of gross negligence or fraud.
Assuming a liberal interpretation of the legal relationship between auditors
and third parties, the answers to a and d would probably both be true. The
other answers would remain the same.
Answer
8. Yes. Normally a CPA firm will not be liable to third parties with whom it has
neither dealt nor for whose benefit its work was performed. One notable
exception to this rule is fraud. When the financial statements were
fraudulently prepared, liability runs to all third parties who relied upon the
false information contained in them. Fraud can be either actual or
constructive. Here, there was no actual fraud on the part of Dantes or the
firm in that there was no deliberate falsehood made with the requisite intent
to deceive. However, it would appear that constructive fraud may be
present. Constructive fraud is found where the auditor’s performance is
found to be grossly negligent. That is, the auditor really had either no basis
or so flimsy a basis for his or her opinion that he or she has manifested a
reckless disregard for the truth. Dantes’ disregard for standard auditing
procedures would seem to indicate such gross negligence and, therefore,
the firm is liable to third parties who relied on the financial statements and
suffered a loss as a result.
Answers:
9. a. Yes. Carlos was a party to the issuance of false financial statements and
as such is a joint tortfeasor. The elements necessary to establish an
action for common law fraud are present. There was a material
misstatement of fact, knowledge of falsity (scienter), intent that the
plaintiff bank rely on the false statement, actual reliance, and damage
to the bank as a result thereof. If the action is based upon fraud there is
no requirement that the bank establish privity of contract with the CPA.
Moreover, if the action by the bank is based upon ordinary negligence,
which does not require a showing of scienter, the bank may recover as
a third-party beneficiary (an exception to the strict privity requirement).
Thus, the bank will be able to recover its loss from Carlos under either
theory.
b. No. The lessor was a party to the secret agreement. As such, the lessor
cannot claim reliance on the financial statements and cannot recover
uncollected rents. Even if he or she was damaged indirectly, his or her
own fraudulent actions led to his or her loss, and the equitable principle
of “unclean hands” precludes him or her from obtaining relief.
c. Yes. Carlos had knowledge that the financial statements did not follow
financial reporting standards and willingly prepared an unqualified
opinion. The financial statements were not in accordance with financial
reporting standards. That is a criminal act because there was an intent
to deceive.
Answers:
10. a. Base, Umapas & Cañada is potentially liable to its client because of the
possible negligence of its agent, the in-charge accountant on audit, in
carrying out duties that were within the scope of his or her employment.
Should there be a finding of negligence, liability would be limited to
those losses that would have been avoided had reasonable care been
exercised.
There being no evidence of the assumption of a greater
responsibility, the in-charge accountant’s conduct is governed by the usual
standard; that is, that the accountant perform his or her duties with the
profession’s standards of competence and care. A question of fact arises as
to whether the duty of reasonable care was breached when the in-charge
accountant failed to investigate further after being apprised by a
competent subordinate of exceptions to 6 percent of the vouchers payable
examined. Moreover, a question of causation arises as to whether further
actions by the in-charge accountant would have disclosed the fraud. If both
lack of due care and causation are established, recovery for negligence will
be available to the client.
b. In a properly organized liability partnership, the partner(s) and staff
responsible for the engagement and the firm would be liable, as
discussed in part a. However, other partners would not be liable.
Answer:
11.Ordinarily, users of financial statements, other than those who contracted
for the audit and those known in advance to the auditor, may not recover
for ordinary negligence by the auditor in the performance of an audit.
Recovery of damages by third parties must usually be based on fraud.
Actual knowledge of falsity (scienter) is also generally required for an action
based on fraud; however, this requirement may be satisfied by the auditor’s
reckless disregard for the truth or gross negligence.
It appears that the three deficiencies in the audit by Gonzales & Esteban
might be sufficient to satisfy either approach. Failure to check the
existence of certain receivables, collectibility of other receivables, and
existence of security investments, taken collectively if not individually,
appear to show a reckless disregard for the truth by the auditor. In fact, the
audit probably lacks sufficient competent evidential matter as a
reasonable basis for an opinion regarding the financial statements under
examination.
The audit appears to have been conducted in a woefully inadequate
fashion, without regard to the usual auditing standards and procedures
necessary to exercise due professional care. Therefore, the auditors were
grossly negligent in the performance of their duties.
Answer:
12.Corpuz has stated that the CPA firm has “reviewed the books and records
of Flores Ventures,” when in fact no such “review” has occurred. A “review”
of financial statements consists of limited investigatory procedures
designed to provide statement users with a limited degree of assurance
that the financial statements are in conformity with financial reporting
standards. Corpuz’s actions are similar to issuing an auditors’ report without
first performing an audit. Such an action may well be considered an act of
criminal fraud, intended to mislead users of the financial statements. If the
financial statements of Flores Ventures turn out to be misleading, there is
little doubt that any court would find the CPA firm guilty of at least
constructive fraud and liable to any third party who sustains a loss as a result
of reliance upon the statements.
The fact that Corpuz violated Vasquez’s policy of submitting all reports for
Vasquez’s review would not lessen the CPA firm’s liability. The concept of
mutual agency allows Corpuz, as a partner, to commit the firm to contracts,
including auditors’ reports and accountants’ reports. The fact that this
report was not submitted for Vasquez’s review might be introduced as
evidence against Corpuz in the event he is accused of criminal fraud.
Answers
13.(1)Yes, but only to the extent of P70,000. Beta is a third-party beneficiary of
the contract between Mega and its auditors, and may therefore
recover from the auditors losses caused by the CPAs’ ordinary
negligence. However, the original P50,000 loan was made prior to Beta’s
reliance upon the negligently audited financial statements. Thus, the
auditors’ negligence was not the proximate cause of this portion of
Beta’s loss. The auditors’ negligence may, however, be considered the
proximate cause of the P70,000 loss incurred as a result of reliance upon
the misleading statements.
(2) The prospects for Manila’s recovery of its P30,000 loss are substantially
less than those of Beta. Manila was not a third-party beneficiary to the
contract. Thus, in many jurisdictions following Ultramares, Manila cannot
recover losses attributable to the CPAs’ ordinary negligence. Similarly, it
is doubtful that Manila would qualify as a foreseen third party as
necessary under the Restatement approach. Even in a jurisdiction
accepting the Rosenblum precedent, which allows third parties to
recover losses caused by the auditors’ ordinary negligence, Manila
would have to prove that it was a “foreseeable third party relying upon
the financial statements for routine business purposes.” It is questionable
whether the loan by Manila was either “reasonably foreseeable” or
“routine,” as Manila was a customer of Mega, not a lender.
CHAPTER 6
MANAGEMENT OF A
PUBLIC ACCOUNTANCY PRACTICE
Questions and Answers:
1. What is the “special function” that auditors perform? Whom does the
public accounting profession serve in performing this special function?
Answer:
The special function performed by the public accounting profession is the
attestation to the fairness of the financial statements of clients. The special
function ensures the reliability and integrity of the financial reporting system.
Judge Burger described the special function as "certifying the public reports
that collectively depict a corporation's financial status," which involves "a
public responsibility transcending any employment relationship with the
client."
2. How does complexity affect (a) the demand for auditing services and (b)
the performance of auditing services?
Answer:
Complexity affects the demand for auditing services in that both users and
management need the expertise of professionals who understand the
underlying economic substance of transactions and financial instruments
and, thus, who have the ability to determine the appropriate accounting
best to "fairly" portray the economic substance of an organization's
activities and financial condition.
The business environment in which the auditor must function is increasingly
complex. The major forms of complexity relate to:
a. Computer
systems,
which
are
interdependent across organizations.
becoming
increasingly
b. Increased complexity of financial instruments and transactions
entered into by organizations.
c. The economic environment in which we all must operate. The
changing environment includes such items as the increased need to
have a global outlook in providing goods and services and the need
to be attuned to societal regulations in such areas as environmental
protection.
3. Are small, local CPA firms that serve only small business and other local
clients subject to the same auditing and accounting standards as the large
international CPA firms?
Answer:
For the most part, local CPA firms are subject to the same auditing and
accounting standards as the large international CPA firms. The differences
relate to whether the audit firms have (a) public clients, or (b) international
clients. If a firm has public clients, then the firm is subject to the standards
of the The Public Company Accounting Oversight Board PCAOB. If a firm
has clients that are domiciled in other countries, then they should utilize
international auditing standards. If the audit firm only has non-pubic clients,
then they are subject to auditing standards promulgated by the PICPA.
4. Many public accounting firms are legally formed as networks of accounting
firms. Explain what the phrase “network of accounting firms” means and
articulate the services provided by the network to its members?
Answer:
A network of accounting firms is a body to which individual CPA firms come
together to pursue common interests. The services generally provided by
the network include:

centralized staff that provides accounting and auditing expertise to its
members on a world-wide basis,

a referral service for audit firms that have clients in different parts of the
country or world,

a referral service for a firm to utilize when clients desire expertise or
consulting services that the audit firm does not provide.

standard audit programs and/or procedure’s manuals for the member
audit firms.
In some cases, the network can be a network of firms that are not otherwise
affiliated. In other cases, the network firms all operate under one common
name, e.g. Grant Thornton International.
5. Comment upon each of the following statements you herd in a
conversation between two newly hired staff auditors.
Answers:
a. Professional skepticism represents a state of mind that is
characterized by appropriate questioning and a critical assessment of
audit evidence. When employing professional skepticism, auditors will not
simply accept all evidence provided and assume that clients are
unquestionably honest. However, the statement that “you really have to
question everything the client tells you” is a bit exaggerative and goes
beyond the concept of professional skepticism.
b. It is correct that internal evidence is generally of lower quality
than external evidence. However, the necessary quality of evidence
depends upon the risk of material misstatement and the effectiveness of
the client’s internal control. In this case, the staff auditor’s statement that
internal evidence is obtained because of time and cost considerations is
not appropriate, unless the risk of material misstatement permits lower
quality of evidence because of other reasons.
c. While appropriate planning will allow audits to be conducted on a
timely basis, it is not appropriate for auditors to ignore transactions and
events between the interim date (in this case, November 1) and the client’s
fiscal year end. Some testing would need to be performed following the
year end for transactions occurring between November 1 and December
31.
d. While the primary purpose of evaluating internal control is to determine the
nature, timing, and extent of substantive tests, auditors must still conduct
some study of internal control to ensure that the condition of the client’s
internal control has not changed from prior years. If it has, the substantive
tests performed by auditors may no longer be appropriate. In addition, for
public companies, auditors are required to study internal control and report
on the effectiveness of the client’s internal controls under Auditing
Standard No. 5.
e. For departures from PFRS, the choice among opinions would be
between a qualified opinion (for less material departures) and an adverse
opinion (for more material departures).
f. While the concept of materiality does consider dollar amounts
and their effects on users’ decisions, qualitative factors also need to be
considered when assessing materiality. For example, a small dollar amount
(in absolute terms) may influence a company’s ability to meet its earnings
expectations or report higher earnings than in previous years. Situations
such as this need to be considered as well as the absolute dollar amount
of an item in assessing materiality.
Multiple Choice Questions
Answers
1.
2.
3.
4.
5.
D
D
D
D
A
Cases
Answers:
1. (1) Auditing does not involve the creation of goods. However, it does serve
a worthwhile purpose in our society because it enhances the flow of
reliable financial information needed to conduct commerce in our
economy. It also assists in the conduct of government by providing
reliable information for tax purposes and regulatory purposes. Audits
have been legally mandated to ensure objective information. However,
research has indicated that audits would be required even if not
mandated. The initial audits performed in conjunction with the
settlement of the new world arose because of owners' need to have an
independent assessment of the returns earned by their managers.
(2)
The accounting profession did provide early warning signals of the
potential problems within many industries. However, it clearly failed in other
areas. Some of the problems were related to the impreciseness of
accounting principles (e.g. Enron) while others were more closely related
to regulatory failures (e.g. Savings & Loan Industry). However, many of the
failures were due to systematic problems in the accounting profession that
has been addressed by Sarbanes-Oxley (often shortened to SOX) is
legislation passed by the U.S. Congress to protect shareholders and the
general public from accounting errors and fraudulent practices in the
enterprise, as well as improve the accuracy of corporate disclosures.
(3) Finding fraud may be important. However, many misstatements that are
made in conjunction with an organization's financial statements are not
intentional but are simply the result of errors. The audit function is designed
to detect material misstatements -- whether they are due to errors or fraud.
Thus, the audit function is actually broader than the colleague had desired.
Ensuring that a financial statement contains no material misstatements also
ensures that the auditor addresses the likelihood that material fraud may
also have occurred.
(4) There is a potential problem with the auditors being hired by
management. The Sarbanes-Oxley Act requires companies that are
publicly traded to have an audit committee composed of independent
directors (nonmembers of management) that have the responsibility for
evaluating the performance of the auditors. The audit committee
should exist to present the views and interests of outside owners of the
organization and provide effective insulation against undue pressure by
management on the audit function. The SEC is very cognizant of
independence issues and periodically addresses actions or relationships
that they believe may impair the auditor’s independence.
(5) PFRS represents rules and conventions that are acceptable at one point
in time. Much of the diversity in accounting principles is necessary to
reflect real economic differences between organizations and the types
of transactions in which the organization is engaged. Beyond this
argument, differences such as Weighted Average / FIFO accounting
have evolved over the years. The profession attempts to mitigate the
potential problems associated with the diversity by providing disclosure
of the differences and by developing other procedures to make it
difficult for firms to change accounting principles. Thus, the financial
statements of a company should be comparable over a period of time.
(6) It seems that this individual really wants to have a career in auditing.
External auditing has changed; in today's environment, the auditor must
thoroughly understand a company's business in order to audit it. A key
function of internal auditors is to add value through their
recommendations.
(7) The external audit is designed to present an opinion on the fairness of a
company’s financial statement in accordance with PFRS. It is not directly
designed to assess the performance of management, although the
financial statements may provide some evidence on the performance
of management.
(8) Auditors operate in an environment in which they must have a sense of
trust with management – at least to the extent that confidential or
proprietary information is not made public. Thus, if all recommendations
made to management were to be made public, management might
simply ask that recommendations no longer be made. Further, it must
be recognized that many of the recommendations made to improve
operations are informal in nature and might not be based on thorough
study of a particular area. Auditors may justifiably fear litigation from
recommendations made public that were made only on informal
observations.
(9) Congress, in developing the Sarbanes-Oxley Act believes this statement
is true. Maintaining adequate controls is a significant part of corporate
governance. Congress believes the owner (shareholder) should receive
reports on the quality of controls implemented by management. In the
first three years of public reports on internal control, there has been a
dramatic change in the quality of controls in many organizations. During
the first year of Sarbanes-Oxley, approximately 16% of the companies
received adverse reports on the quality of their internal controls. This
percentage has gone down dramatically.
Answers:
2. (a) There seems to be a misinterpretation on the part of many users that a
"clean" audit opinion means that the company is in good health. This,
unfortunately, is a miscommunication. A "clean" audit opinion means
only that the financial statements are fairly presented, not that they
represent a company that is in good financial health. The audit function
provides data that are "fairly presented" in accordance with PFRS, but
such information alone does not constitute all the information an
informed user should know about a company.
(b) The auditor is a guarantor only of auditing standards in determining
whether the statements are fairly presented, in all material respects, in
accordance with financial reporting standards. Fair presentation is
guaranteed only within the context of PFRS.
(c) This question and should encourage a widely ranging discussion by
users. Topics that might be addressed include these:
1. The potential deficiencies in PFRS.
2.The ability to detect fraud when management has attempted to
cover it up.
3.The responsibilities of users to perform their own work and to not
expect someone else to make decisions for them.
4.The overall responsibility of management for the integrity of the
financial statements.
5. The value of reports on internal control.
6.The difficulty of measuring the economics of complex
transactions.
CHAPTER 7
SYSTEM OF QUALITY CONTROL FOR PUBLIC ACCOUNTANCY FIRMS
Questions and Answers
1.What does a system of quality control in the context of public
accounting practice encompass?
Answer: Refer to page 292 of the textbook.
2. Describe the elements of quality control policies and procedures at audit
first level.
Answer: Refer to pages 293 and 294 of the textbook.
3. Describe the elements of quality control policies and procedures at
individual audit level
Answer: Refer to pages 293 and 294 of the text.
4. Each of the following quality control policies and procedures is typical of
ones that can be found in public accounting firms’ systems of quality control.
Identify each of them with one of the six elements of quality control identified
by PSQC7.
Answers: Refer to page 293 of the text.
a. Leadership responsibilities for quality within the firm
b. Engagement performance
c. Human resources
d. Monitoring
e. Human resources
f. Relevant ethical requirements
g. Acceptance and continuance of clients
h. Leadership responsibilities for quality within the firm
i.
Engagement performance
Multiple Choice Questions
Answers
1.
2.
3.
4.
5.
A
D
D
B
C
6.
7.
8.
9.
10
B
A
D
B
C
11.
12.
13.
14.
15
D
B
C
C
D
16.
17.
18.
19.
C
B
C
D
Cases
MORALES, CABRERA, & CO., CPAs
a)
1. Supervision;
2. To ensure that work performed meets the firm’s standard of quality;
3. Staff personnel are to follow firm guidelines for working paper
development.
b)
1. Inspection / Review;
2. To verify that quality control procedures are being followed;
3. Inspect that audit programs for all engagements are being complied
with.
c)
1. Acceptance and retention of clients;
2. To minimize the risk associated with clients;
3. New clients must be investigated by a private investigative agency.
d)
1. Skills and Competence;
2. To ensure personnel are qualified to do the tasks they are assigned;
3. An in-charge accountant must have served as a staff auditor on an audit
in the client’s industry.
e)
1..Hiring / Professional requirements;
2. To ensure that new accountants hired must have an accounting degree
from an accredited school;
3. A Filipino citizen.
f)
1. Skills and Competence;
2. To ensure that in-charge accountant must have passed the CPA
examination;
c. Has a certificate of registration and professional identification card from
PRC.
g)
1. Skills and Competence;
2. To ensure that personnel continue to be updated on changes in
accounting or auditing standards;
3. Personnel will participate in forty hours of continuing education per year.
h)
1. Assigning personnel to engagements
2. To ensure that personnel posses the degree of technical training and
proficiency required for an engagement.
3. Personnel have participated in forty hours of continuing education per
year.
i)
1. Independence;
2.To ensure that personnel meet PICPA guidelines for independence;
3. Firm personnel must list their investments. Personnel must report any stock
acquisitions.
2. The Gwen Salcedo should explain in an appropriate meeting with Kristoffer
dela Cruz that it is the responsibility of the audit firm to establish policies and
procedures designed to provide it with reasonable assurance that it has
sufficient personnel with capabilities, competence, and commitment to
ethical principles necessary a) to perform its engagements in accordance with
professional standards and regulatory and legal requirements, and to enable
the firm or engagement partners to issue a report that are appropriate in the
circumstance. She should also explain to the client that the firm is also
responsible for the performance or action of auditors or staff that will be
assigned in the engagement (which may involve legal actions by parties
affected by the performance or action of the said auditor or staff).
If Kristoffer dela Cruz will not agree to such explanation, and insist on his
demand that only persons who graduated from his alma mater will be
assigned in the proposed audit engagement, Gwen Salcedo after thorough
discussion with his Audit Partners will have to decline the proposed audit
engagement because of the reasons cited above.
CHAPTER 8
PHILIPPINE STANDARDS ON AUDITING
Questions & Answers
1. Explain how CPA firms are able to serve clients who operate in foreign
countries?
Answer:
Foreign public accounting firms have found that to retain their multinational
clients, they have had to develop the capacity to provide services
worldwide. Although the roots of at least two of the big firms in the United
States are traceable to European ancestry, public accounting firm
involvement in international activities has paralleled the gradual
involvement of businesses in international activities. In the early 1900s, some
public accounting firms established representative offices in foreign
countries. As business activity expanded, the firms opened offices in foreign
cities. During the 1970s, some countries forced these firms to close their
offices. To be able to serve their clients, the firms established correspondent
relationships with locally owned accounting firms; in these relationships,
local partners remain separate, local, autonomous organizations. Because
domestic and foreign partners in a correspondent relationship agree to
follow a common code of ethics and practice guidelines, each is able to
rely on the work the other performs. A big firm auditing a U.S. business with
significant activities in France, for example, would rely on its Paris office to
audit the activities of the business in France.
The largest firms have organized worldwide partnerships to achieve a
greater uniformity of quality, to facilitate management of personnel, and
to coordinate research and professional development of personnel. Many
small public accounting firms establish correspondent relationships with
foreign public accounting firms or join a federation. Firms in a federation
call on one another to perform services for clients, following agreed-upon
standards in conducting the work they do for one another.
2. Is it possible for an auditor to depart from PSA? What would be the
implication if an auditor does not follow the applicable PSA?
Answer:
Yes. According to paragraph 10 of the Preface to Philippine Standards on
Auditing and Related Services, “an auditor may, in exceptional
circumstances, judge it necessary to depart from a PSA in order to more
effectively achieve the objective of an audit. When such a situation arises,
the auditor should be prepared to justify the departure.”
3. Are PSAs and Philippine Auditing Practice Statements synonymous?
Answer:
No. According to paragraph 14 of the Preface to the Philippine Standards
on Auditing and Related Services, “PAPSs are issued to provide practical
assistance to auditors in implementing the PSAs or to promote good
practice. These Statements are not intended to have the authority of the
PSAs.”
4. What is meant by assurance?
Answer:
Assurance in the context of Framework for Auditing and Related Services
refers to the auditor’s satisfaction as to the reliability of an assertion being
made by one party for the use by another party. (Refer to page 329,
paragraph 6 of PSA 220).
5. How can an auditor provide such assurance?
Answer:
To provide such assurance, the auditor assesses the evidence collected as
a result of procedures conducted and expresses a conclusion. (Refer to
page 329, paragraph 6 of PSA 220).
6. Under PSA 220 , Framework of Philippine Standards on Auditing, auditing
services are distinguished from related services such as review, compilation,
agreed-upon procedures. Discuss the levels of assurance provided by the
CPA in each of these services.
Answer:
In a review engagement, the auditor provides a moderate level of
assurance that the information subject to review is free of material
misstatement. This is expressed in the form of negative assurance on
assertion.
In a compilation engagement, although the users of the compiled
information derive some benefit from the accountant’s involvement, no
assurance is expressed in the report.
For agreed-upon procedures, the auditor simply provides a report of the
factual findings and no assurance is expressed. (Refer to pages 329 and
330, paragraphs 8, 9 and 10 of PSA 220).
Multiple Choice Questions
1.
2.
3.
4.
5.
D
B
B
D
C
6.
7.
8.
9.
10.
C
C
D
D
A*
11
D
* b and d are also options available to the auditor
Cases
1. The PICPA currently develops independence and ethical standards, quality
control standards, and auditing and attestation standards that apply to its
members. However, PICPA standards are applicable to the audits and
auditors of nonpublic clients based on general acceptance by the courts,
and adoption by state boards of accountancy and other regulatory
bodies. The AICPA also has a voluntary peer review program, and enforces
its standards on its members.
The PCAOB (Public Company Accounting Oversight Board) was given the
legal authority to develop independence and ethical standards, quality
control standards, and auditing and attestation standards that apply to
public company auditors and integrated audits.
The PCAOB also is
charged with performing inspections of registered audit firms, and may
sanction the firms for noncompliance with its standards and the provisions
of Sarbanes-Oxley Act.
The state boards of accountancy regulate CPA firms and CPAs in the
various states and jurisdictions. They have the authority to establish their
own standards, but have generally adopted the standards of other bodies
such as the PICPA and the PCAOB. A state board enforces its standards in
its state or jurisdiction and has the authority to revoke a CPA firm or
individual CPA’s right to practice in the state.
2. Applicable Technical and Professional Standards

It was inappropriate for Arnold to hire the two students to conduct
the audit. The audit must be conducted by persons with proper
education and experience in the field of auditing. Although a junior
assistant has not completed his formal education, he or she may help
in the conduct of the audit as long as there is proper supervision and
review.

Because of the financial interest in whether the bank loan is granted,
Arnold is not independent.

Arnold did not review the work or the judgments of the assistants and
clearly failed to adhere to this standard.

Arnold accepted the engagement without considering the availability of competent staff. Arnold failed to supervise the assistants
and did not adequately plan the work.

Arnold and the assistants did not obtain the required understanding
of the entity and its environment, including internal control.

Arnold acquired no evidence that would support the financial
statements. Merely checking the mathematical accuracy of the
records and summarizing the accounts is inadequate.

Arnold's report makes no reference to applicable reporting
framework. Because Arnold did not conduct a proper audit, the
report should state that no opinion can be expressed.

In this case both the statements and the auditor's report lack
adequate disclosures.
Although Arnold’s report contains an expression of opinion, such opinion is
not based on the results of a proper audit. Arnold should disclaim an opinion because he failed to conduct an audit in accordance with Philippine
Standards on Auditing (PSAs).
3. (a) When the auditors discover illegal acts by a public client, they should
consider three major factors. First, the auditors should consider the
effect of the acts on the client's financial statements, including the
possibility of fines and loss of business. To comply with the applicable
reporting framework, the financial statements must reflect the material
effects of illegal acts.
Second, the illegal acts may affect the auditors' assessment of the
integrity of management. In deciding whether to continue to serve the
client, the auditors should consider the nature of the illegal acts and
management's response to the acts after they are uncovered.
Third, the auditors should consider whether the occurrence of the illegal
act indicates that there is a material weakness in the company’s internal
control over financial reporting.
(b) The following courses of action are available to the auditors:
(1)
The auditors could issue an unqualified opinion and take no
further steps regarding the illegal activities. This course of action
could be argued on the basis that the effect of the acts on the
financial statements is not material. If the auditors take this course
of action, they should also consider whether the illegal act and
related actions by management and the board indicate a
material weakness exists that would affect their report on internal
control over financial reporting.
(2)
The auditors could issue a qualified opinion because the financial
statements depart from the applicable reporting framework, in
that they fail to disclose the illegal acts. This course of action
could be argued on the basis that any illegal activities by the
client are material, especially when management fails to take
any steps to prevent the acts. If the auditors take this course of
action, they should also consider whether the illegal act and
related actions by management and the board indicate a
material weakness exists that would affect their report on internal
control over financial reporting.
(3)
The auditors could withdraw from the engagement, because the
client's failure to take actions to prevent such activities indicates
that Generic's management lacks sufficient integrity.
(c) We believe that the auditors should consider withdrawing from the
engagement. Generic's top management seems far too complacent
regarding these activities. Their refusal to take any action to prevent the
acts in the future provides a signal to lower level management that top
management approves of illegal acts. The auditors clearly should
question the integrity of management in this situation.
4. The following memorandum summarizes the response of Alice Borromeo,
CPA, to the request of a client for extension of the attest function to the
problem of pollution control.
Dear Jenny:
As much as I support your strenuous efforts to minimize air and water
pollution from the manufacturing operations of your company, there are
specific reasons which make it impossible for me as a CPA to attest to the
extent of your accomplishments in this area along the lines you have
suggested. When we perform the attest function with respect to your
financial statements each year, we are expressing our professional opinion
that your financial statements are prepared in conformity with certain
standards, or applicable reporting framework.
In order for us to attest to the effectiveness of your pollution control
program, recognized standards would have to be established in this field.
No such standards presently exist for a factory to the best of my knowledge.
Of course the national government has set standards for exhaust emissions
on automobile engines and we could, by retaining independent consulting
engineers, obtain a basis for attesting to the compliance of a given
automobile engine to those standards.
We are quite willing to extend the attest function in various directions
if we can find a basis for objective comparison of a given operation with a
clearly defined standard. Perhaps your engineering department can
develop some specific quantitative data on the industrial waste from your
operations. We might then be able to perform the necessary examination
of such data to enable us to attest to the validity of your representations as
to your operations. Of course, this would not be the same thing as providing
your relative position in the industry. After reviewing this possibility with your
engineering staff, if you would like to discuss the matter further with us, we
will be glad to meet with you.
Sincerely,
Alice Borromeo
CHAPTER 9
OVERVIEW OF RISK-BASED
AUDIT PROCESS
Questions and Answers
1. What information should a CPA firm seek in its investigation of a prospective
client?
Answer:
In their investigation of a prospective client, the CPAs should assess the
backgrounds and reputations of the prospect and its major shareholders,
directors, and officers. Thus, inquiries are made of underwriters, bankers,
and attorneys that conduct business with the prospective client. Also, the
CPAs are required to make inquiries of the prospect's predecessor auditors
to obtain information that might enter into the acceptance decision, such
as information regarding the integrity of management. The prospect's
financial reports, SEC filings, credit reports, and tax returns are used as
sources of financial background information.
2. State the purpose and nature of engagement letter?
Answer:
An engagement letter is sent to the client by the auditors to make clear the
nature of the engagement, any limitations on the scope of the audit, work
to be performed by the client's staff, and the basis for computing the
auditors' fee. The engagement letter represents the written contract for the
engagement, and its primary objective is to prevent possible
misunderstandings between the client and the auditors. It constitutes an
executory contract between the auditors and the client.
An executory contract is a contract made by two parties in which the terms
are set to be fulfilled at a later date. The contract stipulates that both sides
still have duties to perform before it becomes fully executed.
3. Discuss what is meant by the phrase “shopping for accounting principles”.
What mechanisms have served to prevent this practice by management?
Answer:
“Shopping for accounting principles” is a practice whereby management
changes auditors to a CPA firm that is more likely to allow an accounting
principle that has been the subject of dispute with the company’s prior
auditors. A number of mechanisms serve to discourage the practice,
including: (1) the requirements under PAS No. 84 for the successor auditors
to inquire of the predecessors about the reasons for the change in auditors,
(2) the SEC 8-K requirements for management to report the reasons for a
change in auditors which also require the auditors to express their
agreement with the details, and (3) the requirements under PAS No. 97 that
require accountants who are being asked to provide a report on the
accounting treatment of an prospective or completed transaction to
consult with the client’s auditors to ensure that they have a complete
understanding of the form and substance of the transaction. In addition,
the Sarbanes-Oxley Act of 2002 requires the audit committee to assume
responsibility for engaging, compensating, and overseeing the auditors.
4. Criticize the following statement. Throughout this audit, for all purposes we
will define a “material amount” as “P500,000”.
Answer:
The approach described in the statement is not appropriate. Materiality
depends on both the peso amount and the nature of the item. For
example, auditors apply a more rigorous standard of materiality in
evaluating transactions between related parties and potentially illegal acts
than they apply to misstatements in accounts.
5. Describe the two types of misstatement due to fraud.
generally of more concern to the auditor?
Which one is
Answer:
The two types of misstatements due to fraud are (1) misstatements arising
from fraudulent financial reporting, and (2) misstatements arising from
misappropriation of assets (sometimes referred to as defalcation).
Fraudulent financial reporting is of more concern to the auditors because it
typically results in effects that are much more material to the financial
statements. Defalcations often are not material to the financial statements.
6. Many CPA firms are taking a business risk approach to audits. Define what
is meant by business risk? Provide an example of a business risk that could
result in a risk of material misstatement of the financial statement?
Answer:
A business risk is a treat to achieving management’s objectives. There are
many examples of business risks that may result in a risk of material
misstatement of the financial statements. Two are shown below:
Business Risk
Risk of Material
Misstatement
Rapidly
changing
technology in the client’s
industry may threaten to
cause
the
client’s
products
to
become
obsolete.
Inventory
may
be
overvalued because it is
not
valued
at
net
realizable value.
Economic conditions in
the industry may result in
significant
uncollectible
accounts receivable.
Accounts receivable may
be overvalued because
the
allowance
for
uncollectible accounts is
not adequate.
7. Should a separate audit program be prepared for each audit
engagement, or can a standard program be used for most engagements?
Answer:
The audit procedures to be followed in a given engagement depend upon
such factors as the risks of material misstatement of the financial
statements, the assumption about the effectiveness of internal control, the
auditors' estimates of materiality, the nature of the accounting records, the
caliber of accounting personnel, and any special objectives of the
engagement. Consequently, a separate, tailor-made audit program
should be prepared for each audit engagement.
8. “An audit program is desirable when new staff members are assigned to
an engagement, but an experienced auditor should be able to conduct
an audit without reference to an audit program.” Do you agree? Discuss.
Answer:
The quotation is misleading because it implies that an audit program is no
more than a checklist of instructions for inexperienced auditors. Actually,
audit programs are essential to assessing that all work is performed and are
used on virtually all audit engagements regardless of the amount of
experience of the auditor. Also, a written audit program is required for all
audits.
9. Describe the risk material misstatement of an assertion.
components that make up the risk.
List the two
Answer:
The risk of material misstatement is the probability that an account, class of
transactions, or disclosure is materially misstated. It consists of: 1) inherent
risk (the risk of material misstatement without considering internal control)
and 2) control risk (the risk that internal control will fail to prevent or detect
and correct the material misstatement).
10.Certain audit risks are significant in that they require special audit
consideration. Describe the typical characteristics of this risk?
Answer:
Significant risks often relate to non-routine transactions and estimation
transactions. Such transactions typically involve more subjective judgment
than routine transactions and, therefore, they often have a higher risk of
material misstatement. Significant risks may also be fraud risks.
11.Suggest some factors that might cause an audit engagement to exceed
the original time estimate. Would the extra time be charged to client?
Answer:
Factors which may cause an audit engagement to exceed the original
time estimate include the following:
(1) Accounting records may not be up to date and complete.
(2) Inadequacies in internal control may be discovered necessitating a
more detailed audit than anticipated.
(3) A significant risk, such as a fraud risk, may be discovered requiring an
extension of audit procedures.
(4) Fraud may be discovered, and an extended investigation may be
authorized by the client to clarify the situation.
(5) Inadequate supervision of audit staff may permit unnecessary or misdirected work to be performed.
(6) Findings during the course of the audit may cause the client to
request extension of the scope of the work.
In some engagements, clients are charged at agreed daily or hourly rates
for the time used to perform the audit. The difficulty of forecasting time
requirements is a principal reason for the use of per diem rates rather than
quoting a fee for the entire engagement. For many engagements, a
maximum fee is agreed upon; this plan may, of course, force the auditing
firm to absorb part of the cost of unexpected amounts of work. A decision
as to charging the client for unusual amounts of time will involve
consideration of all aspects of the engagement and prior relations with the
client. Generally, however, the client should not be billed for excessive time
attributed to audit inefficiencies (e.g. item (5) above).
12.What problems are created for a CPA firm when audit staff members
underreport the amount of time spent in performing the specific audit
procedures?
Answer:
Underreporting of time results in the CPA firm not billing the client for all of
the time actually involved in rendering the professional services. 1) Thus,
the firm's revenue is being restricted. 2) In addition, the underreporting will
cause the firm to underestimate the amount of time required for future
engagements. 3) Thus, auditors on future engagements will be expected
to perform audit procedures in an unrealistically short period of time. 4) This
interferes with the performance of an effective audit as well as the realistic
evaluation of firm personnel.
Cases
1. a. Prior to acceptance of the engagement, Argante & Tan should have
communicated with the predecessor auditor regarding:




Facts that might bear on the integrity of management.
Disagreements with management concerning accounting
principles, auditing procedures, or other significant matters.
The predecessor’s understanding about the reason for the
change.
Any other information that may be of assistance in determining
whether to accept the engagement.
b. The form and content of engagement letters may vary, but they would
generally contain information regarding:












The objective of the audit.
The estimated completion date.
Management’s responsibility for the financial statements.
The scope of the audit.
Other communication of the results of the engagement.
The fact that because of the test nature and other inherent
limitations of any system of internal control, there is an
unavoidable risk that even some material misstatement may
remain undiscovered.
Access to whatever records, documentation, and other
information may be requested in connection with the audit.
Arrangements with respect to client assistance in the
performance of the audit engagement.
Expectation of receiving from management written confirmation
concerning representations made in connection with the audit.
Notification of any changes in the original arrangements that
might be necessitated by unknown or unforeseen factors.
Request for the client to confirm the terms of the engagement by
acknowledging receipt of the engagement letter.
The basis on which fees are computed and any billing
arrangements.
2. a. Typical engagement letter generally includes the following:
 The name and address of the person or persons who retained the
auditor to perform the auditing services.
 An opening paragraph that confirms the understanding of the
auditor and the client.
 A summary of significant events that lead to the retention of the
services of the auditor.
 A general description of the CPA firm that will conduct the
examination.
 A statement that the examination will be performed in
accordance with auditing standards.
 A description of the scope of the services to be rendered, which
should establish the nature of the engagement.
 Any scope restrictions or special limitations and their effect on the
auditor’s report.





A statement regarding the auditor’s responsibility for the
detection of fraud.
An indication of the possible use of client personnel in connection
with the audit work to be performed.
A statement that the auditor will provide a management letter if
required in the circumstances.
The method and timing of billings as well as billing rates and fee
arrangements.
Space for the client representative’s signature, which indicates
“acceptance” of the letter and the understandings, therein.
b. The benefits of preparing an engagement letter include the avoidance
of possible problems between the CPA and the client concerning (1)
the scope of the work, (2) the service to be rendered, and (3) the audit
fee. In addition, the “in-charge” auditor conducting the examination
can avoid misunderstanding the nature and scope of the engagement
if the engagement letter is included in the permanent section of the
audit working papers. The letter should eliminate misunderstandings
and confusion about the type of financial statements to be examined,
the estimated report date, and the type of opinion expected. In
addition to avoiding possible misunderstandings, any legal problems
relating to the auditor’s failure to perform certain procedures can be
reviewed with reference to the contractual commitment assumed. (For
example, if scope limitations prevent the auditor from performing normal
audit procedures, the auditor cannot be legally responsible if an
irregularity is not detected when clearly it would have been detected if
such procedures were performed.)
The engagement letter is also useful as a reference document when
preparing for future engagements.
c. The CPA usually prepares the engagement letter as a follow-up to a
verbal understanding that he and his client have reached. It is desirable
that the client endorse and return an approved copy of the
engagement letter to the CPA. It also is acceptable for the client to
prepare his own letter summarizing his understanding of the nature of
the engagement.
d. Preferably the engagement letter should be sent at the beginning of the
engagement so that misunderstandings, if any, can be remedied.
e. Obviously, the engagement letter will be most useful in clarifying
misunderstandings on a first engagement. But it is desirable that the
letter be renewed periodically. Client personnel or the nature of the
engagement may change, and the resubmission of the letter gives both
parties an opportunity to review the circumstances. Accordingly, for
recurring examinations of financial statements, it is appropriate to
prepare an engagement letter at the start of each examination. For
other continuing engagements, the engagement letter also should be
updated periodically – probably on a yearly basis.
3. a. The procedures that Francis should follow prior to accepting the
engagement include the following:
(1) Francis should explain to Nikolai the need to inquire of Jo and should
request permission to make such inquiries.
(2) Francis should request that Nikolai authorize Jo to respond fully to all
of Francis’ inquiries since Jo would be prohibited from disclosing
confidential information obtained in the course of his professional
engagement with Nikolai.
(3) Francis should advise Jo of Nikolai’s decision to change auditors as
an act of professional courtesy.
(4) Francis should make reasonable inquiries of Jo regarding matters that
will aid in deciding whether to accept the engagement. (Francis’
inquiries should include questions regarding facts which might bear
on the integrity of management, disagreements with management
as to accounting principles, auditing procedures or other significant
matters, and Jo’s understanding of the reason(s) for the change of
auditors.)
(5) Francis should weigh all the information received from Jo. If Jo does
not respond fully to Francis’ questions, Francis should consider the
implications of the limited response in deciding whether to accept
the engagement.
(6) After weighing all information received from Jo, Francis should inform
Nikolai that a first-time audit is more time-consuming than a recurring
audit because the new auditor is generally unfamiliar with client’s
operations and does not have the benefit of past knowledge of
company affairs to use a guide.
(7) A discussion with Nikolai of the estimated required audit time and fee
arrangement should be coordinated with a clear explanation of the
purpose and scope of the audit. Any work that can be done by
client personnel should also be discussed so that excess audit time
might be eliminated and proposed report deadlines can be
reasonably met.
(8) To satisfy Francis’ quality control objectives, Francis should use
procedures such as reviewing the financial statements of Nikolai;
inquiring of third parties such as Nikolai’s banks, legal counsel,
investment bankers, and others in the business community as to
Nikolai’s reputation; and evaluating his ability to serve Nikolai
properly with reference to industry expertise, size of engagement,
and available staff.
(9) If Francis has no reservations, after all significant factors have been
considered, discussed, and agreed to, Francis should accept the
engagement and confirm the understanding in an engagement
letter.
b. Francis’ procedures on this first-time audit should include the following:
(1) Francis should review the workpapers of Jo to obtain information that
will help plan the audit work.
(2) Francis should make arrangements as early as possible for the initial
meeting with “key” company personnel who will be contacted
throughout the engagement.
(3) Since basic information about the company is not readily available
to Francis on this first-time audit, information of a general nature
should be obtained as early in the planning stage as possible. (Such
information should include company history, nature of the business,
credit policies, financing methods, sales methods and terms,
seasonal business patterns, products, services, plant locations,
internal procedures, accounting policies, tax status, etc. Client
procedures manuals and manuals of accounts should be read to
obtain such information.)
(4) Francis should immediately start obtaining the data needed to
create a permanent working paper file. (The file should include items
such as articles of incorporation,by-laws, minutes, internal audit
reports, deeds of trust, pension agreements, loan agreements,
leases, important contracts, and other pertinent data.)
(5) Francis must determine the coverage of work necessary to verify the
opening balances. Such balances must be reviewed to determine
whether they are stated on a basis comparable with those of the
period under review. If Francis cannot verify the opening balances,
Francis should consider disclaiming an opinion on the earnings
statement and statement of changes in financial position.
(6) The composition of all important accounts should be reviewed.
Francis should limit his examination of prior period accounts to a
review or survey of such accounts, without a detailed examination,
unless the results of Francis’ survey and analyses indicate the need
for further investigation of accounting methods in the prior years.
(7) Francis must consider whether the financial statements are prepared
using financial reporting standards that were consistently applied. If,
after performing necessary audit procedures, Francis cannot be
satisfied as to consistency, considerations must be given to qualifying
the auditor’s report as to consistency.
Francis should use professional judgment to determine the extent of
reliance that should be placed on the work of Jo. The scope of Francis’
work may be reduced as a result of Francis’ consultation with Jo and a
review of the prior-year work-papers of Jo.
4. a. A CPA can use the following sources of information to help decide
whether to accept a new audit client.
Financial information prepared by the prospective client:
Annual reports to shareholders
Interim financial statements
Securities registration statements
Annual report on SEC
Reports to regulatory agencies
Inquiries directed to the prospect’s business associates:
Banker
Legal counsel
Underwriter
Other persons, e.g., customers, suppliers
Predecessor auditor, if any, communication, re:
Integrity of management, Disagreements with management
Analysis:
Special or unusual risk related to the prospect
Need for special skills (e.g., computer or industry expertise)
Internal search for relationships that would comprise independence
b. Students can decide this acceptance question either way, although the
brief facts prejudice the conclusion toward non-acceptance. The
CPA’s own firm decided to resign only 10 years ago, presumably over
matters of owner-manager integrity. Yet, Mr. Sello appears to be a
respected member of his new community. Maybe his “fast and loose”
accounting past is behind him. Maybe not.
5.
a) Describe the objectives of an independent audit.
Answer:
1) The main objective of an independent audit is to express an
opinion whether the financial statements are prepared in all
material respects, in accordance with an identified financial
reporting framework.
2) One of the primary goals of an independent audit is the
examination of the company's financial statement to ensure
the financial books are accurate and compliant with fiscal
laws and regulations. Independent auditors inspect the
accounting system and account books of a company for
accuracy.
3) Another common objective behind an independent audit
process is an attestation engagement, a scenario where a
company hires auditors to evaluate an earlier report or analysis
conducted by the company.
4) Companies may hire independent auditors to achieve
specialized goals. For instance, some independent auditors
specialize in risk management, where their primary goal is to
determine the accuracy of a financial document, while others
specialize in assurance services, where the objective is to
review, confirm and improve the information the
management board already has. Auditors may focus on tax
matters or forensic accounting. Companies may also contract
an independent audit to investigate suspicion of fraud or
embezzlement.
b) Identify five ways in which an independent audit may be beneficial to Filan.
Answer:
Five ways in which an independent audit may be beneficial to
Filan:
1) The credibility of Filan’s financial statements;
2) Reliability of information;
3) Stockholders may invest in Filan’s business, because of the credible
financial statements;
4) Business risks will be identified and prevented;
5) Filan could decide properly on what strategies to be used in order
to improve the business operation and its internal control.
CHAPTER 10
UNDERSTANDING THE ENTITY
Questions and Answers:
1. Many CPA firms are taking a business risk approach to audits. Define what
is meant by business risk. Provide an example of a business risk that could
result in a risk of material misstatement of the financial statements.
Answer:
A business risk is a treat to achieving management’s objectives. There are
many examples of business risks that may result in a risk of material
misstatement of the financial statements. Two are shown below:
Business Risk
Rapidly changing
technology in the client’s
industry may threaten to
cause the client’s
products to become
obsolete.
Risk of Material
Misstatement
Inventory may be
overvalued because it is
not valued at net
realizable value.
Economic conditions in
the industry may result in
significant uncollectible
accounts receivable.
Accounts receivable may
be overvalued because
the allowance for
uncollectible accounts is
not adequate.
2. Define and differentiate between an audit plan and audit program.
Answer:
An audit plan provides essential background information for an audit
assignment, and outlines the objectives, timing, staffing, special risks and
considerations, and other requirements of the engagement. An audit
program is a detailed outline of the auditing work to be performed,
specifying the procedures to be followed in verification of each item in the
financial statements. Although both the audit plan and the audit program
are technically plans, the audit plan serves more as a broad overview of
the engagement, while the audit program is more specific and limited in
scope.
3. Auditing standards require the auditors to have a team meeting regarding
the risk of fraud for engagement. What is the purpose of this meeting?
Answer:
The purpose of the team meeting on fraud risk is designed to allow the more
experienced team members to share insights and exchange ideas about
how and where the entity’s financial statements might be susceptible to
material misstatement due to fraud, to discuss how to design appropriate
tests to detect the misstatements, and to emphasize the importance of
maintaining the proper degree of professional skepticism regarding the
possibility of fraud.
4. When planning an audit, the auditors must assess the levels of risk and
materiality for the engagement. Explain how the auditors’ judgments
about these two factors affect the auditors’ planned audit procedures.
Answers:
During the planning process, the auditors make preliminary estimates of
both risk and materiality for the engagement. The auditors must plan their
engagements to reduce the audit risk of issuing an unqualified opinion on
materially misstated financial statements to a relatively low level. At the
account balance level, audit risk actually has three components: (1)
inherent risk, (2) control risk, and (3) detection risk. On audits where the risk
of misstatement is relatively high, the auditors must compensate by
increasing the effectiveness of their audit procedures. They may design
more effective procedures, increase the number of items selected for
testing, or perform more procedures at the balance sheet date rather than
at an interim date. They may also add an element of unpredictability to
the procedures.
The auditors' preliminary estimates of levels of materiality also affect the
nature, timing, and extent of their planned procedures. Materiality levels
determine which accounts are significant enough to require audit, affect
the size of the test samples, and determine the dollar amount of individual
items that warrant examination.
5.
Answers:
(a) Auditors must obtain an understanding of the client and its environment
in order to determine whether the client should be accepted and to
plan the audit. This understanding encompasses the following:
(1) The nature of the client, including the client’s application of
accounting policies—The auditors’ understanding of this area will
include the client’s competitive position, organizational structure,
accounting policies and procedures, ownership, capital structure,
and product lines. The understanding will also encompass an
understanding of the client’s business model and its major business
processes.
(2) The industry, regulatory, and other external factors—The factors
included here are industry conditions, such as the competitive
environment, supplier and customer relationships, and technological
developments. They also include the regulatory, legal, and political
environment, and general economic conditions.
(3) Objectives and strategies and related business risks—The auditors
obtain an understanding of the operating and financing strategies
of management.
They also obtain an understanding of
management’s risk assessment process. This assists the auditors in
identifying significant business risks that may create risks of material
misstatement of the financial statements.
(4) Methods of measuring and reviewing performance—The auditors
obtain an understanding of the methods management uses to
measure and review performance at various levels within the
organization.
These methods are important to determining
incentives of management and other employees. The measures
may also be used in designing effective analytical procedures.
(5) Internal control—The auditors’ understanding of internal control
assists them in planning the audit and assessing control risk.
(b) Sources of information on prospective clients include trade publications,
and governmental agency publications. Previous audit reports, annual
reports to stockholders, SEC filings, and prior years' tax returns are
excellent sources of financial background information.
Informal
discussions between the auditors and key officers can provide
information about the history, size, operations, accounting records, and
controls of the enterprise. Inquiries of others within the organization can
provide information that confirms inquiries of management, and
provides more detailed information about risks and business processes.
Inspection of internal documents and records can provide information
about the nature of the client’s operations and internal control. The
predecessor auditor may also provide information.
(c) Knowledge of the client and its environment helps the auditors in:
(1) Identifying areas that may need special consideration.
(2) Identifying significant business risks that may result in risks of material
misstatement of the financial statements.
(3) Assessing inherent risk and making preliminary assessments of control
risk.
(4) Making judgments about the appropriateness of accounting
principles in use and the adequacy of disclosures.
(5) Evaluating the reasonableness of estimates, such as depreciation
lives and the allowance for doubtful accounts.
(6) Evaluating the reasonableness of management representations.
(7) Developing an efficient audit strategy.
(8) Determining the staffing requirements of the engagement.
6.
Answer:
During the tour of the client's plant facilities, Sison inspects all inventory
areas and makes note of the location, types, security, "housekeeping," and
general condition of the inventories. He also visits the receiving and
shipping departments and reviews the types of documents maintained. His
observations in these areas enable him to form a preliminary impression of
the adequacy of internal controls for inventories, and possible problems
with respect to obsolete or slow-moving inventories. He also can begin
formulating plans for staffing and carrying out the physical inventory
observation.
Sison’s observation of the productive processes will acquaint him with the
client's physical plant facilities and layout, the nature of the products and
computer applications employed in the production process. He may also
obtain information on the client's documentation such as for production
orders, raw materials requisitioned to production, direct and indirect labor,
and inspection and testing of finished products. He meets the supervisory
personnel, engineers, and other key personnel responsible for production,
and through inquiries and conversations learns of any unique production
problems, including excessive spoilage and scrap. As a result, he will be in
a position to evaluate the client's cost accounting system during the course
of the audit. He will also inquire about the details of the client’s business
processes.
Throughout the tour, Sison will add to his impression of the client's business
processes, control procedures and accounting records. He will notice, for
example, what personnel have access to computer terminals and
accounting records, whether plant assets have identification tags, and
whether documents such as production orders and receiving reports are
serially numbered or controlled by the computer.
7.
Answers:
(a) Misstatements due to fraudulent financial reporting are intentional
misstatements or omissions of amounts or disclosures in the financial
statements to deceive financial statement users. Misstatements arising
from misappropriation of assets (sometimes referred to as defalcation)
involve the theft of an entity’s assets where the effect of the theft causes
the financial statement not to be presented in conformity with generally
accepted accounting principles.
(b) The three conditions necessary for the commission of fraud include: (1)
some type of incentive or pressure, (2) an opportunity to commit the
fraud, and (3) an attitude that allows the individual to rationalize the act.
In a case of fraudulent financial reporting, members of top
management may have an incentive to commit the act relating to
maintaining the value of their stock options. They may have an
opportunity based on weaknesses in the corporate governance of the
organization. Finally, they may be able to rationalize the act by
assuming that the company will make enough income next period to
allow them to correct the misstatement.
(c) The auditors may respond to fraud risks by (1) a modification in the
approach having an overall effect on how the audit is conducted, (2)
an alteration in the nature, timing, and extent of the procedures
performed, and (3) performance of procedures to further address the
risk of management override of internal control.
8.
Amswer:
(a) Shin may respond to fraud risks in the following three ways:
(1) A modification in the overall approach to the audit which might
involve:
(a) Applying increased professional skepticism and designing
procedures that provide more reliable evidence.
(b) Assigning additional staff with specialized skill and knowledge or
by assigning more experienced staff to the engagement. Also the
extent of the supervision of the staff should be adjusted to reflect
the fraud risks.
(c) Giving further consideration to the appropriateness of the
accounting principles used by the client.
(d) Incorporating an added element of unpredictability in the
selection of auditing procedures.
(2) An alteration in the nature, timing and extent of the procedures
performed. For example, Shin might apply procedures that provide
more reliable evidence, shift more audit tests to year-end, or increase
sample sizes for certain substantive tests.
(3) Perform procedures to further address the possibility of management
override of internal control, including (1) examining journal entries
and other adjustments for evidence of fraud, (2) reviewing
accounting estimates for biases, and (3) evaluating the business
rationale for significant unusual transactions.
(b) Whenever the auditors believe that there is evidence that fraud may
exist, the matter should be brought to the attention of an appropriate
level of management. Fraud involving senior management and fraud
that causes a material misstatement of the financial statements should
be reported directly to the audit committee. In very serious situations
the auditors should consider resigning the engagement.
Multiple Choice Questions
1.
2.
3.
4.
5.
d
a
d
d
d
6.
7.
8.
9.
10.
d
d
d
d
d
Answer:
1)
A)
(a)There is an increased risk of fraudulent financial reporting by subsidiary
management. More specifically, subsidiary management would likely
attempt to increase revenue or decrease expenses.
(b)The
auditors
would probably respond by performing more
procedures
at the subsidiary location. Additional tests of revenue would be performed
and the auditors would likely decide to observe inventory at year-end.
In addition, some of the procedures may be performed on
an
unannounced basis.
B)
(a) There is an increased risk of fraudulent financial reporting by
management related to revenue.
(b)The auditors would likely respond by utilizing more experienced audit
Team members. Specifically, audit staff that had experience with complex
Revenue contracts in the telecommunications industry. They would also
likely increase the extent of the substantive tests of revenue.
C)
(a) There is an increased risk that the futures traders will fraudulent
Overstate the value of the contracts to increase their compensation.
(b)The auditors would likely respond to this situation by bringing in a
specialist to assist in valuing the contracts. In addition, they would do
extensive testing of the valuation of the contracts.
D)
(a) There is an increased risk that management may be fraudulently
overstating income at one or more of the stores.
(b)The auditors would likely respond by doing increased testing of revenue
And inventory at the stores. The auditors could use the results of the
Analytical procedures to identify stores that are more likely to have
Fraudulent reported results (e.g., those with unusually high profit margins).
The auditors also may not disclose the locations that they intend to visit
for inventory observation.
2. Mr. Gian Lee
President
Palace Corporation
Dear Mr. Lee:
Our recent tour of Palace's plant was a most pleasant and interesting
experience. The information obtained on this tour and during the discussion
of your financial statements and accounting records has enabled us to
plan the scope of an audit especially suited to your needs.
Our fees are based on the time spent on the engagement by various
members of our audit staff, and will be billed at our established rates. The
total time required for an initial engagement is usually somewhat greater
than in repeat examinations, since the latter do not require analysis of past
years' transactions. Considerable savings in the cost of the audit may be
made by utilizing the services of your accounting staff to help us in certain
phases of the work. We can arrange for your employees to prepare for us
a number of working papers. If you approve, we shall indicate to your chief
accountant the exact nature of the working papers to be prepared.
Our audit will be performed in accordance with generally accepted
auditing standards and will include all procedures which we consider
necessary to provide a basis for expression of our opinion on the fairness of
the financial statements. The audit will include:
(1) A consideration of the internal control.
(2) Tests of the financial statement accounts and balances to the extent
we consider necessary, based on our consideration of risks and
internal control.
(3) Preparation of the income tax returns.
(4) Issuance of our auditor's report upon your financial statements.
If our investigation indicates the desirability of any changes in internal
control procedures, we shall prepare a report on this subject for your
consideration. However, an audit cannot be relied upon to identify all
weaknesses in internal control. The purpose of our audit is to enable us to
express an opinion on the fairness of the financial statements; the audit is
designed to provide reasonable, but not absolute, assurance of detecting
material fraud and defalcations, and we will notify you if our audit does bring
them to light.
Although it is not possible to determine in advance the exact number of
days required for the engagement, our estimates indicate that the total fee
will be between ___________ and _________. The audit will be completed
and our report submitted by March 1, 2014.
We would like an opportunity during the next few days to discuss with you
and your chief accountant the nature of the preliminary work to be done by
your staff. We shall also be pleased to answer any further questions which
you may have concerning the determination of audit fees.
Very truly yours,
Chariya, Modena and Company, CPAs
CHAPTER 11
CONSIDERATION OF INTERNAL CONTROL
IN A FINANCIAL STATEMENTS AUDIT
Questions and Answers
1. For what reasons does an auditor obtain an understanding of the internal
control structure?
Answer:
An auditor obtains an understanding of a client’s internal control structure
as a part of the control risk assessment process in order (1) to plan the
nature, timing, and extent of subsequent substantive audit procedures, and
(2) to obtain information about reportable conditions (control deficiencies)
to report to the client.
2. What are the primary and secondary reasons for conducting an evaluation
of an audit client’s internal control?
Answer:
The primary reason for conducting an evaluation of a client’s existing
internal control system is to give the auditors a basis for finalizing the details
of the account balance audit program – to determine the nature, timing
and extent of subsequent substantive audit procedures.
A secondary purpose for conducting an evaluation of internal control is to
be able to make constructive suggestions for improvements. Officially, the
profession considers these suggestions a part of the audit function and does
not define the work as a must consultation.
Another purpose of the evaluation is to report to management and the
board of directors or its audit committee any discovery of “any reportable
conditions” of internal control deficiencies.
3. What are the factors that would affect the nature, timing and extent of the
procedures performed by the auditor to obtain an understanding of the
accounting and internal control system?
Answer: Refer to pages 465/480.
4. What are the advantages and disadvantages of documenting internal
Control by using 1) an internal control questionnaire, 2) a narrative
Memorandum, 3) a flowchart?
Answer: 1) For an Internal Control Questionnaire refer to pages 486 to 487;
2) For a Narrative Memorandum refer to page 490;
3) For a Flowchart refer to pages 487 to 488.
5. What is the difference between observation and re-performance in tests of
controls audit procedure?
Answer:
“Observation,” in a test of control procedure, refers to auditors looking to
see whether client personnel stamped, initialed, or left other signs that their
assigned control procedures had been performed.
“Re-performance,” in a test of control procedure, refers to auditors doing
again the control that was supposed to have been performed by the client
personnel (recalculating, looking up the right price, comparing quantities,
and so forth).
6. What two kinds of engagements can produce an auditor’s written report
on internal control intended for external use? Describe the reports in
general terms?
Answer:
Written reports on internal accounting control (IAC) for external use.
Type of Engagement
Special IAC study
Character of Report
Report on IAC with opinion
on IAC system taken as a
whole.
Service auditor engaged
to report for benefit of user
auditor and their mutual
client.
A special-purpose report
on IAC can take special
forms, the main feature of
which includes an opinion
relating to the controls
applied by the service
organization to the client
organization’s
transactions.
7. What is meant by the auditor’s understanding of a client’s internal control?
Answer:
The auditor must obtain a sufficient understanding of the client’s system of
internal financial controls to identify the types of potential material
misstatements of financial statement components, and the risks associated
with each. Such understanding is obtained by gathering evidence relating
to the basic elements of the client’s internal financial controls.
8. How does the auditor obtain an initial understanding of a client’s financial
internal control policies and procedures?
Answer:
The auditor obtains an initial understanding of the client’s financial controls
by studying the organizational structure, inquiring of management, and
studying last year’s working papers if a recurring audit.
9. What kind of documentation is required relative to the auditor’s
understanding of a client’s internal financial controls?
Answer:
The documentation of the auditor’s understanding must provide clear
evidence of support for the auditor’s conclusions regarding the assessed
level of control risk. This is especially necessary if control risk is assessed
below the maximum level. The documentation at this point typically
consists of some combination of narrative memoranda, questionnaires or
checklists, and internal control flowcharts, as well as documentation of the
auditor’s conclusions, and the reason(s) for assessing control risk below
maximum, if applicable.
10.How does testing of internal controls help in the design of substantive audit
procedures?
Answer:
Testing of internal financial controls may permit the auditor to further
reduce the assessed level of control risk. This, in turn, should lead to a
decrease in the nature, timing, and/or extent of substantive audit testing in
the circumstances.
11.Under what circumstances might an auditor decide not to test internal
financial controls beyond obtaining an initial understanding?
Answer:
The following factors may cause the auditor to decide not to test the
client’s internal financial controls beyond obtaining an initial
understanding:
a. Controls may already have been evaluated as ineffective;
b. Further testing is not cost effective (i.e., the cost of further testing is
greater than the cost savings resulting from reduced substantive
testing)
12.Identify alternative means for testing of internal financial controls?
Answer
Some combination of the following means is typically utilized by the auditor in
testing a client’s internal financial controls:
a. Reprocessing transactions through the client’s system;
b. Observation of controls; and
c. Document examination and testing.
13.Differentiate between misrepresentation and misappropriation?
Answer:
Misrepresentation is a form of financial statement misstatement
caused by intentional efforts by management to distort reported financial
position and/or results of operations. Misappropriation is a form of fraud
whereby one or more employees effect a transfer of assets from employer to
employee, accompanied by concealment in the form of account or
substance alteration.
14.Give an example showing how a control weakness may lead to an
expansion of substantive audit procedures?
Answer:
The following are some examples of internal control weaknesses and
suggested expanded substantive testing, given the weaknesses:
a. Perpetual inventory records not maintained: Expand test counts during
inventory observation;
b. Bank accounts not reconciled: Expand year-end audit of cash
accounts;
c. Customer exceptions to monthly statements not investigated and
cleared: Expand accounts receivable confirmation at year-end.
15.What is meant by reportable conditions? What purpose is served by the
letter communicating matters related to internal control to the audit
committee?
Answer:
Reportable conditions are matters coming to the auditor’s attention, as a
result of his/her study and evaluation of the client’s internal financial controls,
relating to significant deficiencies in the design or operation of the internal
controls that could adversely affect the organization’s ability to record,
process, summarize, and report financial data consistent with the assertions
of management in the financial statements. The purpose of the reportable
conditions letter is to inform the audit committee, or similar body within the
organization, of weaknesses for which they may not be aware. Such
communication increases the likelihood that the weaknesses will be
corrected on a timely basis.
16.Describe how a memorandum, questionnaire or checklist, and flowchart
approaches might be used in combination to provide an effective means
for studying and evaluating a client’s internal financial controls.
Answer:
Use of any one of the approaches to studying and documenting a client’s
internal financial controls, by itself, is inadequate. Each approach adds a
needed dimension to the analysis. The memorandum requires depth of
analysis not found in the flowchart. The flowchart, on the other hand,
promotes ease of understanding and ready identification of strengths and
weaknesses in controls. The questionnaires and checklists add the
dimension of completeness of coverage. By using the three tools in
combination, the auditor is able to gain a deeper and clearer
understanding of each of the subsets of the transaction cycles, including
major control strengths and weaknesses, thereby permitting more accurate
control risk assessments and more useful substantive audit programs based
on such assessments.
Multiple Choice Answers
Cases
1.
Answers:
a. Given identified financial control weaknesses, the auditor may elect to
expand the extent of substantive testing, or search for and test
compensating controls. In the present case, the following errors and
irregularities may occur, given the control weaknesses in the payroll
subset of the expenditure cycle:
1. Hours may be in error, inasmuch as the time cards are prepared
by employees and not reviewed.
This could lead to
overstatement or understatement of wages expense in the
income statement. This could also affect the carrying value of
finished goods inventories if Quicky is a manufacturing company.
2. The payroll could be “padded” inasmuch as signed checks are
returned to the department supervisors for distribution. This could
result in overstatements of salaries and wages expense on the
income statement. It could also cause a finished goods inventory
overstatement.
b. If, based on the initial understanding, controls are thought to be
adequate, the auditor should consider the following alternatives:
1. Document the understanding, assess control risk below maximum,
as considered appropriate, and document the basis for
conclusions; or
2. Document the understanding and test controls as a means for
further reduction in the assessed level of control risk. This
alternative would be chosen if the following conditions exist:
a. Controls are thought to be effective; and
b. Cost reductions through reduced substantive testing
exceed cost of further testing of controls.
c. 1. Auditors must study and evaluate internal control each year
because the environment within which the client operates is subject
to constant change; and controls must adapt to these changes if the
system is to remain effective.
The auditor must identify the
environmental changes and determine that the relevant control
points remain covered after the changes.
2. A minimum audit is necessary, even under conditions of excellent
internal control, because of the following inherent limitations in all
internal control systems:
Internal control assumes the nonexistence of collusion;
Management can override the financial controls;
Temporary breakdowns in the control system may occur and
produce material errors;
Given that these inherent limitations could produce material
financial statement misstatements, and given that the audit report
provides reasonable assurance that the financial statements do not
contain material misstatements, the auditor must perform a minimum
audit, even under conditions of excellent internal control if such
assurance is to be provided.
2.
Answer:
ISLANDER DRUG STORE, INC.
Processing Cash Collections
Internal Control Questionnaire
-Question
Are customers who pay by check
identified via store I.D. card or other
means?
Yes
No
Does company policy prohibit accepting
checks
for
anything
except
merchandise sales plus a nominal cash
amount?
Is a receipt produced by the cash register
given to each customer?
Is the reading of each cash register taken
periodically by an employee who is
independent of the handling of cash
receipts?
Are cash counts made on a surprise basis
by an individual who is independent of
the handling of cash receipts?
Is the reading of each cash register
compared regularly to the cash
received?
Is a summary listing of cash register
readings prepared by an employee
who is independent of physically
handling cash receipts?
Are
receipts
forwarded
to
an
independent employee who makes
the bank deposits?
Are each day’s receipts deposited intact
daily?
Is the summary listing of cash register
receipts reconciled to the duplicate
deposit slips authenticated by the
bank?
Are entries to the cash receipts journal
prepared from duplicate deposit slips
or the summary listing of cash register
readings?
Are the entries to the cash receipts journal
compared to the deposits per bank
statement?
Are areas involving the physical handling
of cash reasonably safeguarded?
Are employees who handle receipts
bonded?
Are charged back items (NSF checks,
etc.) directed to an employee who
does not physically handle receipts or
have access to the books?
CHAPTER 12
FRAUD AND ERROR
Questions and Answers
1. Why should auditors act as though there is always a potential conflict of
interest between the auditor and the management of the enterprise under
audit?
Answer:
Holding a belief that a potential conflict of interests always exists causes
auditors to perform procedures to search for errors or irregularities that
would have a material effect on financial statements. This tends to make
audits more extensive for the auditor and more expensive for the client. The
situation is not a desirable one in the vast majority of audits where no errors
or irregularities exist.
2. What difference, if any, exists between auditors’ responsibilities concerning
errors and irregularities and responsibilities concerning clients’ illegal acts?
Answer:
Errors and irregularities: Auditors are required to plan the audit to detect
errors and irregularities that would have a material effect on the financial
statements.
Clients’ illegal acts: Auditors are not required to search for illegal acts, but
they are warned to be alert to any that might be detected in the ordinary
course of an audit.
3. List and briefly explain the seven major assertions that can be made in
financial statements and auditors’ objectives related to each.
Answers:
Seven major assertions in financial statements:
a. Existence assertion:
The practical objective is to establish with evidence that assets,
liabilities and equities actually exist and that sales and expense transactions
actually occurred. Cut-off can be considered an aspect of the existence
assertion.
b. Occurrence assertion:
The practical objective is to establish with evidence that recorded
transactions or events that occurred during a given accounting period
pertained to the entity.
c. Completeness assertion:
The practical objective is to establish with evidence that all transactions
of the period are in the financial statements and all transactions that
properly belong in the preceding or following accounting periods are
excluded. Another term for these aspects of completeness is cut-off.
Completeness also refers to proper inclusion in financial statements of all
assets, liabilities, revenue, expense, and related disclosures.
d. Rights and Obligations assertion:
The practical objectives related to rights and obligations are to establish
with evidence that assets are owned (or rights such as capitalized leases
are shown) and liabilities are owed.
e. Measurement assertion:
The practical objective is to establish with evidence that a transaction
or event is recorded at the proper amount and revenue or expense is
allocated to the proper period.
f. Valuation assertion:
The practical objective is to establish with evidence that proper
values have been assigned to things (assets, liabilities, equities and related
disclosures) and events (revenues, expenses and related disclosures).
Auditing Standards refer to the practical objective of obtaining evidence
about “valuations” achieved by cost allocations such as depreciation and
inventory costing methods.
g. Presentation and Disclosure assertion:
The practical objective is to establish with evidence that accounting
principles used by management are appropriate in the circumstances and
are applied properly, and that disclosures contain all information required
by generally accepted accounting principles.
4. What benefits are claimed for auditors’ preliminary assessment of
materiality as a matter of audit planning? Is P500,000 a material amount of
misstatements to leave uncorrected in financial statements?
Answer:
Benefits of preliminary assessment of materiality:
Fine-tune the audit for effectiveness and efficiency.
Help auditors avoid surprises related to:
Finding out too late about not auditing enough.
Finding out later about auditing too much.
Is P500,000 material? Maybe.
Absolute size. If you think so, it’s material just because it’s a large
number.
Relative size.
No. If P500,000 is less than 5% of a relevant base.
Maybe. If P500,000 is between 5% and 10% of a
relevant base.
Yes. If P500,000 is 10% or more of a relevant base.
Nature of the item. Yes, P500,000 is material if it arises from an illegal
act.
5. Are analytical procedures very effective for discovering errors and
irregularities?
Answer:
Yes, auditors have credited discovery of errors and irregularities to
analytical review procedures in 27.1% of the cases in a set of audits, and
another 18.5% discovery rate was attributed to “prior expectations” and
“discussions.”
6. In what way is materiality related to audit risk?
Answer:
In assessing inherent risk and control risk, the auditor must consider the
types of errors or irregularities that might occur and their impact on the
financial statements (materiality.) In evaluating materiality, the auditor
should consider the impact of errors and irregularities both individually and
in the aggregate. Auditing Standards require that the auditor design the
audit to provide reasonable assurance of detecting errors and
irregularities that are material to the financial statements. Auditing
Standards require that audit risk and materiality be considered both in
planning the audit and in evaluating audit results.
Control risk and inherent risk are also directly related to the setting of
materiality thresholds. If, for example, application of analytical procedures
(inherent risk analysis) leads the auditor to suspect earnings inflation,
individual item materiality thresholds should be reduced accordingly (i.e.,
either the materiality percentage or the amount of unaudited income
should be decreased.) Similarly, if control risk analysis leads the auditor to
suspect numerous errors, aggregate materiality thresholds need to be
lowered accordingly.
7. How will an auditor react to the discovery of an immaterial error? An
immaterial irregularity?
Answer:
An auditor’s reaction to an immaterial error may differ from his or her
reaction to an immaterial irregularity. Auditors generally accumulate the
amount of individual immaterial errors to be sure that the aggregate of all
errors is not material. In addition, the auditor is concerned about whether
an error came from a misunderstanding or other cause that would have
resulted in yet more errors during the period. An auditor is expected to
report all irregularities to the audit committee or the board of directors and
senior management.
8. Give examples of conditions or events which increase the risk of fraud or
error.
Answer: Refer to pages 436 to 437 of the textbook.
9. Discuss briefly the auditor’s responsibility of reporting suspicion of fraud to:
a. Management
b. Users of the auditor’s report
c. Regulatory and enforcement authorities
Answer:
Refer to pages 549 to 550 of the textbook.
10. PSA 320 states that the auditor should consider materiality and its
relationship with audit risk when conducting an audit. Explain briefly the
relationship between materiality and audit risk.
Answer:
PSA 320 states… that materiality and audit risk are considered throughout
the audit, in particular, when:
(a) Identifying and assessing the risks of material misstatement;
(b) Determining the nature, timing and extent of further audit procedures;
and
(c) Evaluating the effect of uncorrected misstatements, if any, on the
financial statements and in forming the opinion in the auditor’s report.
11. What factors should an auditor consider in assigning planning materiality
to accounts?
Answer:
The factors that should be considered are the peso amount of the account,
the likelihood of error, and the cost of auditing the account.
12. At what point in the audit process does the auditor deal with inherent risk?
With control risk?
Answer:
The auditor deals with both inherent risk and control risk during the planning
phase of the audit. Inquiry of client personnel, study of the business and
industry, application of analytical procedures, and documentation of the
auditor’s initial understanding of internal control are all performed during
the planning phase of the audit. Further study of internal control
procedures may occur after the planning phase if the auditor wishes to
further reduce the assessed level of control risk, and considers it
economically feasible to do so.
Multiple Choice Answers
Cases
1.
Answers:
a. Antonio’s activity is an irregularity (intentional distortion of financial
statements) rather than error (unintentional mistake). It is also an illegal
act on Antonio’s individual part.
b. The problem does not describe the kind of related party transactions
discussed in PSA 550.
PSA 550 Definition of a Related Party (Ref: Para. 10(b))
A4. Many financial reporting frameworks discuss the concepts of control
and significant influence. Although they may discuss these concepts
using different terms, they generally explain that:
(a) Control is the power to govern the financial and operating
policies of an entity so as to obtain benefits from its activities; and
(b) Significant influence (which may be gained by share ownership,
statute or agreement) is the power to participate in the financial and
operating policy decisions of an entity, but is not control over those
policies.
A5.The existence of the following relationships may indicate the
presence of control or significant influence:
(a) Direct or indirect equity holdings or other financial interests in the
entity.
(b) The entity’s holdings of direct or indirect equity or other financial
interests in other entities.
(c) Being part of those charged with governance or key
management (i.e., those members of management who have the
authority and responsibility for planning, directing and controlling the
activities of the entity).
(d) Being a close family member of any person referred to in
subparagraph (c).
(e) Having a significant business relationship with any person referred
to in subparagraph (c). Related Parties with Dominant Influence.
A6. Related parties, by virtue of their ability to exert control or significant
influence, may be in a position to exert dominant influence over the
entity or its management. Consideration of such behavior is relevant
when identifying and assessing the risks of material misstatement due to
fraud, as further explained in paragraphs A29-A30. Special-Purpose
Entities as Related Parties.
A7. In some circumstances, a special-purpose entity 17 may be a
related party of the entity because the entity may in substance control
it, even if the entity owns little or none of the special-purpose entity’s
equity.
c. Yes. a weakness in internal control exists. It may be considered a
material weakness because the compensating control (internal
auditors’ work on slow-moving inventory) did not operate in a timely
enough manner to detect the irregularity before it had gotten large.
If a material weakness in internal control exists, Brava & Campos are
obligated to report it to management and/or the board of directors.
d. The problem description indicates that this element of the audit was
conducted in a negligent manner. There’s nothing wrong about
auditing a sample of the transactions, but Campos’ follow-up and
explanation of the missing receiving reports leaves much to be desired.
At the very least he could have reviewed the reports produced by
Antonio at a later date, and he could have traced the purchases to the
inventory records and perhaps noticed an over-stocking condition. The
auditors had some evidence that an irregularity might exist, but they
failed to apply extended audit procedures properly.
2.
Answer:
a. Yes. Nicolas was a party to the issuance of false financial statements
and as such is a joint tortfeasor. The elements necessary to establish an
action for common law fraud are present. There was a material
misstatement of fact, knowledge of falsity (scienter), intent that the
plaintiff bank rely on the false statement, actual reliance and damage
to the bank as a result thereof. If action is based upon fraud there is no
requirement that the bank establish privity of contract with the CPA.
Moreover, if the action by the bank is based upon ordinary negligence,
which does not require a showing of scienter, the bank may recover as
a third-party beneficiary (an exception to the strict privity requirement).
Thus, the bank will be able to recover its loss from Nicolas under either
theory.
b. No. The lessor was a party to the secret agreement. As such, the lessor
cannot claim reliance on the financial statements and cannot recover
uncollected rents. Even if he was damaged indirectly, his own
fraudulent actions led to his loss, and the equitable principle of “unclean
hands” precludes him from obtaining relief.
c. Nicolas was not independent. His report is improper and he is probably
subject to disciplinary action by the professional organization or
regulatory body. According to the ethics interpretation on actual or
threatened litigation:
“An expressed intention by the present management to commence
litigation against the auditor alleging deficiencies in audit work for the
client is considered to impair independence if the auditor concludes
that there is a strong possibility that such a claim will be filed.”
CHAPTER 13
CORPORATE GOVERNANCE AND AUDITS
Questions and Answers
1. Define “corporate governance” and identify the key parties involved in
effective corporate governance.
Answer:
Corporate governance is defined as:
“a process by which the owners and creditors of an
organization exert control and require accountability for the
resources entrusted to the organization. The owners (stockholders)
elect a board of directors to provide oversight of the organization’s
activities and accountability back to its stakeholders.”
The key players in corporate governance are the stockholders (owners),
board of directors, audit committees, management, regulatory bodies,
and both internal and external auditors.
2.
Identify the parties that, at least to some degree, failed to meet
their corporate governance objectives in the past decades.
Answer:
In the past decade, all parties failed to a certain extent. For detailed
analysis, see exhibit in the chapter and repeated here:
Corporate Governance Responsibilities and Failures
Party
Stockholders
Board of
Directors
Management
Overview of Corporate
Overview of Responsibilities
Governance Failures
Broad Role: Provide effective Focused
on
short-term
oversight through election of prices; failed to perform
Board process, approve major long-term growth analysis;
initiatives, buy or sell stock.
abdicated all responsibilities
to management as long as
stock price increased.
Broad
Role:
the
major
representative of stockholders to
ensure that the organization is run
according to the organization
charter and there is proper
accountability.
Specific activities include:
 Selecting management.
 Reviewing management
performance
and
determining
compensation.
 Declaring dividends
 Approving major changes,
e.g. mergers
 Approving
corporate
strategy
 Overseeing accountability
activities.
 Inadequate oversight of
management.
 Approval of management
compensation
plans,
particularly stock options
that provided perverse
incentives,
including
incentives to manage
earnings.
 Non-independent, often
dominated
by
management.
 Did not spend sufficient
time or have sufficient
expertise
to
perform
duties.
 Continually re-priced stock
options when market price
declined.
Broad Role:
Operations and  Earnings management to
Accountability. Managing the
meet
analyst
organization
effectively
and
expectations.
provide accurate and timely  Fraudulent
financial
accountability to shareholders
reporting.
and other stakeholders.
Specific activities include:
Party
Overview of Corporate
Overview of Responsibilities
Governance Failures
 Formulating strategy and  Pushing
accounting
risk appetite.
concepts
to
achieve
 Implementing
effective
reporting objective.
internal controls.
 Viewed accounting as a
 Developing
financial
tool, not a framework for
reports.
accurate reporting.
 Developing other reports to
meet public, stakeholder,
and
regulatory
requirements.
Audit
Committees
of the Board
of Directors
Broad Role: Provide oversight of  Similar to Board members –
the internal and external audit
did not have expertise or
function and the process of
time to provide effective
preparing the annual accuracy
oversight
of
audit
financial statements and public
functions.
reports on internal control.
 Were not viewed by
Specific activities include:
auditors as the ‘audit
 Selecting the external audit
client’. Rather the power
firm.
to hire and fire the auditors
 Approving any non-audit
often
rested
with
work performed by audit
management.
firm.
 Selecting
and/or
approving
the
appointment of the Chief
Audit Executive (Internal
Auditor),
 Reviewing and approving
the scope and budget of
the internal audit function.
 Discussing audit findings
with internal auditor and
external
auditor
and
advising the Board (and
management) on specific
actions that should be
taken.
SelfRegulatory
Organizations:
AICPA, FASB
Broad Role: Setting accounting  AICPA: Peer reviews did
and auditing standards dictating
not
take
a
public
underlying financial reporting
perspective; rather than
and auditing concepts. Set the
looked at standards that
expectations of audit quality and
were developed and
accounting quality.
reinforced internally.
Specific roles include:
 AICPA:
Leadership
 Establishing
accounting
transposed
the
principles
organization for a public
Party
Overview of Corporate
Overview of Responsibilities
Governance Failures
 Establishing
auditing
organization to a “trade
standards
association” that looked
 Interpreting
previously
for revenue enhancement
issued standards
opportunities
for
its
 Implementing
quality
members.
control processes to ensure  AICPA: Did not actively
audit quality.
involve third parties in
 Educating members on
standard setting.
audit and accounting  FASB: Became more rulerequirements.
oriented in response to (a)
complex
economic
transactions; and (b) an
auditing profession that
was more oriented to
pushing the rules rather
than enforcing concepts.
 FASB:
Pressure from
Congress to develop rules
that enhanced economic
growth,
e.g.
allowing
organizations
to
not
expense stock options.
Other SelfRegulatory
Organizations,
e.g. NYSE,
NASD
Broad Role:
Ensuring the  Pushed for improvements
efficiency of the financial markets
for
better
corporate
including oversight of trading and
governance procedures
oversight of companies that are
by its members, but failed
allowed to trade on the
to implement those same
exchange.
Specific activities
procedures
for
its
include:
governing
board,
 Establishing
listing
management,
and
requirements – including
trading specialists.
accounting requirements,
governance requirements,
etc.
 Overseeing
trading
activities,
Regulatory
Agencies: the
SEC
Broad Role: Ensure the accuracy,  Identified problems but
timeliness, and fairness of public
was
never
granted
reporting of financial and other
sufficient resources by
information
for
public
Congress
or
the
companies.
Specific activities
Administration to deal with
include:
the issues.
 Reviewing all mandatory
filings with the SEC,
Party
External
Auditors
Internal
Auditors
Overview of Responsibilities
 Interacting with the FASB in
setting
accounting
standards,
 Specifying independence
standards
required
of
auditors that report on
public
financial
statements,
 Identify corporate frauds,
investigate causes, and
suggest remedial actions.
Broad Role: Performing audits of
company financial statements to
ensure that the statements are
free of material misstatements
including misstatements that may
be due to fraud.
Specific activities include:
 Audits of public company
financial statements,
 Audits
of
non-public
company
financial
statements,
 Other accounting related
work such as tax or
consulting.
Overview of Corporate
Governance Failures
 Pushed
accounting
concepts to the limit to
help
organizations
achieve
earnings
objectives.
 Promoted
personnel
based on ability to sell
“non-audit products”.
 Replaced direct tests of
accounting balances with
a greater use of inquiries,
risk analysis, and analytics.
 Failed to uncover basic
frauds in cases such as
WorldCom
and
HealthSouth
because
fundamental
audit
procedures
were
not
performed.
Broad Role: Perform audits of  Focused
efforts
on
companies for compliance with
‘operational audits’ and
company policies and laws,
assumed that financial
audits to evaluate the efficiency
auditing was addressed
of operations, and audits to
sufficiently by the external
determine the accuracy of
audit function.
financial reporting processes.
 Reported
primarily
to
Specific activities include:
management with little
 Reporting
results
and
effective reporting to the
analyses to management,
audit committee.
(including
operational  In
some
instances
management), and audit
(HealthSouth, WorldCom)
committees,
did not have access to the
 Evaluating
internal
corporate
financial
controls.
accounts.
3. In what ways were the board of directors responsible for corporate
governance failures in the past decades?
Answer:
The board of directors is often at the top of the list when it comes to
responsibility for corporate governance failures. Some of the problems
with the board of directors included:
o Inadequate oversight of management.
o Approval of management compensation plans, particularly stock
options that provided perverse incentives, including incentives to
manage earnings.
o Non-independent, often dominated by management.
o Did not spend sufficient time or have sufficient expertise to perform
duties.
o Continually re-priced stock options when market price declined.
4. In what ways was the
auditing profession partially responsible for
corporate governance failures in the past decades?
Answer:
Some of the ways the auditing profession was responsible were:





Too concerned about creating “revenue enhancement”
opportunities for the firm, and less concerned about their core
services or talents
Were willing to “push” accounting standards to the limit to help
clients achieve earnings goals
Began to use more audit “shortcuts” such as inquiry and analytical
procedures instead of direct testing of account balance.
Relied on management representations instead of testing
management representations.
Were too often ‘advocates’ of management rather than protectors
of users
5.What should users reasonably expect from the audit profession?
Answer:
Users should expect auditors to have the expertise, independence, and
professional skepticism to render an unbiased and justified opinion on the
financial statements. Auditors are expected to gather sufficient
applicable evidence to render an independent opinion on the financial
statements.
6. To whom do a company’s financial statements belong: management, the
audit committee, or the auditor? Explain and discuss why the ownership
issue is important.
Answer:
Management is responsible for issued financial statements. Although other
parties may be sued for what is contained in the statements, management
is ultimately responsible. Ownership is important because it establishes
responsibility and accountability. Management must set up and monitor
financial reporting systems that help it meet its reporting obligations. It
cannot delegate this responsibility to the auditors.
7. What is an audit committee? What critical role does the audit committee
play in corporate governance?
Answer:
An audit committee is a subcommittee of the board of directors that is
composed of independent, outside directors. The audit committee has
oversight responsibility (on behalf of the full board of directors and its
stockholders) for the outside reporting of the company (including annual
financial statements); risk monitoring and control processes; and both
internal and external audit functions.
8. An audit committee should be composed of outside directors. Define
“independent directors” within the context of an audit committee. How
does the existence of an audit committee affect the auditor’s
independence? Explain.
Answer:
An outside director is not a member of management, legal counsel, a
major vendor, outside service provider, former employee, or others who
may have a personal relationship with management that might impair their
objectivity or independence.
The audit committee is responsible for assessing the independence of the
external auditor and engage only auditors it believes are independent.
Auditors are now hired and fired by audit committee members, not
management.
The intent is to make auditor accountability more
congruent with stockholder and third-party needs.
9.
Identify the specific items that must be communicated by the
external auditor to audit committee on every engagement.
Answer:
The external auditor should 1) discuss any controversial accounting
choices with the audit committee and 2) must communicate all
significant adjustments made to the financial statements during the
course of the audit. In addition, 3) the processes used in making
judgments and 4) estimates as well as any disagreements with
management should be communicated. Other items that need to be
communicated include:
5) All adjustments that were not made during the course of the audit;
6) Difficulties in conducting the audit;
7) The auditor’s assessment of the accounting principles used and overall
fairness of the financial presentation;
8) The client’s consultation with other auditors;
9) Any consultation with management before accepting the audit
engagement;
10)Significant deficiencies in internal control.
10. How would an auditor go about assessing the quality of an organization’s
corporate governance?
Answer:
The auditor might utilize the following procedures in determining the actual
level of governance in an organization:
1. observe the functioning of the audit committee by participating in
the meetings, noting the quality of the audit committee questions
and responses;
2. interactions with management regarding issues related to the
audit, e.g. :
a) providing requested information on a timely basis,
b) quality of financial personnel in making judgments,
c) accounting choices that tend to ‘push the limits’ towards
aggressiveness or creating additional reported net income,
d) the quality of internal controls within the organization.
3. review the minutes of the board of directors meetings to determine
that they are consistent with good governance;
4. review internal audit reports and especially determine the actions
taken by management concerning the internal auditor’s findings
and recommendations;
5. review the compensation plan for top management;
6. review management expense reimbursements to determine:
(a) completeness of documentation,
(b) appropriateness of requested reimbursement, and
(c) extent of such requests.
7. review management’s statements to the financial press to
determine if they are consistent with the company’s operations.
Multiple Choice Answers:
Cases
1.
Answer:
a. The auditor might use the following approaches to determine
whether a corporate code of ethics is actually followed:
1. observe corporate behavior in tests performed during the audit,
e.g. approaches the company takes to purchasing goods,
promoting personnel, and so forth;
2. observe criteria for promoting personnel; for example does
performance always take on greater importance than how things
are done;
3. observe corporate plans to communicate the importance of
ethical behavior, e.g. webcasts, emails, and so forth to
communicate the importance of ethics;
4. review activity on the client’s whistle blowing website, or a
summary of whistle blowing activities reported by the internal
auditor;
5. read a sample of self-evaluations by corporate officers, the
board, and the audit committee and compare with the auditor’s
observations of behavior;
6. examine sales transactions made during the end of quarters to
determine if the sales reflect ‘performance goals’ as opposed to
the company’s code of ethics.
b. Are auditors equipped to make subjective judgments? This should
be a great discussion question because many young people are
attracted to the accounting profession because there are rules and
relative certainty as to how things are done. However, as the
profession is evolving, more judgments are required in both auditing
and accounting. Audit personnel need to be equipped to make
judgments on whether the company’s governance structure operates
as intended and whether there are deficiencies in internal control
when it does not operate effectively. The profession believes that
auditors can make such judgments.
c. Assessing the competence of the audit committee can occur in a
number of ways. Fortunately, the most persuasive evidence comes
from the auditor’s direct interaction with the audit committee on a
regular basis. The auditor can determine the nature of questions
asked, the depth of understanding shared among audit committee
members, and the depth of items included in the audit committee
agenda. Many audit committees have self-assessment of their
activities using criteria developed by CPA firms, or by the National
Association of Corporate Directors. The auditor should also review the
minutes of the audit committee meetings and determine the amount
of time spent on important issues.
An external auditor should be very reluctant to accept an audit
engagement where the audit committee is perceived to be weak.
There are a number of reasons including:
a) The lack of good governance most likely influences the
organization’s culture and is correlated with a lack of
commitment to good internal control.
b) The auditor has less protection from the group that is designed
to assist the auditor in achieving independence.
c) The company may be less likely to be fully forthcoming in
discussions with the auditor regarding activities that the auditor
might question.
d. Internal auditing is an integral part of good corporate governance.
It contributes to corporate governance in three distinct ways:
a) It assists the audit committee in its oversight role by performing
requested audits and reporting to the audit committee,
b) It assists senior management in assessing the continuing quality
of its oversight over internal control throughout the
organization,
c) It assists operational management by providing feedback on
the quality of its operations and controls.
2.
Answer:
a. Corporate governance is defined as:
“a process by which the owners and creditors of an organization
exert control and require accountability for the resources entrusted
to the organization. The owners (stockholders) elect a board of
directors to provide oversight of the organization’s activities and its
accountability to stakeholders.”
The key players in corporate governance are the stockholders
(owners), board of directors, audit committees, management,
regulatory bodies, and auditors (both internal and external).
b.
In the past decade especially, all parties failed to a certain extent.
For detailed analysis, see exhibit 2.2 in the chapter and reproduced
below:
Corporate Governance Responsibilities and Failures
Party
Stockholders
Board of
Directors
Management
Overview of Corporate
Overview of Responsibilities
Governance Failures
Broad Role: Provide effective Focused
on
short-term
oversight through election of prices; failed to perform
Board process, approve major long-term growth analysis;
initiatives, buy or sell stock.
abdicated all responsibilities
to management as long as
stock price increased.
Broad
Role:
the
major
representative of stockholders to
ensure that the organization is run
according to the organization
charter and there is proper
accountability.
Specific activities include:
 Selecting management.
 Reviewing management
performance
and
determining
compensation.
 Declaring dividends
 Approving major changes,
e.g. mergers
 Approving
corporate
strategy
 Overseeing accountability
activities.
 Inadequate oversight of
management.
 Approval of management
compensation
plans,
particularly stock options
that provided perverse
incentives,
including
incentives to manage
earnings.
 Non-independent, often
dominated
by
management.
 Did not spend sufficient
time or have sufficient
expertise
to
perform
duties.
 Continually re-priced stock
options when market price
declined.
Broad Role:
Operations and  Earnings management to
Accountability. Managing the
meet
analyst
organization
effectively
and
expectations.
provide accurate and timely  Fraudulent
financial
accountability to shareholders
reporting.
and other stakeholders.
Party
Overview of Corporate
Overview of Responsibilities
Governance Failures
Specific activities include:
 Pushing
accounting
 Formulating strategy and
concepts
to
achieve
risk appetite.
reporting objective.
 Implementing
effective  Viewed accounting as a
internal controls.
tool, not a framework for
 Developing
financial
accurate reporting.
reports.
 Developing other reports to
meet public, stakeholder,
and
regulatory
requirements.
Audit
Committees
of the Board
of Directors
Broad Role: Provide oversight of  Similar to Board members –
the internal and external audit
did not have expertise or
function and the process of
time to provide effective
preparing the annual accuracy
oversight
of
audit
financial statements and public
functions.
reports on internal control.
 Were not viewed by
Specific activities include:
auditors as the ‘audit
 Selecting the external audit
client’. Rather the power
firm.
to hire and fire the auditors
 Approving any non-audit
often
rested
with
work performed by audit
management.
firm.
 Selecting
and/or
approving
the
appointment of the Chief
Audit Executive (Internal
Auditor),
 Reviewing and approving
the scope and budget of
the internal audit function.
 Discussing audit findings
with internal auditor and
external
auditor
and
advising the Board (and
management) on specific
actions that should be
taken.
SelfRegulatory
Organizations:
AICPA, FASB
Broad Role: Setting accounting  AICPA: Peer reviews did
and auditing standards dictating
not
take
a
public
underlying financial reporting
perspective; rather than
and auditing concepts. Set the
looked at standards that
expectations of audit quality and
were developed and
accounting quality.
reinforced internally.
Specific roles include:
 AICPA:
Leadership
transposed
the
Party
Overview of Corporate
Overview of Responsibilities
Governance Failures
 Establishing
accounting
organization for a public
principles
organization to a “trade
 Establishing
auditing
association” that looked
standards
for revenue enhancement
 Interpreting
previously
opportunities
for
its
issued standards
members.
 Implementing
quality  AICPA: Did not actively
control processes to ensure
involve third parties in
audit quality.
standard setting.
 Educating members on  FASB: Became more ruleaudit and accounting
oriented in response to (a)
requirements.
complex
economic
transactions; and (b) an
auditing profession that
was more oriented to
pushing the rules rather
than enforcing concepts.
 FASB:
Pressure from
Congress to develop rules
that enhanced economic
growth,
e.g.
allowing
organizations
to
not
expense stock options.
Other SelfRegulatory
Organizations,
e.g. NYSE,
NASD
Broad Role:
Ensuring the  Pushed for improvements
efficiency of the financial markets
for
better
corporate
including oversight of trading and
governance procedures
oversight of companies that are
by its members, but failed
allowed to trade on the
to implement those same
exchange.
Specific activities
procedures
for
its
include:
governing
board,
 Establishing
listing
management,
and
requirements – including
trading specialists.
accounting requirements,
governance requirements,
etc.
 Overseeing
trading
activities,
Regulatory
Agencies: the
SEC
Broad Role: Ensure the accuracy,  Identified problems but
timeliness, and fairness of public
was
never
granted
reporting of financial and other
sufficient resources by
information
for
public
Congress
or
the
companies.
Specific activities
Administration to deal with
include:
the issues.
 Reviewing all mandatory
filings with the SEC,
Party
External
Auditors
Internal
Auditors
c.
Overview of Responsibilities
 Interacting with the FASB in
setting
accounting
standards,
 Specifying independence
standards
required
of
auditors that report on
public
financial
statements,
 Identify corporate frauds,
investigate causes, and
suggest remedial actions.
Broad Role: Performing audits of
company financial statements to
ensure that the statements are
free of material misstatements
including misstatements that may
be due to fraud.
Specific activities include:
 Audits of public company
financial statements,
 Audits
of
non-public
company
financial
statements,
 Other accounting related
work such as tax or
consulting.
Broad Role: Perform audits of
companies for compliance with
company policies and laws,
audits to evaluate the efficiency
of operations, and audits to
determine the accuracy of
financial reporting processes.
Specific activities include:
 Reporting
results
and
analyses to management,
(including
operational
management), and audit
committees,
 Evaluating
internal
controls.
Overview of Corporate
Governance Failures
 Pushed
accounting
concepts to the limit to
help
organizations
achieve
earnings
objectives.
 Promoted
personnel
based on ability to sell
“non-audit products”.
 Replaced direct tests of
accounting balances with
a greater use of inquiries,
risk analysis, and analytics.
 Failed to uncover basic
frauds in cases such as
WorldCom
and
HealthSouth
because
fundamental
audit
procedures
were
not
performed.
 Focused
efforts
on
‘operational audits’ and
assumed that financial
auditing was addressed
sufficiently by the external
audit function.
 Reported
primarily
to
management with little
effective reporting to the
audit committee.
 In
some
instances
(HealthSouth, WorldCom)
did not have access to the
corporate
financial
accounts.
There is an inverse relationship between corporate governance and
risk to the auditor i.e. the better the quality of corporate governance,
the lower the risk to the auditor. This relationship occurs because
lower levels of corporate governance implies two things for the
auditor:


There is more likelihood that the organization will have
misstatements in its financial statements because the
commitment to a strong organizational structure and oversight
is missing,
There is greater risk to the auditor because the governance
structure is not designed to prevent/detect such
misstatements, and will likely not be as forthcoming when the
auditor questions potential problems.
3.
Answer:
Element of Poor
Corporate Governance
The company is in the
financial services sector
and has a large number
of
consumer
loans,
including
mortgages,
outstanding.
The CEO and CFO’s
compensation is based
on three components:
(a) base salary, (b)
bonus based on growth
in assets and profits, and
(c)
significant
stock
options.
Audit Activity to
Determine if
Governance is actually
Poor
This is not necessarily
poor
governance.
However, the auditor
needs to determine the
amount of risk that is
inherent in the current
loan
portfolio
and
whether the risk could
have been managed
through
better
risk
management by the
organization.
This is a rather common
compensation package
and, by itself, is not
necessarily
poor
corporate governance.
However, in combination
with other things, the use
of
‘significant
stock
options’ may create an
incentive
for
management
to
Risk Implication of Poor
Governance
The lack of good risk
management by the
organization
increases
the risk that the financial
statements
will
be
misstated because of
the
difficulty
of
estimating
the
allowance
for
loan
losses. The auditor will
have to focus increased
efforts on estimating loan
losses,
including
a
comparison of how the
company is doing in
relation to the other
companies
in
the
financial sector.
In
combination
with
other things, the use of
‘significant stock options’
may create an incentive
for
management
to
potentially
manage
reported earnings in
order to boost the price
of the company’s stock.
Element of Poor
Corporate Governance
The audit committee
meets semi-annually. It is
chaired by a retired CFO
who knows the company
well because she had
served as the CFO of a
division of the firm before
retirement.
The other
two members are local
community members –
one is the President of
the
Chamber
of
Commerce and the
other
is
a
retired
executive
from
a
successful
local
manufacturing firm.
Audit Activity to
Determine if
Governance is actually
Poor
potentially
manage
reported earnings in
order to boost the price
of the company’s stock.
The
auditor
can
determine if it is poor
corporate governance
by
determining
the
extent
that
other
safeguards are in place
to protect the company.
There is a strong indicator
of
poor
corporate
governance. If the audit
committee meets only
twice a year, it is unlikely
that
it
is
devoting
appropriate amounts of
time to its oversight
function,
including
reports from both internal
and external audit.
There is another problem
in that the chair of the
audit committee was
previously employed by
the company and would
not meet the definition of
an
independent
director.
Finally, the problems with
the other two members is
that there is no indication
that either of them have
sufficient
financial
expertise.
The company has an The good news is that the
internal auditor who organization
has
an
reports directly to the internal audit activity.
CFO, and makes an
annual report to the
audit committee.
Risk Implication of Poor
Governance
The
auditor
should
carefully examine if the
company’s
reported
earnings and stock price
differs
broadly
from
companies in the same
sector. If that is the case,
there is a possibility of
earnings
manipulation
and the auditor should
investigate to see if such
manipulation
is
occurring.
This is an example of poor
governance because (1)
it
signals
that
the
organization has not
made a commitment to
independent oversight
by the audit committee,
(2) the lack of financial
expertise means that the
auditor does not have
someone independent
that they can discuss
controversial accounting
or audit issues that arise
during the course of the
audit.
If there is a
disagreement
with
management, the audit
committee does not
have the expertise to
make
independent
judgments on whether
the
auditor
or
management has the
appropriate view of the
accounting or audit
issues.
The bad news is that a
staff
of
one
isn’t
necessarily as large or as
diverse as it needs to be
to cover the major risks of
the organization.
The
Element of Poor
Corporate Governance
The CEO is a dominating
personality – not unusual
in this environment. He
has been on the job for 6
months
and
has
decreed that he is
streamlining
the
organization to reduce
costs
and
centralize
authority (most of it in
him).
The Company has a loan
committee.
It meets
quarterly to approve, on
an ex-post basis all loans
that are over $300 million
(top
5%
for
this
institution).
Audit Activity to
Determine if
Governance is actually
Poor
A dominant CEO is not
especially unusual, but
the centralization
of
power in the CEO is a risk
that many aspects of
governance, as well as
internal control could be
overridden. The auditor
should look at policy
manuals, as well as
interview other members
of management and the
board – especially the
audit committee.
The
auditor
should
observe the minutes of
the loan committee to
verify its meetings. The
auditor
should
also
interview the chairman
of the loan committee to
understand
both
its
policies and its attitude
towards controls and risk.
Risk Implication of Poor
Governance
external auditor will be
more
limited
in
determining the extent
that his or her work can
rely on the internal
auditor.
The centralization of
power in the CEO is a risk
that many aspects of
governance, as well as
internal control could be
overridden.
This
increases the amount of
audit risk.
There are a couple of
elements
in
this
statement that carries
great risk to the audit
and to the organization.
First, the loan committee
only meets quarterly.
Economic
conditions
change more rapidly
than once a quarter,
and thus the review is not
timely. Second, the only
loans reviewed are (a)
large loans that (b) have
already been made.
Thus, the loan committee
does not act as a control
or
a
check
on
management or the
organization. The risk is
that many more loans
than would be expected
could be delinquent,
and need to be written
down.
Element of Poor
Corporate Governance
The previous auditor has
resigned because of a
dispute regarding the
accounting
treatment
and
fair
value
assessment of some of
the loans.
Audit Activity to
Determine if
Governance is actually
Poor
The
auditor
should
contact the previous
auditor to obtain an
understanding as to the
factors that led the
previous auditor to either
resign or be fired. The
auditor is also concerned
with who led the charge
to get rid of the auditor.
Risk Implication of Poor
Governance
This is a very high risk
indicator.
The auditor
would look extremely
bad if the previous
auditor resigned over a
valuation issue and the
new auditor failed to
adequately address the
same issue.
Second, this is a risk
factor
because
the
organization shows that it
is willing to get rid of
auditors with whom they
do not agree. This is a
problem
of
auditor
independence
and
coincides
with
the
above identification of
the weakness of the
audit committee.
This
action
confirms
a
generally poor quality of
corporate governance.
4.
Answer:
a&b. Cookie jar reserves are essentially funds that companies have
“stashed away” to use when times get tough. The rationale is that
the reserves are then used to “smooth” earnings in the years when
earnings needs a boost. “Smooth” earnings typically are looked
upon more favorably by the stock market. An example of a cookie
jar reserve would be over-estimating an allowance account, such
as allowance for doubtful accounts. The allowance account is
then written down (and into the income statement) in a bad year.
“smooth” earnings-The use of accounting techniques to level
out net income fluctuations from one period to the next.
Companies indulge in this practice because investors are generally
willing to pay a premium for stocks with steady and
predictable earnings streams, compared with stocks
whose earnings are subject to wild fluctuations.
“stashed away”- means keep or lay aside for future use.
Auditors may have allowed cookie jar reserves because they are
known to smooth earnings, and smooth earnings are rewarded by
the market. On the flip side, fluctuating earnings are penalized, and
present more risk to the company of bankruptcy or other problems.
The Sarbanes-Oxley Act addressed the issue by creating an oversight
body, the PCAOB, but also addressed the issue in other ways. For
example, Congress felt that creating more effective Boards would
decrease the use of earnings management.
Allowing improper revenue recognition is one thing that auditors may
have done in their unwillingness to say “no” to clients. For example,
companies shipped out goods to customers at the end of the year
for deep discounts and allowed returns at the beginning of the next
year. This practice is known as channel stuffing. Since the goods had
a great chance of being returned, it would be improper to recognize
all as revenue.
deep discount-a large or greater than usual reduction in price or
substantially
more
than
the
normal
discount.
channel stuffing- is a deceptive business practice used by a
company to inflate its sales and earnings figures by deliberately
sending retailers along its distribution channel more products than
they are able to sell to the public.
Again, auditors were unwilling to say “no” to clients. Greed is
probably the reason here. If companies claim more revenue, their
stock would grow in the short-term, making management richer, and
making management more willing to give pay raises to their auditors.
With the establishment of stronger audit committees and certification
of financial statements in the Sarbanes-Oxley Act, this kind of
accounting trickery will certainly decrease.
Creative accounting included the use of the “pooling” method of
accounting. Pooling allowed acquiring companies to value existing
assets at historical costs and did not require the recognition of
goodwill for the acquisition. Because true costs (values) were not
shown on the financial statements, management was often
encouraged to bid up prices for acquisitions with the result that many
of them were not economic. The creative accounting also shielded
the income statement from charges that would have otherwise hit
income including:
goodwill amortization, depreciation, and
depletion expenses.
Creative accounting consists of accounting practices that follow
required laws and regulations, but deviate from what those
standards intend to accomplish. Creative accounting capitalizes
on loopholes in the accounting standards to falsely portray a better
image of the company. Although creative accounting practices are
legal, the loopholes they exploit are often reformed to prevent such
behaviors.
Greed, the same reasons as the revenue recognition issue, was most
likely the motivation for this creative accounting.
Discussion between an educated audit committee and auditor plus
certification of financial statements required by Sarbanes-Oxley will
certainly address this issue.
Assisting management to meet earnings.
Too often, auditors
confused ‘financial engineering’ with value-adding. In other words,
auditors often sought to add value to their clients by finding ways to
push accounting to achieve earnings objectives sought by
management. These earnings objectives then played a major role in
escalating stock prices – all desired because of the heavy emphasis
of management compensation on stock options.
Incentives were misaligned. Most of management compensation
came in the form of stock options.
5.
Answer:
a. This is intended to be an open-ended discussion. There are a
number
of factors that have been mentioned in the discussions
regarding auditor independence. The following is representative of
some issues discussed:
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The audit firm’s policy for rotating auditors in charge of the
engagement,
Whether or not the client has hired personnel from the audit firm
for significant financial or management positions in the company,
such as the Chief Financial Officer was the former partner in
charge of the audit engagement,
The nature of non-audit services provided by the audit firm,
The existence of any social or other relationships with
management,
Audit committee experience with the audit firm in other situations,
such as the auditor provides services for other entities with which
the audit committee member has an association,
The existence of any charges brought against the auditing firm by
the SEC,
The audit firm’s involvement in significant lawsuits where their
judgment has been questioned,
The amount of fees charged by the auditing firm. If the audit fees
are too low, the audit committee should question the
thoroughness and independence of the work. If fees from nonaudit work are high, the audit committee will want to question
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that relationship and possible effect on judgments made by the
auditor.
The manner in which individual audit partners are compensated
by the public accounting firm. For example, if an audit partner’s
compensation is determined significantly by whether or not a
client is retained, then there might be questions about what the
auditor would do to retain the client.
The general reputation of the firm.
The firm’s policies and procedures for attracting and retaining
talented audit personnel.
The process of assigning personnel to an audit.
The firm’s expertise in the industry.
b.
The main way that the audit committee can influence the
independence of the internal audit department is by choosing who
is in charge of the department. The “tone at the top” in the internal
audit department will go a long way. Further, the audit committee
ought to approve the scope of the internal audit charter, approve
annual audit plans, as well as annual budgets.
c. 1.Tax Return for Company: Approval argument. The auditor is
already aware of all the information, so can efficiently prepare
the return. Tax accounting is different than audit accounting, so
accounting treatments can be different in both settings and will
not affect each other.
Non-Approval:
On the other hand, some argue that tax
preparation is a consulting activity, i.e. the auditor would need to
be a client advocate and thereby should not prepare the tax
return.
2. Tax Return for Management and Board Members: Approval: The
auditor is an expert. The services can be viewed as a benefit for
management and the board.
Not Approve: Performance of the tax services too closely aligns
the auditor with management and the board. The auditor has to
be a client advocate in developing the tax returns. This may
mentally conflict with the auditor’s need to be objective in all
other work involving the client.
3. Tax Return paid for by Managers, not company: Approval: This is
an independent service not paid for by the company.
Not Approve: The argument is the same as #2 above. Although
paid for by the individuals, there is still the possibility of conflict.
4. Overseas Assistance for Internal Audit Department: Do not
approve. It is the responsibility of management to prepare a
review of internal control, and the auditor does an independent
analysis. Further, the performance of internal audit work is one of
the areas that have been explicitly prohibited by the SEC.
5. Security Audit of Information Systems: Approve. This is not a
conflict of interest as it is an audit or assurance service.
6. Train Operating Personnel on Internal Controls: Approve. Auditors
are
experts on this area. There is no direct conflict with the
performance of the audit. Better trained personnel should imply
better internal controls –
beneficial for both management and
the auditor.
Not Approve. The PCAOB is explicit that management has the
responsibility to design, implement, and evaluate internal control.
Thus, training personnel is a management task that cannot be
performed by the auditor. It could, however, be performed by a
different public accounting firm.
7. Perform Internal Audit Work for the Company: Do not approve. It
is the responsibility of management to prepare a review of internal
control, and the auditor does an independent analysis. Usually
internal audit is responsible for “management’s” end of assessing
internal controls. The audit of effectiveness and efficiency is akin
to consulting and would be interpreted by most people as
compromising the auditor’s independence.
8. Provide, at no cost, Seminars to Audit Committee Members.
Approve. The audit committee can make a decision as to
whether a particular member will attend the seminar. It is one way
that an audit committee member can keep up on the profession.
The only potential problem would occur if the audit committee
only relied on the audit firm for updates on accounting and audit
issues.
9. Seminars for both Audit and Non-Audit Clients. Recommend
Approval. The key is whether the audit committee feels that it
may lose some of its objectivity in performing its oversight role.
CHAPTER 14
DESIGNING AN EFFECTIVE
RESPONSE TO ASSESSED RISKS
Questions and Answers
1. Identify the audit procedure that comprise inspection.
Answer:
Inspection techniques include physical examination of assets, examination
of documents and records, performance of mechanical accuracy tests,
and analytical procedures.
2. Explain how vouching differs from tracing, and identify the financial
statement assertions each can be used to test.
Answer:
Vouching and tracing are two types of commonly performed
documentation. Vouching involves the examination of documents that
served as a basis for recording the transaction. Vouching usually starts with
a recorded transaction and works back to the documents and addresses
existence. Tracing involves determining whether source documents have
been recorded properly in the accounting records. By tracing, an auditor
can obtain evidence that the recording of the transaction is complete.
3. How does a confirmation differ from an inquiry?
Answer:
An inquiry involves requesting information from client personnel and
receiving their response. The request and response may be either written
or oral. A confirmation is the process of obtaining a representation of
information or of an existing condition directly from a third party.
Confirmations are also used to obtain audit evidence about the absence of
certain conditions.. The response includes information about certain
transactions, relationships, and/or balances that have an impact on a
specific financial statement assertion.
4. Why is confirmation generally more reliable than inquiry?
Answer:
Confirmations are usually considered more reliable because they are from
outside parties, while inquiries are made of client personnel.
5. When may an auditor consider cost in deciding which audit procedures to
use?
Answer:
When equivalent procedures are available to satisfy the need for
evidence, an auditor may consider cost in selecting among the
alternatives.
6. Give an example of an audit procedure that is relevant to an assertion and
one that is not.
Answer:
Vouching is relevant to testing the existence of sales; tracing is not. Tracing
is relevant to testing the completeness of sales, but vouching is not.
Multiple Choice Answers
Cases
1.
Answer:
Types of procedures used by auditors in general, with examples:
1. Recalculation by the auditor
* recomputing the client’s calculation of depreciation expense
2. Observation by the auditor
* observation, test-counting of client’s physical inventory-taking
3. Confirmation by letter
* obtaining accounts receivable confirmations
* obtaining client’s lawyer’s letter
4. Inquiry and written representations
* ask client personnel about accounting events
* complete an internal control questionnaire
* obtain written client representation letter
5. Vouching
* find brokers’ invoices and cancelled checks showing agreement
with record amounts for securities investments
6. Tracing
* select a sample of shipping documents and trace them to sales
invoices, sales journal recording and posting to general ledger
7. Scanning
* scan expense accounts for credit entries
* scan payroll check lists for unusually large checks
8.
Analytical procedures – any example that fits one of these:
*
*
*
*
*
compare financial information with prior periods
compare financial information with budgets and forecasts
study predictable financial information patterns (e.g., ratio analysis)
compare financial information to industry statistics
study financial information in relation to nonfinancial information
2.
Answer:
a. A material decline in sales may indicate unrecorded sales; a
decrease in cost of goods sold may be due to unrecorded purchases;
and an increase in cost of good sold may be the result of omissions from
the ending inventory. An increase or decrease in gross profit will result
from any one or a combination of the above omissions.
b. A decline in the miscellaneous revenue account balance, or the
absence of a previously existing source of miscellaneous revenue, could
be attributable to a failure to record miscellaneous revenue.
c. Unrecorded accounts payable at year-end would cause an
increase in calculated accounts payable turnover.
d. An apparent increase in accounts receivable turnover may, in fact,
be the result of failure to record credit sales transactions.
e. A higher than average operating return may be indicative of
unrecorded purchases or operating expenses; a lower than average
return could result from unrecorded sales.