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Frederick Choo

Financial and Integrated


Audits

Table of Contents
1 Financial and Integrated Audits

2 The Auditor's Professional Environment

23

3 The Auditor's Ethical Environment

47

4 The Auditor's Legal Environment

75

5 Audit Plan - Preplan and Documentation

103

6 Audit Plan - Objectives

137

7 Audit Plan - Evidence

165

8 Audit Plan - Internal Control

191

9 Audit Plan - Materiality and Risk

229

10 Audit Plan - Program and Technology

255

11 Audit Sampling for Tests of Controls

283

12 Audit Sampling for Tests of Balances

304

13 Revenue Cycle - TOC and TOB

324

14 Expenditure Cycle - TOC and TOB

362

15 Inventory Cycle - TOC and TOB

396

16 Payroll Cycle - TOC and TOB

430

17 Capital Cycle - TOC and TOB

452

18 General Cash and Investments - TOC and TOB

476

19 Completing the Audit

504

20 Audit Report

540

21 Other Audit Engagements

588

Appendix A

630

Appendix B

631

Appendixes C D E

632

Appendix F

633

Financial and Integrated Audits - Frederick Choo

Chapter 1
Financial and Integrated Audits
Chapter Learning Outcomes (LOs) Checklist
After reading this chapter, you should be able to:
LO1-1 Understanding the reason for auditing.
LO1-2 Distinguish among auditing, attestation, and assurance services.
LO1-3 Differentiate between financial audit and integrated audit.
LO1-4 Differentiate between assurance and consulting services.
LO1-5 Explain the different categories of audit and types of auditor.
LO1-6 Explain the organizational structure, category, and hierarchy of CPA firms.

1 Financial and Integrated Audits

Chapter 1 Financial and Integrated Audits


Definition of Auditing
Auditing may be defined as:
"A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions
and events to ascertain the degree of correspondence between those assertions and established criteria and
communicating the results to interested users."
Source: Committee on Basic Auditing Concepts, Statement of Basic Auditing Concepts AAA, 1973, p.2.

Several key phrases of this definition merit special comment in Table 1-1.
TABLE 1-1 Definition of Auditing

Key Phrase
A systematic process
Objectively evaluating and
examining of evidence
Assertions about economic actions
and events
Degree of correspondence between
assertions and established criteria
Communicating results to
interested users

Comments
Auditing is a logically structured and planned inquiry process.
Auditing involves independently obtaining and gathering evidence, such as confirmations of
balances, and objectively evaluating the sufficiency and appropriateness of this evidence.
These are assertions made explicitly and/or implicitly by the auditee with regard to the accounting
information presented to the auditor, for example, the auditee has valued inventories at the lower
of cost or market value.
Based on the evidence gathered, the auditor forms an opinion as to the closeness with which the
auditee's assertions comply with established standards and polices, for example, generally accepted
accounting principles (GAAP) and other statutory rules and regulations.
The auditor communicates the degree of correspondence between the auditee's assertions and
established criteria in the form of an audit report to interested parties that include stockholders,
lenders and creditors.

The Demand for Auditing


The definition of auditing can further be discussed in terms of a principal-agent framework that explains the demand
for auditing. See Figure 1-1 below for the relationships. First, stockholders (referred to as principals) of a
corporation appoint a board of directors who in turn hires a professional management team (referred to as agents) to
run the corporation. Second, both the stockholders and management seek to maximize their self-interest. Their
goals/activities are not necessarily congruent. Third, the stockholders appoint an outside independent party (an
external auditor) to monitor and report the goals/activities of the management. The auditor provides a form of
attestation service, an auditing service, to the stockholders. Fourth, the external auditor gathers and evaluates
evidence concerning the explicit and implicit assertions made by the management (auditees assertions) in the
financial statements and reports to the stockholders about the fairness of the financial statements presentation in the
form of an audit opinion report. If the managements financial statements are presented fairly, the auditor issues an
unqualified opinion report. On the other hand, if the managements financial statements are not presented fairly, the
auditor issues a qualified opinion report. See Table 1-2 for a brief description of the various types of audit opinion
report. A qualified audit opinion usually means that the managements financial statements contain material
misstatements. Misstatements may be in the form of errors, unintentional mistakes, or frauds, intentional
misrepresentations. Two common types of intentional misrepresentations are misappropriation of assets, also known
as employee fraud, and fraudulent financial reporting, also known as management fraud.
Table 1-2 Types of Audit Opinion Report
Types of Audit Opinion Report
Unqualified Opinion,
Standard Report
Unqualified Opinion,
Explanatory paragraph Added
Qualified Opinion

Brief Description

This report is issued when the auditor judges that the clients financial statements fairly present, in
all material respects, the financial position, results of operations, and cash flows in conformity with
GAAP.
This report is issued when the auditor judges that it is necessary to add a paragraph to explain
certain accounting related matters in a standard unqualified opinion report.
This report is issued when the auditor judges that the clients financial statements fairly present, in

Financial and Integrated Audits - Frederick Choo

Types of Audit Opinion Report

Brief Description
all material respects, the financial position, results of operations, and cash flows in conformity with
GAAP except for the material effect of certain accounting related matters to which the
qualification relates.
This report is issued when the auditor judges that the clients financial statements, taken as a whole,
do not fairly present the financial position, results of operations, and cash flows in conformity with
GAAP.
This report is issued when the auditor does not express an opinion on the clients financial
statements.

Adverse Opinion

Disclaimer of Opinion

Figure 1-1 The Demand for Auditing in a Principal-Agent Framework


XYZ Company
Stockholders

Board of Directors

XYZ Co.
Management
(Accountant)

Independent Auditor
(External)

Audit
Report
(Opinion)

Unqualified

Qualified
Attestation
Service
(Audit)

Financial Statements
containing
Managements
Implicit/Explicit
Assertions

Misstatement
Error

Fraud

Unintentional
Intentional
mistake
misrepresentation

Misappropriation
of assets
(Employee fraud)

Fraudulent
financial reporting
(Management fraud)

The Demand of Other Users


The principal-agent framework above focuses on the stockholders as a primary party demanding audited financial
statements. Besides the stockholders, there are a diversity of other users (other 3 rd parties) of the audited financial
statements. Table 1-3 describes other users of the audited financial statements.
Table 1-3 Other Users of Audited Financial Statements
User
Bondholders
Court System
Economists

Use of Audited Financial Statements


Assess the ability of a company to repay indebtedness.
Assess the financial position of a company in litigation.
Assess the effects of economic policies and the implications for public policy decisions.

1 Financial and Integrated Audits

User

Use of Audited Financial Statements

Financial Institutions
Labor Unions
Management
Potential investors
Regulatory Agencies
Taxing Authorities

Determine whether to make a loan to a company.


Assess the profitability of a company and the potential for future wages or profit sharing contracts.
Review performance and make decisions affecting future directions of a company.
Determine whether to invest in a company.
Determine whether regulatory action is necessary to protect the public.
Determine taxable income and tax due.

Type of Services
CPA firms provide five broad types of services as shown in Table 1-4.
Table 1-4 Five Broad Types of Services

Type of Service
Attestation services

Tax services

Management advisory
(consulting) services

Accounting services

Assurance services

Nature of Service
Attestation services are any professional services in which a CPA firm issues a written report that expresses
an opinion or conclusion about the reliability of a written assertion that is the responsibility of another party.
Attestation services include financial audit of private (non-publicly traded) companies and integrated audit
of public (publicly traded) companies; report on a client's internal control structure; review of private
companies' financial statements; examination of prospective financial statements, and application of agreedupon procedures on specific elements, accounts, or items of a financial statement. The AICPAs Auditing
Standard Board issues Statements on Auditing Standards (AUs), which provide guidance for CPAs who
perform financial audit for private companies. On the other hand, the SECs Public Company Accounting
Oversight Board (PCAOB) issues Auditing Standards (ASs), which provide guidance for CPAs who perform
integrated audit for public companies. Table 1-5 describes four broad types of attestation services.
See Appendix A for a list of the AUs and see Appendix B for a list of the ASs.
Tax services include preparation of tax returns, assistant in tax planning, and engagement in tax litigation.
The AICPA's Federal Taxation Executive Committee issues Statements on Responsibilities in Tax Practice
(SRTPs), which provide guidance for CPAs who perform tax services.
Management consulting services include design of accounting information systems, and engagement in
marketing study, and executive recruiting. The AICPA's Management Advisory Service Executive
Committee issues Statements on Standards for Management Advisory Services (SSMASs) , which provide
guidance for CPAs who perform management advisory services.
Accounting services include preparation of financial statements and compilation of financial statements. The
AICPA's Accounting and Review Services Committee issues Statements on Standards for Accounting and
Review Services (ARs), which provide guidance for CPAs who perform accounting services.
See Appendix D for a list of the ARs.
Assurance services are independent professional services that improve the quality of information, or its
context, for decision-makers. By this broad definition, assurance services include attestation services in that
they improve the quality of information for decision-makers by issuing a written report about the reliability
of certain written assertions of another party. Assurance services also encompass compilation services in
that they improve the quality of information for decision-makers by presenting (compiling) them as financial
statements in accordance with GAAP. However, assurance services do not include consulting services
although they often deliver a similar body of knowledge and skills. A key difference between assurance and
consulting services is the objective of the engagement. Assurance services are designed to optimize the
clients decision making whereas consulting services are designed to improve the clients outcomes or
conditions. The AICPA's Auditing Standards Board issues Statements on Standards for Attestation
Engagements (ATs), which provide guidance for CPAs who perform accounting services. Table 1-6
describes six common types of assurance services.
See Appendix C for a list of the ATs.

CPA firms provide four broad types of attestation services that are described in Table 1-5.
Table 1-5 Four Broad Types of Attestation services

Financial
Audit
(private company)

Integrated
Audit
(public company)

Four Broad Types of Attestation services

This type of service involves obtaining and evaluating evidence about a clients financial statements. The AICPAs
GAAP and Auditing Standard Boards Auditing Standard AU 700 require that auditors of private companies in the
United States to provide an opinion on the companys financial statements. Based on this financial audit, the auditor
issues a positive (means certain or confident) expression of opinion on whether the financial statements are presented
fairly in conformity with the GAAP and Auditing Standards. Figure 1-3 presents an overview of the financial audit.
This type of service involves obtaining and evaluating evidence about a clients internal control over financial
reporting (ICFR) and its financial statements. The Sarbanes-Oxley Act Section 404(b) and PCAOBs Auditing
Standard AS 5 require that auditors of public companies in the United States to provide an opinion on the effectiveness

Financial and Integrated Audits - Frederick Choo

Four Broad Types of Attestation services

Examination

Review

Agreed-upon
procedures

of the companys ICFR and an opinion on the companys financial statements. Based on this integrated audit, the
auditor issues an opinion on the effectiveness of the clients ICFR and an opinion on the fair presentation of the
financial statement in accordance with the standards of the PCAOB. Figure 1-4 presents an overview of the integrated
audit.
This type of service involves obtaining and evaluating evidence about a variety of situations which contain assertions
made by another party. The auditor performing this type of service normally follows the AICPAs Statements on
Standards for Attestation Engagements (ATs). Based on the examination, the auditor issues a positive expression of
opinion on whether the other partys assertion conforms to certain applicable criteria. Examples of examination
services include (1) prospective (rather than historical) financial statements, (2) managements assertions about the
effectiveness of a clients internal control structure, and (3) a clients compliance with specified laws and regulations.
This type of service involves inquiries of an audit clients management and comparative analyses of financial
information. The scope of this service is significantly less than that of an audit or examination in that it usually does
not involve obtaining and evaluating evidence. The auditor performing this type of service normally follows the
AICPAs Statements on Standards for Accounting and Review Services (ARs). Based on the review, the auditor issues a
negative (means uncertain or unconfident) expression of opinion on whether the financial statements are presented
fairly in conformity with established criteria such as GAAP. Thus, instead of stating a positive opinion that the
financial statements are presented fairly in conformity with GAAP, a negative opinion is usually stated as that we
are not aware of any material modifications that should be made to the statements in order for them to be in conformity
with GAAP. Examples of review services include (1) review of interim financial statements of public companies and
(2) review of annual financial statement of non-public companies.
This type of service involves the auditor, the client, and the intended users to agree on certain procedures to be
performed on specified financial statement/non-financial statement matters. The auditor performing this type of service
normally follows the AICPAs Statements on Standards for Attestation Engagements (ATs) for financial matters (e.g.,
gross sales account for a lease agreement) and non-financial statement matters (e.g., compliance with federal
affirmative action laws). Based on the agreed-upon procedures, the auditor issues a summary of findings report,
which does not include an opinion.

Figure 1-3 An Overview of the Financial Audit (Private Company)

Management

Financial Audit

Implements internal controls

Conducts transactions

Attests to managements
internal controls

Accumulates transactions
into account balances

Prepares financial statements

Issues financial statements

Attests to managements
financial statements

Issues audit report:


1. An opinion on the fair presentation
of the financial statements

1 Financial and Integrated Audits

Figure 1-4 An Overview of the Integrated Audit (Public Company)

Management

Integrated Audit

Reports on ICFR

Attests to managements
report on ICFR

Management Report on ICFR contains


an explicit statement on whether managements
assessment of ICFR is effective as of the end
of the period reported on

Issues audit report:


1. An opinion on the effectiveness of the
companys ICFR

Attests managements
financial statements

Prepares financial statements

Issues audit report:


2. An opinion on the fair presentation
of the financial statements

Issues financial statements

ICFR = Internal Control Over Financial Reporting

CPA firms offer a wide variety of other assurance services. The six common other assurance service are shown
in Table 1- 6. Chapter 21, Other Audit Engagements, provides more discussion on some other assurance services
and attestation services of the assurance services.
Table 1-6 Six Common Other Assurance Services

Type
Risk Assessment
Business Performance Measurement

Information Systems Reliability


Electronic Commerce

Healthcare Performance

Function

This assurance service identifies a clients profile of business risks and assesses whether the
client has appropriate systems in place to effectively manage those risks.
This assurance service evaluates whether a clients performance measurement system contains
relevant and reliable measures for assessing the degree to which the clients goals and objectives
are achieved or how its performance compares to its competitors.
This assurance service assesses whether a clients internal information systems (financial and
non-financial) provide reliable information for operating and financial decisions.
This service assesses whether systems and tools used in electronic commerce provide data
integrity, security, privacy, and reliability. See Figure 21-15 in Chapter 21 for an example of a
WebTrust report.
This assurance service assesses and reports on the quality of care delivered by health care

Financial and Integrated Audits - Frederick Choo

Type

Function

Measurement

systems, and to provide comparative analyses on costs and delivery systems.


This assurance service provides assistance to elderly people and their family members by
offering financial advice and measuring how effectively health care providers meet the needs of
the elderly and their families.

Elder Care

A diagrammatic representation of the relationship among the professional services is shown in Figure 1-2.
Figure 1-2 Relationships among Professional Services

Assurance Services

Nonassurance Services

Attestation services
Examination

Review

Financial
Audit

Integrated
Audit

Certain
Management
Consulting
Services
E.g.,
Fraud
Investigation

Management Consulting Services

Tax Services

Agreed-Upon Procedures
Accounting Services
Compilation
Risk Assessment

Web/SysTrust

XBRL

ElderCare Plus

Health Care

Performance Measurement

Source: Adapted from the Elliott Committee Report (AICPA, 1997)

The five broad types of services shown in Table 1-4 above fall into four categories of audit (see Table 1-7) and they
are usually conducted by several types of auditor (see Table 1-8).
Table 1- 7 Four Categories of Audit

Category of Audit
Financial audit

Integrated audit

Compliance audit

Operational audit

Nature of Work

This type of service involves obtaining and evaluating evidence about a clients financial statements.
The AICPAs GAAP and Auditing Standard Boards Auditing Standard AU 700 require that auditors of
private companies in the United States to provide an opinion on the companys financial statements.
Based on this financial audit, the auditor issues a positive (means certain or confident) expression of
opinion on whether the financial statements are presented fairly in conformity with the GAAP and
Auditing Standards. See Figure 1-3 for an overview of the financial audit.
This type of service involves obtaining and evaluating evidence about a clients internal control over
financial reporting (ICFR) and its financial statements. The Sarbanes-Oxley Act Section 404(b) and
PCAOBs Auditing Standard AS 5 require that auditors of public companies in the United States to
provide an opinion on the effectiveness of the companys ICFR and an opinion on the companys
financial statements. Based on this integrated audit, the auditor issues an opinion on the effectiveness of
the clients ICFR and an opinion on the fair presentation of the financial statement in accordance with
the standards of the PCAOB. See Figure 1-4 for an overview of the integrated audit.
A compliance audit involves reviewing internal controls, operational procedures, and regulations. This
type of audit attests whether internal procedures of management and external regulations of regulatory
authorities are complied with. The outcome of a compliance audit is a report prepared by (or
recommendation made by) the auditor to the management or the relevant authorities.
An operational audit involves analyzing organization structure, internal functions, workflow, and
managerial performance. This type of audit determines (or measures) the efficiency and effectiveness of
an organization. The outcome of an operational audit is a report prepared by (or recommendation made
by) the auditor to the management or the relevant authorities.

10

1 Financial and Integrated Audits

Table 1-8 Types of Auditor


Category of audit
Financial Audit
Integrated Audit
Compliance Audit
Operational Audit

IRA
IIA
DCA
CFE
CIA
CISA
CFP
CFF

Type of auditor

Affiliation

CPA

AICPA, CPA Associations

IRA, Internal Auditor, DCA


Federal and State Auditor

IRS, IIA, DCA Agency


US Government
Accountability Office (GAO), State
Auditors

Title
CPA, CFE, CFP, CISA, CFF,
etc.
CIA

= Internal Revenue Agent


= Institute of Internal Auditors
= Defense Contract Auditor
= Certified Fraud Examiner
= Certified Internal Auditor
= Certified Information Systems Auditor
= Certified Financial Planner
= Certified in Financial Forensics

The function of the various types of auditor is shown in Table 1-9.


Table 1-9 Function of Various Types of Auditor

Type of Auditor
CPA

IRA, Internal Auditor,


DCAA

Federal and State


Auditor

Function
An independent or external auditor (CPA) performs financial audit and integrated audit. The independent
auditor is either an individual practitioner or a member of a public accounting firm. For private companies,
the CPAs work focuses on the fair presentation of financial statements and accounting records. The CPA is
responsible for reporting (in the form of an audit opinion) to the stockholders. For public companies, the
CPA performs an integrated audit which focuses on the effectiveness of internal control over financial
reporting (ICFR). The CPA is responsible for reporting on the fair presentation of the companys financial
statements as well as the effectiveness of the companys ICFR.
Internal Revenue Agent (IRA)
An internal revenue agent's work focuses on the compliance with and enforcement of federal tax law. The
IRA also audits the income tax returns of individuals and corporations. The IRA reports to the
Commissioner of Internal Revenue.
Internal Auditor (CIA)
An internal auditor's work focuses on compliance with operational procedures and regulations. The CIAs
work may supplement the work of an independent auditor in a financial audit. The CIA reports to the
management of an entity.
Defense Contract Audit Agent (DCAA)
A defense contract audit agent's work focuses on the compliance and fulfillment of defense contracts. The
DCAA reports to the Department of Defense.
The U.S. Government Accountability Office (GAO) auditor (federal auditors) and the state Auditor General
Office auditor (state auditors) perform operational audits. A federal or state auditor's work focuses on the
effectiveness and efficiency of federal or state departments and agencies. The federal auditor of GAO,
headed by the comptroller general, reports to Congress while the state auditor reports to the respective state
governments.

Table 1-10 provides brief comments on the six organizational structures of CPA firms.
Table 1-10 Organizational Structure of CPA Firms

Organizational Structure

Proprietorship
General Partnership

General Corporation

Professional
Corporation (PC)

Brief Comments
Traditionally, all one-owner CPA firms were organized as proprietorships, but in recent years, most of them
have changed to organizational structures with limited liability because of increased litigation risks.
This organizational structure is the same as a proprietorship, except that is applies to multiple owners. This
organizational structure has also become less popular as other organizational structures that offer some legal
liability protection became authorized under state laws.
The advantage of a corporation is that stockholders are liable only to the extent of their investment in the
corporation. Most CPA firms do not organize as general corporations because they are prohibited by law from
doing so in most states.
A professional corporation provides professional services and is owned by one or more stockholders. PC laws
and the resulting liability protection vary significantly from state to state. PC laws in some states offer
personal liability protection similar to that of general corporations, whereas the protection in other states is
minimal. This variation makes it difficult for a CPA firm with clients in different states to operate as a PC.

Financial and Integrated Audits - Frederick Choo

Organizational Structure

Limited Liability
Company (LLC)

Limited Liability
Partnership (LLP)

Brief Comments
A limited liability company combines the most favorable attributes of a general corporation and a general
partnership. An LLC is typically structured and taxed like a general partnership, but its owners have limited
personal liability similar to that of a general corporation. Currently, nearly all of the states have LLC laws,
and most also allow accounting firms to operate as LLCs.
A limited liability partnership is owned by one or more partners. It is structured and taxed like a general
partnership, but the personal liability protection of an LLP is less than that of a general corporation or an
LLC. Partners of an LLP are personally liable for the partnerships debts and obligations, their own acts, and
acts of others under their supervision. Partners are not personally liable for liabilities arising from negligent
acts of other partners and employees not under their supervision. It is not surprising that all the Big Four CPA
firms and many smaller CPA firms now operate as LLPs.

Table 1-11 describes the organizational category of CPA firms.


Table 1-11 Organizational Categories of CPA Firms

Category
Local CPA Firms

Regional CPA Firms

National CPA Firms

The Big 4
International CPA Firms

Other Category

Brief Comments
Local CPA firms typically have one or two offices, include only one CPA or a few CPAs as partners, and
serve clients in a single city or area. These firms usually provide income tax, management consulting, and
accounting services. Auditing service is usually only a small part of the practice and tends to involve small
business concerns that find a need for audited financial statements to support applications for bank loans.
Many local CPA firms have become regional CPA firms by opening additional offices in neighboring cities or
states and increasing the number of professional staff. Merger with other local firms is often a route to
regional status. This growth is often accompanied by an increase in the amount of auditing as compared to
other services.
CPA firms with offices in most major cities in the United Stated are called national CPA firms. They are also
referred to as second tier CPA firms (the first tier is the Big 4). The national CPA firms may operate
internationally as well, either with their own offices or through affiliations with firms in other countries.
Since the beginning of 1990s, mergers of the then Big 8 international CPA firms and the dissolution of the
then Arthur Andersen LLP have reduced them to the Big 4 international CPA firms. Since only a very large
international CPA firms has sufficient staff and resources to audit a large corporation, these Big 4 CPA
firms audit nearly all of the largest American corporations (the Fortune 500 corporations). Although these
firms offer a wide range of professional services, auditing services typically represent the largest share of their
profession services. Annual revenue of an international CPA firms is in the billions of dollars. In alphabetical
order, the Big 4 CPA firms are Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, and
Pricewaterhouse-Coopers LLP.
Since the late 1990s, a number of publicly traded companies such as American Express, CBIZ, Inc., and H&R
Block began acquiring CPA firms. These companies are often referred to as consolidators because they
acquire CPA firms in various cities and consolidate them into their overall corporations. They usually only
acquire the non-attestation services division of the CPA firms and absorb the non-attestation services partners
and other personnel of the acquired CPA firms as employees of the overall corporations. Then they
outsource back these non-attestation services partners and other personnel to the remaining
attestation/auditing services partners of the acquired CPA firms to provide attestation/auditing services for the
overall corporations.

Table 1-12 describes the organizational hierarchy of CPA firms.


Table 1-12 Organizational Hierarchy of CPA Firms

Level
Staff Accountant or Associate
Senior or in-charge Accountant
Manager

Partner

Average
Experience

Typical Responsibilities

0-2 years

Performs most of the detailed audit-field-work.

2-5 years

Coordinates and is responsible for the detailed audit-field-work, including


supervising and reviewing staff work.
Helps the senior or in-charge auditor plan and manage the audit, reviews the incharges work, and manages relations with the client. A manager may be
responsible for more than one engagement at the same time.
Reviews the overall audit work and is involved in significant audit decisions. A
partner is an owner of the firm and therefore has the ultimate responsibility for
conducting the audit and serving the client.

5-10 years

10+ years

Figure 1-5 shows organization of a typical CPA firm.

11

12

1 Financial and Integrated Audits

Figure 1-5 Organization of a Typical CPA Firm


Executive Committee
Managing Partner

Practice Offices
Partners-in-Charge

Tax Services

Auditing, Attestation, and Assurance Services

Partner

Manger

Advisory and Accounting Services

Partner

Manager

Senior or in-charge accountant

Staff accountant or associate

Senior or in-charge accountant

Staff accountant or associate

Senior or in-charge accountant

Staff accountant or associate

Staff accountant or associate

A Brief History of Auditing


The last Table 1-13 in this Chapter presents a brief history of auditing.
Table 1-13 A Brief History of Auditing

Time
In the 60s and 70s

A Brief History of Auditing


In the 60s and 70s, the detection of fraud began to assume an important role in auditing. Auditing standards used
the term irregularities to describe fraudulent financial reporting and misappropriation of assets. Auditors began
to take on a greater responsibility for the detection of fraud because (a) there was an increase in congressional
pressure to account for fraud in large corporations, (b) there were a number of successful lawsuits claiming that
fraudulent financial reporting had gone undetected by the independent auditors, and (c) there was a perception by
the public that the auditors should be expected to detect material fraud.
Consequently, the major accounting organizations (including the AICPA) sponsored the National Commission
on Fraudulent Financial Reporting (the Treadway Commission or COSO) to study the causes of fraudulent
reporting and make recommendations to reduce its incidence. The commissions final report, which was issued
in 1987, made a number of recommendations for auditors, public companies, regulators, and educators. Many of
the recommendations for auditors were enacted by the AICPA in a set of Statements on Auditing Standards
(AUs) known as the expectation gap standards. In addition, the commissions recommendations about internal
control led to the development of an internal control framework, titled Internal Control-Integrated Framework,
which was to be used to evaluate the internal control of an organization. Overall, the development of these
internal control concepts and criteria had increased the demand for auditors to attest to the effectiveness of an

Financial and Integrated Audits - Frederick Choo

Time
In the 80s and 90s

In the 2000s

A Brief History of Auditing

organizations internal control.


In the 80s and 90s, the billions of dollars in federal funds that were required to bail out the Saving and Loan
industry caused a movement toward increased regulation of federally insured financial institutions. Congress and
regulatory agencies believed that the key to preventing such problems was to enact effective laws and regulations
and to require auditors to report on compliance with provisions of these laws and regulations.
In 1996, in response to a continuing expectation gap between user demands and auditor performance, the AICPA
issued standards that require the auditors to explicitly assess the risk of material misstatement in all financial
statement audits. Later, these standards were replaced with even more stringent standards that require the
auditors to design specific audit procedures that can detect fraudulent financial reporting.
Meanwhile, the vast improvement in information technology has resulted in the need for auditors to develop
innovative computer assisted auditing techniques (CAATs) in auditing. Consequently, a special group of
auditors, known as the Certified Information Systems Auditor (CISA), was formed to specialize in auditing
computer information systems.
In 2001, Enron Corporation filed for bankruptcy after acknowledging that fraudulent accounting had been used
to significantly inflate its earnings. Shortly thereafter, it was revealed that WorldCom had also used fraudulent
accounting to significantly overstate its reported income. At the same time, there were a record number of public
companies restating their prior-period financial statements. Consequently, investors began to question the
reliability of financial statements and the credibility of the auditing profession.
These events drew quick responses from a number of congressional committees, the SEC, and the U.S. Justice
Department. In 2002, Congress passed the Sarbanes-Oxley Act of 2002, which imposed reforms such as the
increased penalties for corporate fraud; the restriction on management consulting services that the auditors can
perform, and the creation of the Public Company Accounting Oversight Board (PCAOB) to oversee the auditing
profession. The PCAOB has broad power to issue and enforce auditing standards, and to register CPA firms that
audit public companies. Thus, the establishment of the PCAOB has significantly reduced the auditing
professions power in self-regulation. Consequently, auditors who perform financial audit for private companies
follow the AICPAs Statements on Auditing Standards (AUs) whereas auditors who perform integrated audit for
public companies follow the PCAOBs Auditing Standards (ASs).
In 2010, the Dodd-Frank Act of 2010 amended Section 404 of the Sarbanes-Oxley Act by exempting certain
smaller companies from the requirement for an integrated audit of their internal control over financial reporting
(ICFR). However, management of these smaller companies must still provide their annual assessment of the
effectiveness of internal controls.

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Multiple-Choice Questions
1-1

The primary objective of an independent audit is


a. to gather and evaluate evidence.
b. to investigate errors and irregularities.
c. to form an opinion about the fairness of a client's financial statements.
d. to match a client's assertions on financial items with established criteria.

1-2

An audit that determines the strength of a client's internal controls or its conformity with tax law is not classified as a(n)
a. internal audit.
b. tax audit.
c. financial audit.
d. compliance audit.

1-3

The independent auditor is ultimately responsible to


a. the client's management.
b. the client's management and stockholders.
c. the client's board of directors.
d. the client's stockholders and board of directors.

1-4

Attestation services performed by a CPA include


a. audit, review and tax services.
b. audit, review and compilation services.
c. audit, review and management consulting services.
d. audit, review and examination services.

1-5

Operational auditing is primarily concerned with


a. future improvement to accomplish the goals of management.
b. the accuracy of data reflected in managements financial records.
c. verification that a companys financial statements are fairly presented.
d. past protection provided by existing internal control.

1-6

Other assurance services are similar to, yet differ somewhat from, attestation services. When performing other assurance services,
the CPA
a. is not required to issue a written report, and the assurance is about the reliability and relevance of information.
b. is required to issue a written report, and the assurance is about the reliability and relevance of information.
c. is not required to issue a written report, and the assurance is about the completeness and sufficiency of information.
d. is required to issue a written report, and the assurance is about the completeness and sufficiency of information.

1-7

Which of the following audits can be regarded as solely compliance audits?


a. An independent CPA firms audit of the local school district.
b. An internal auditors review of his employers payroll authorization procedures.
c. GAO auditors evaluation of the computer operations of governmental units.
d. Internal Revenue Service Agents examinations of the returns of taxpayers.

1-8

A CPA certificate is evidence of


a. recognition of independence.
b. culmination of the educational process.
c. basic competence at the time the certificate is granted.
d. membership in the AICPA.

1-9

The use of the title CPA is regulated by


a. the federal government through the licensing department of the Commerce Department.
b. state law through the licensing department of each state.
c. the AICPA through the licensing departments of the tax and auditing committees.
d. the Securities and Exchanges Commission (SEC).

Financial and Integrated Audits - Frederick Choo

1-10

An examination of part of an organizations procedures and methods for the purpose of evaluating efficiency and
effectiveness is what type of audit?
a. Production audit.
b. Financial statement audit.
c. Compliance audit.
d. Operational audit.

1-11

CPA firms have as their primary responsibility the performance of the audit function on published financial statements of
a. all corporations.
b. all corporations listed on the New York Stock Exchange.
c. all publicly-traded companies.
d. all federally-charted corporations.

1-12

In response to the growing demand for assurance of business transacted electronically over the Internet, the AICPA
created
a. Information System Reliability assurance services.
b. CPA WebTrust assurance services.
c. AICPA WebPartner assurance services.
d. Internet Reliability assurance services.

1-13

The independent auditor is primarily accountable to


a. the management of an audit client because the auditor is hired and paid by the management.
b. the audit committee of an audit client because that committee is responsible for coordinating and reviewing the audit.
c. stockholders, creditors, and the investing public.
d. the SEC because it determines the responsibility of the auditor.

1-14

Assurance services involves all of the following except


a. improving the quality of information for decision making.
b. improving the quality of the context for decision making.
c. improving the relevance of information.
d. improving the outcome of an information system.

1-15

The work of an internal auditor is best described as


a. an audit of a companys compliance with managements policies and procedures.
b. an evaluation of a companys susceptibility to fraud.
c. an audit of companys computer systems.
d. an audit of a companys efficiency and effectiveness.

1-16

Which of the following best describes why an independent auditor reports on financial statements?
a. Independent auditors are likely to detect fraud.
b. Competing interests may exist between management and the users of the financial statements.
c. Independent auditors are likely to correct misstated account balances.
d. Ineffective internal controls are likely to be discovered by the independent auditors.

1-17

Who is primarily responsible for the assertions in financial statements?


a. Audit partner in charge of the audit engagement.
b. Senior auditor in charge of audit field work.
c. Staff auditor in charge of audit work papers.
d. Audit clients management.

1-18

In performing an attestation engagement, a CPA typically


a. supplies litigation support services.
b. assesses control risk at a low level.
c. expresses a conclusion in the form of a written communication about an assertion.
d. provides management consulting advice.

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1-19

Which of the following professional services would be considered an attest engagement?


a. A consulting service engagement to provide computer advice to a client.
b. An engagement to report on compliance with statutory requirements.
c. An income tax engagement to prepare federal and state tax returns.
d. The compilation of financial statements from a clients accounting records.

1-20

The main objective of assurance services is to


a. provide more reliable information for decision makers.
b. provide confidential information for decision makers.
c. improve the quality of information for decision makers.
d. improve the quantity of information for decision makers.

1-21

Other assurance services performed by a CPA include


a. ElderCare Plus, Web Trust, and review.
b. Risk Assessment, business performance measurement, and certain management consulting.
c. Examination, electronic commerce, and compilation.
d. Audit, review, and agreed-upon procedures.

1-22

The Sarbanes-Oxley Act of 2002 and PCAOB Standard No.5 require an integrated audit for publicly traded companies in the United
States. This integrated audit is usually performed by which of the following types of auditor?
a. Internal auditor (CIA) of a public company.
b. Internal revenue agent (IRA) or defense contract audit agent (DCAA).
c. Federal, state, or local government auditor.
d. Certified public accountant (CPA).

1-23

In 2002, Congress passed the Sarbanes-Oxley Act of 2002 that did not impose which of the following reforms?
a. The creation of the Government Accountability Office (GAO).
b. The increased penalties for corporate fraud.
c. The restriction on management consulting services.
d. The creation of the Public Company Accounting Oversight Board (PCAOB).

1-24

Which of the following statements accurately describes U.S. CPA firms that are not sole proprietorships?
a. The firm will be subject to an annual peer review.
b. The most common organizational structure is the limited liability partnership structure.
c. Most derive the majority of their revenues from tax services.
d. The number of other professionals within a firm generally equals the number of partners in the firm.

1-25

Which of the following is the total number of opinion in a financial audit and an integrated audit?
Number of opinion

I.
II.
III.
IV.

Financial Audit
None
One
Two
Three

Integrated Audit
Two
Three
Two
Three

a. I
b. II
c. III
d. IV

Key to Multiple-Choice Questions


1-1c. 1-2 c. 1-3 d. 1-4 d. 1-5 a. 1-6 a. 1-7 d. 1-8 c. 1-9 b. 1-10 d. 1-11 c.
1-12 b. 1-13 c. 1-14 d. 1-15 a. 1-16 b. 1-17 d. 1-18 c. 1-19 b. 1-20 c. 1-21 b.
1-22 d. 1-23 a. 1-24 b. 1-25 b.

Financial and Integrated Audits - Frederick Choo

Simulation Question 1-1


Simulation Question 1-1 is an adaptation with permission from a case by Walker, P. L., W.G. Shenkir, and C.S. Hunn in the Issues in Accounting
Education, a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.
The information contained in the simulation question was obtained from publicly available sources.

Introduction

The Nicholsons Story

What Went Wrong?

Prudential Insurance Company of America (hereafter, PI), whose symbol is the Rock of Gibraltar, assures its customers that for
financial security and peace of mind they could depend on the Rock. For years its advertisements built its Rock-Solid image. PI was created
around its people, who were committed to a set of core values lauded by management: client focus, winning, trust, and respect for each other. The
company was dedicated to selling the right product, to the right client, in the right way. Yet for Prudential customers, selling the right product
in the right way proved to result in something less than peace of mind.
Keith and Carol Nicholson trusted their financial security to the PI when they purchased a rather sizable life insurance policy from
their PI agent. At one point, the policys cash value was $103,000. Since Keith suffered from leukemia, this policy was comfort for the unstable
times that lay ahead of them. Carol needed to know that this money was going to be there.
Carol had been known to say that she trusted her PI agent as she trusted her pastor. He was going to play a vital role in smoothing a
very uncertain future. Therefore, when her agent suggested that she and her husband take out a new life insurance policy on Keith at no
additional cost, the couple agreed, no questions asked. They just signed the forms, believing that they had bought even more certainty to the
unpredictable future.
Eventually, Keith succumbed to leukemia. Much to Carols surprise, the six figure nest egg that she thought would be awaiting her
was now a mere $22,000. Carols agent had not been honest when he had Carol and her husband changed his life insurance policy. The
Nicholsons agent had taken advantage of the couples trust by having them borrow against their old policy to purchase a new and more
expensive policy.1 Without even realizing it, Carol and Keith had signed a blank withdrawal form that allowed their agent to raid the cash value
of the old policy to begin to pay for the new policy. Carols reaction was a tearful plea of How could they?
PI is a massive entity whose asset base is equivalent to the economy of Sweden. You should access Data File 1-1 in iLearn for
Table 1, which presents the top ten life/health insurers ranked by assets, and Table 2, which presents them ranked by premium income.
PIs primary businesses were life insurance, health care, investments, and property and casualty insurance. Of all the different types of insurance
being offered by PI and its competitors, life insurance was the most lucrative for both the company and its agents. From 1983 through to 1987, PI
saw record-breaking increases in its sales of life insurance policies, even though the industry saw a decline in sales. You should access Data File
1-1 in iLearn for Table 3, which presents PIs total life insurance sales 1982-1987, and Table 4, which presents industry life insurance
purchases in the United States.
Carol and Keith Nicholson were not the only victims of PIs churning scam. Before the end of 1995, over 10.7 million life insurance
policyholders had allegedly fallen prey to the scam and a class action lawsuit was soon filed. Additionally, investigations of the nations largest
life insurer spanned the country, from New Jersey to Florida to Arizona, in an effort to answer the question, How could they?
In 1996, as part of the Florida Department of Insurances investigation of PI, a former PI Vice-President of Regional Marketing
testified regarding sales practices. In part of his testimony, the witness discussed the process of how customers buy life insurance.
WITNESS: They said that their agent sits there, and he says sign there, sign here, sign here, sign here, and I have to trust in the agent.
I sign; he turns it over and says sign here, sign here, and sign here. I sign.
Most people, even after they signed them, didnt take them home and read them. That is what its like applying for life insurance.
The Nicholsons were among the many insurance customers who just signed forms as instructed by their agent. According to this e-PI
employee, the most prevalent financing scam at PI was selling a new policy as free life insurance by essentially using the accumulated cash
value of an older policy to pay the new, increased premiums. In many cases, the old whole life or universal policy was replaced with a term
policy. The former policies build up cash value, whereas term policies do not. In some cases, insured persons would increase their total life
insurance coverage because they had more overall coverage from the term policy. In his two days of testimony, the confidential witness
commented as follows:
WITNESS: I would say financing was minuscule in 82, 83, 84 and then started growing rapidly in 85, 86,87,88, and then
started to level off probably in 90,91.92, and then may have gone down a little bit in 93, 94.
PI contended that such practices were never condoned. Under oath, the ex-employee stated otherwise:
WITNESS: That has always been Prudentials public statement, financing and replacement is bad; not generally in the best interests of
the policy holder At the peak, it was used in at least 30 percent of the cases and probably higher.
According to a Coopers & Lybrands (now PricewaterhouseCooper LLP) assessment of PIs controls:
Training of field management with respect to supervising sales practices and identifying and dealing with compliance-related issues
has been inconsistent at best. As such, managers are not always sure as to what constitutes good vs. bad sales practices, are reactive toward
compliance issues, and are not held accountable for their own actions or those of their representatives.
PI, like many life insurers during this period (1982-1993), offered a very complex product. Without adequate instruction, many agents
felt as if they had been misled about what they were selling. Even so, it should be noted that many PI employees were fully aware of the
consequences of their actions. The deposed former employee noted that there existed an informal system of training on refinancing policies. The
witness told how this manipulative practice was able to spread:
WITNESS: What happens is because there is no formal training of this kind of thing; it passes by word of mouth or by transfer of
people. So it doesnt surprise me that you will find it pop up here or pop up there. Then after these people got to be very successful, they would
go to conferences and say, this is how we do it. An then it spread countrywide, and my belief is it really got heavy in 84 and 85 because
illustration sold nicely, too.

Such a tactic is referred to as a churning, financing, or refinancing.

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The ex-employee remarked that many agents set up booths at the Regional Business Conference in an effort to illustrate the art of
selling financed insurance. The employee also claimed that, in support of these practices, many agents developed and used their own sales
materials, as revealed by testimony on these self-developed materials:
QUESTION: Typically, would he [management] say anything about it? Would he care?
WITNESS: I dont know. Im not sure. But keep in mind that the managers are paid overrides. If there is a piece that appears to be
working, theyre not going to stop using it, because it affects their pocketbook.
The former PI worker also discussed the monetary consequences of churning:
QUESTION: So this document [a memo] would indicate that the company knew way back in 76 that financed insurance was
regularly producing unacceptable results?
WITNESS: Correct. And the next question is why it was producing unacceptable results. Did you [Prudential] look into it? Did you
[Prudential] ascertain what occurred in the sale that produced unacceptable results? The answer is nothing. The reason that Prudential didnt care
was they were sales driven. Everything was measured off new sales There was a benefit to the agents, to management, to individuals working
for the company, because their bonuses grew dramatically If you look at the pay scale of management in 1976, a senior vice president in 1976
probably made $$100,000 a year, a lot of money. A senior vice president in the company today probably in the same position might make a
million dollars a year. Now inflation has been eating away a lot since 1976, but I dont think it ate ten times so there was a financial incentive
for he employees, all employees, not just senior people.
The incentive for the salesperson was simply commissions. Characteristically, a large percentage of the premium paid by the
consumer in the first year went directly to the agent. That commission shrunk in later years. The ex-employee further elaborated upon this subject
in the second day of his testimony:
WITNESS: Another file you would want to look at is Phoenix West. That was an investigation done last year [1995] As a result of
that investigation, there were recommendations with regard to the discipline of many, many people; but if you look at that whole investigation,
you will see the attitude of the company toward people who were engaged in wrongful financial insurance transactions over a long period of time,
with the knowledge of many people They merely state that we did it because we made money and we didnt care And Phoenix West is just
a microcosm of what was really going on in the country.
John Vetter, an insurance representative in the beleaguered Phoenix West Agency, admitted to some questionable sales. In an
investigation of the Phoenix West Agency, the Florida Department of Insurance documented that:
He [John Vetter] said your judgment gets clouded out in the field when you are pressured to sell, sell, sell. In response to questions on
how he could explain a case where he had rewritten a policy instead of reinstating it when the rewrite resulted in a higher premium for the
insured, he responded that it was pure greed.
With everyone in PI benefiting financially from refinanced life insurance policies, there seemed to be no need to stop, regardless of
managements official stance on the issue:
WITNESS: You will probably see that in Prudential all the documents that you see or the bulk of the documents you see will be very
good on their face, theyll say you shall not do this. The problem was that there was nothing behind you shall not do this. There was no
mechanism to punish. In fact, I dont believe youll find a single termination of an agent or member of management for financing insurance
outside of Cedar Rapids and a couple of other districts in the 80s.
The ex-employee felt not only that management condoned churning, but also that management explicitly allowed it. Many PI
customers complained about their new life insurance policies before this scandal fully surfaced in 1994, and, according to this ex-employee, PI
addressed such complaints in the following manner:
WITNESS: whenever they [the customer] had a complaint, the first thing they had to do if they had an oral complaint, they had to
put it in writing. That knocked down a number of the complaints right away because most of our customers, because most of their educational
level and because of their financial circumstances, hesitated to put things in writing. The second thing we did is we would get the complaint and
then would ask the agent what the agent did. If the agent said he did it right, we would deny the complaint and we would hold to that denial
through three or four subsequent complaints. And basically we didnt actually do an investigation except to get the statement of the person who
was complained about, and that was the position in Prudential probably until late 1994.
Some PI executives did seek changes, given the growing number of customer complaints (although it was later alleged that not all
complaints were logged into the companys database). One such measure was having the customer sign a release verifying that he or she fully
understood the terms and conditions of his or her new policy. Testimony recounts the reaction to such a measure:
WITNESS: The next one is a memo [dated August 29, 1995] from Bill Hunt [Head of Ordinary Agencies]: I do not believe we
should have the applicant sign off on anything. Not only does this imply a lack of trust toward agents, it also has the potential to build skepticism
from the prospective insured regarding what they are being sold. Basically what he is saying is he is not going to ask him to sign anything
because it could disrupt the sale.
The selling of life insurance has become a complex process. Clearly, customers frequently do not understand the product they are
buying, but instead appear to place a high level of trust in their agent. That trust places additional burdens and responsibilities on agents and PI
itself. It also appears evident that sales practices such as churning and refinancing were not only widespread but may have been occurring for an
extended period of time. The witness implied that financial incentives may have encouraged this activity and that managements attitude toward
controls and problems was questionable.

A New CEO

The New CEOs Reaction and Changes

As early as 1982, the companys internal auditors reported to the Board of Directors fraudulent practices on the part of sales agents. In
addition, internal audits of individual divisions and regional offices in the early 1990s detailed a failure by management to enforce consumerprotection laws and regulations. In a June 1994 report commissioned by PI in the wake of regulatory inquiries about insurance sales practices,
Coopers & Lybrand stated that PI officials failed to act adequately upon such warnings. The Board admitted that it had been made aware of
major irregularities, but they continually asserted that they trusted managements claims that the problems were being properly monitored.
In November 1994, PIs Board of Directors turned to Arthur Ryan (the president of Chase Manhattan Corp.) This was the first time in
over 120 years that PI had looked outside the company to fill the position of CEO. Lacking any formal background in the field of insurance, his
reputation was built upon his ability to streamline operations and introduce new technology. He is renowned to rolling up his sleeves at his own
computer. He enjoys working one-on-one and is perfectly comfortable at center stage of the company auditorium. Simply put, Ryan is direct,
open, focused, and engaged.

Financial and Integrated Audits - Frederick Choo

Ryan had made a conscious choice to change PIs business approach. Under Ryans command, PI would no longer be a series of
independent silos, freewheeling subsidiaries working at cross-purpose with fragmented game plans. The buzzword at Ryans PI would be about
facilitating teamwork and cooperation.
To break from the past, Ryan began recreating PIs management team. Much of the old guard was released. Ryan hired twelve of the
14 executives who reported directly to the CEO. Of the top 150 executives, two-thirds were new, and half of these replacements were newcomers
to PI.
Ryan also decided on cutbacks like those that had won him much praise at Chase Manhattan. Within two years of Ryans arrival, a
workforce of 100,000 had been reduced to 83,000. Ryan also eliminated about $790 million in overhead by shutting down five regional
headquarters (that had once been proud outposts for the companys management). He also sold the home-mortgage operation, thereby reducing
the companys exposure in the homeowners insurance side of the business. By the end of 1995, Ryans restructuring had resulted in seven major
operating groups: individual insurance, money management, securities, healthcare, private asset management, international insurance, and a
diversified group.
Although Ryans actions would appear to be a step in the right direction, not all of his streamlining was met with open arms. The
companys insurance sales force, which numbered 20,000 when Ryan came to PI, was cut in half within four years. The company fired or
counseled out agents who could barely sell enough insurance to cover the costs of their employee benefits. During the first months of 1997, more
than 1,600 junior and senior insurance-sale managers were still going through very severe reviews. As a result, about 100 of these employees
left PI.
Ryans labor troubles did not end with complaints from the sales force over tighter controls. In an effort to mitigate some of the
damage to PIs bottom line resulting from the churning scandal, PI attempted to increase agent production quotas. The proposed labor contract
would have increased quotas by 25 percent, but the union representing PIs insurance agents rejected the deal.
In 1998, PI officials estimated that the class-action suit could cost PI as much as $2 billion. Many questions still remain for Ryan, but
for the customers of PI, the most significant question remaining is, Has enough been done to ensure that they will no be the next Carol
Nicholson?

Required
1. a. Research the risk framework suggested by the Special Committee on Assurance Services (also known as Elliott Committee) at the AICPAs
website: http://www.aicpa.org
b. Assume you were engaged by PI to provide Risk Assessment assurance services. Identify and discuss the following risks associated with
PI for the period from the 1980s and the early 1990s:
i.
Marketing and sales risks
ii.
Corporate culture risks
iii.
Strategic risks
A document that may help you in answering 1.b. is the AICPAs statement of Position 98-6, Reporting on Managements Assessment Pursuant to
the Life Insurance Ethical Market Conduct Program of the Insurance Marketplace Standards Association.
2. Assume you were engaged by PI to provide Risk Assessment assurance services. Suggest controls that should be established to manage the
risks identified in 1.b.
Note: These controls are not the traditional internal controls. Rather, they are controls that are needed to help PI manage its risk and ultimately
achieve its objectives.
A document that may help you in answering SQ1-1 is the Committee of Sponsoring Organizations (COSO) report,
Internal Control-Integrated Framework (also known as the Treadway Commission Report).

Simulation Question 1-2


Simulation Question 1-2 is an adaptation with permission from a case by Phillips, F. and D. Kalesnikoff in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts. The
information contained in the simulation question was obtained from publicly available sources.

Introduction

Professor Irene Ballinger is founder and chief executive officer of Q-Dots Incorporated (hereafter, QDI) a small, private company
that operates adjacent to Cornell University in Ithaca, NY. QDI has pioneered ways to mass produce and manipulate nanoscopic fragments of
silicon, which are called quantum dots. In addition to being extremely small, consisting of only a few hundred atoms, quantum dots have the
unique capability of being tuned to light-up in any color by simply changing their size.
Dr. Ballinger first reported the properties of quantum dots or q-dots, as she calls them, at an academic conference in June 1999. A
discussant at the conference commented that the discovery might be useful in a broad array of applications, ranging from microscopic lighting to
television display. Intrigued by these possibilities, Ballinger set out to determine whether the theory could be applied in practice. After nearly two
years of further research, she discovered that Q-dots could be used in multiphoton microscopy. Simply put, with q-dots, Ballinger could make
tiny blood vessels beneath a mouse skin appear so bright and vivid in high-resolution images that she could see the vessel walls ripple with each
hearbeat-100 times a second. Ballinger referred to this application as a Q-light a finding that published in a leading academic journal in May
2001.
Within a few months, Ballinger began receiving enquiries from scientists around the world about the availability of Q-lights for use in
their laboratories. In late 2001, Ballinger decided to create QDI (a private company), employing a team of nanotechnology engineers to fully
develop the Q-lights and make the marketable to a broader base of customers. In addition, Ballinger hired a management team to take care of the
business side of things. The management team purchased a 25 percent interest in QDI when it was incorporated at the beginning of January
2002.

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The first line of Q-lights was completed and available for commercial distribution in March 2002. Q-lights were an immediate
success, and have become one of QDIs primary sources of revenue. The other major source of revenue for QDI is the manufacture and
distribution of raw Q-dots that other researchers are using to develop their own new product applications.
Things had been going well for Ballinger and QDI until August 14, 2004, when Ballinger received a letter from attorneys at the
University of California, Berkeley claiming that Ballingers Q-lights discover took place several months later than a similar discovery by a
team of researchers from Berkeley. Patent applications had been filed by both Ballingers management team and the Berkeley team around the
same time, and it is not clear which researchers, if any, will be granted the patent for multiphoton microscopy. The Berkeley attorneys threaten
legal action if QDI does not immediately stop production and sale of Q-lights. These threats have shaken Ballenger, who now wants out of the
commercial side of her scientific work. She has said, The last thing I want is to have my research lab shut down. She has advised her
management team to ship Q-lights only to existing customers and to store any excess Q-dots production at a colleagues research lab in
Pittsburgh. Fortunately for Ballinger, the QDI management team does not view the legal action as a credible threat, and has agreed to purchase
Ballingers shares under the terms set out in Table 1. You should access Data File 1-2 in iLearn for Table 1, which presents details of the
purchase-and-sale agreement.

Request for Business Performance Measurement Assurance Services

Your CPA firm has been providing tax services to QDI since it was incorporated as a private company on January 1, 2002. In 2004,
QDI also engaged your firm to provide business performance measurement assurance services. Specifically, Ballinger would like your firm to
look at the numbers that will be used to determine the purchase-and-sale price and to analyze the purchase-and-sale agreement to make absolutely
certain that she is rewarded fairly for what she contributed to QDI.

Required
Tom Cohen, the assurance services partner in your CPA firms office has asked you to review the proposed terms of the agreement
(see Table 1) and the notes he made during his meeting with Ballinger (see Table 2). You should access Data File 1-2 in iLearn for Table 1,
which presents details of the purchase-and-sale agreement, and Table 2, which presents Tom Cohens notes on information gathered
from Dr. Ballinger. After reviewing these two documents, Tom Cohen also would like you to write him a report that identifies and analyses
significant engagement issues pertaining to this business performance measurement assurance services. Your report should consist of three
parts that fully address the questions provided in each part as follows:
Part 1: Regarding the proposed buy-out agreement.
a. What are the strong and weak points of the proposed buy-out agreement?
b. What is it that has to be measured for the buy-out to occur?
c. What skills are required in performing this measurement?
d. What level of assurance can be reached?
e. Will this level of assurance meet the needs of Dr. Ballinger?
f. Will this level of assurance meet the needs of QDIs management?
g. What are the 3.0 and 1.5 multipliers intended to represent?
h. What are the implications of the non-compete clause?
i. What suggestions/advice should Tom Cohen make with regards to the proposed agreement?
Part 2: Regarding litigation
a. Who is bearing the risk of the litigation?
b. What are the ramifications if Berkeleys threat of litigation becomes a reality?
c. What would be the implications of losing a law suit to Berkeley?
Part 3: Regarding financial reporting
a. What are your general thoughts on managements accounting decisions?
b. Is managements write-off of Q-lights and Q-screen product development costs consistent with their earlier communicated thoughts on the
litigation?
c. Is the payment to lobbyists unethical or just smart business?
d. Does the payment to lobbyists constitute an asset or expense?
e. If the payment to lobbyists is an expense, is it an operating or non-operating expense?
f. How does the FBI contract fit with principles governing revenue recognition? What about conservatism? What makes sense given the
situation?
g. Is managements decision to expense the Q-prints development and production costs consistent with fundamental accounting concepts and
principles?
Note: Your report must not be a list of answers to the above questions. It must be written in a report format with Parts 1, 2 and 3 as three
sub-headings.

Financial and Integrated Audits - Frederick Choo

Simulation Question 1-3


Simulation Question 1-3 is an adaptation with permission from a case by R. N. Schmidt and F. Phillips in the Issues in Accounting Education, a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts. The
information contained in the simulation question was obtained from publicly available sources.

Introduction

Company Background

The Meeting

Assume that you are an audit manager at KST LLP, a mid-sized public accounting firm located in northern Colorado. Recently, you
attended a local Oktoberfest celebration and had the opportunity to be seated at a table with Sammy Blitzthe CEO of a local private
manufacturing firm. Always looking for the opportunity to extend your network of contacts and potential clientele, you engage in an insightful
conversation with Sammy and learn a great deal about him and his business, both of which have interesting backgrounds.
Blitz Bow Corporation (BBC) is a manufacturer of archery equipment with a predominant focus on manufacturing high-quality bows
for competitive archers and bow hunting enthusiasts. BBC was incorporated in 1977 when former repeat summer Olympic competitor Samuel
(Sammy) Blitz, with the financial support of his sister, Lauren Blitz, began to manufacture bows for archery competitors. Since 1983, BBC has
exclusively sold its bows through its single retail store located immediately beside its manufacturing facility. The proximity of the manufacturing
facility and retail store has allowed Sammy to maintain strict quality control over BBC products while also permitting patrons the opportunity to
tour the manufacturing facilities. Despite the demands of owning and managing a family business, Sammy took time and great pride in watching
his son, Brandon, share in his passion for the sport of archery. After enjoying success as a junior amateur, Brandon later pursued a mechanical
engineering degree. Now, Brandon is the VP of Operations at BBC, and for nearly a decade Sammy and Brandon have worked closely together at
BBC leading a team on product innovations.
Although relatively small compared to its competitors in terms of gross sales, BBC has established itself as a North American leader
in product innovation and as such has reaped the benefits of the strong consumer brand loyalty that typically plagues the sports market.
Specifically, BBC has changed its product line from initially focusing on traditional recurve bows, which are the only bows permitted at the
Olympic Games, to compound bows. Innovation in the archery industry, market preferences, and resurgence in bow hunting have established
compound bows as the fastest growing market niche in the bow manufacturing industry.
Consumers in the compound bow market demand specific features to maximize their probability of success in the field. In particular,
the bow's ability to propel arrows with high levels of kinetic energy is critical to bow hunting enthusiasts (widely referred to as knock down
power), in addition to flat arrow trajectory, accuracy, and quiet operation. In regard to the first two features, bow manufacturers have focused on
modifying the design of the bow to mechanically maximize arrow speed, which is a key driver for kinetic energy and flat trajectory. As such, bow
manufacturers use their estimates of arrow speed in their advertising campaigns to differentiate their bows from competitors. Moreover, consumer
research conducted by the archery industry has documented that this single measure of foot-per-second arrow speed is an important determinant
in the consumer's choice to purchase a particular bow, despite the fact that bows that offer blazing arrow speeds often do so at the cost of reduced
accuracy and increased noise of operation. Given that every incremental foot per second is important, consumers demand that manufacturers
furnish a highly accurate estimate of arrow speed for every bow model.
Looking out your office window, you are reminded by the thick layer of snow that December has arrived. As your mind slips to your
upcoming weekend snowboarding plans, your phone rings. It is your receptionist announcing that you have a drop-in client that has asked
specifically to meet with you. Glancing at the clock, you realize that it is already 4:00 p.m. on Friday, but are always happy to meet with potential
new clients. You open the boardroom door and are surprised to see a familiar faceSammy Blitz. After a brief catch up over coffee, the
conversation turns to business.
Sammy: Thank you for seeing me on such short notice. I was happy to have the opportunity to meet you several months ago, and I
noted your interest then in our business at BBC.
You: It was my pleasure. How can I be of service?
Sammy: With the new line-up of bows set to be unveiled next month, I was recently informed about the advertising campaigns of
my competitors. I'm tired of seeing my competitors make up stories about how great their bows are. This really has gotten out of
control. Given the structural complexities in compound bows, manufacturers have seen the opportunity to make ridiculous statements
with limited to no support for their claims.
You: What are some examples?
Sammy: Our closest competitor, Wicked Axis Archery, came out with a new line of bows this year which it claims are quiet as a
mouse. In truth, Wicked bows vibrate violently when you release the arrow, to the extent that the sound would wake the dead!
Another competitor, ProCam, is misleading consumers in its claims that its cam designs deliver superior let-off' for the archer at full
draw. Perhaps what is bothering me the most is the marketing campaign of the newest entrant to the bow manufacturing market, Bow
Fever. This company is advertising that its bows are able to deliver arrow speeds of 365 feet per second, when in truth these speeds are
being determined in conditions that take advantage of the more flexible IBO standards rather than the more stringent ATA standards.
As we had discussed in October, arrow speed is arguably the most critical element that manufacturers focus on, given its importance
to consumers. It is no secret that we take great pride at BBC to make our bows capable of sending arrows at the fastest speeds in the
industry. We view Bow Fever's claims as a serious threat to our future profitability.
You: Sounds like you either need a lawyer or a new engineer. How can I help you today?
Sammy: I just got back from a bow manufacturer association conference last week. Consumers are seriously complaining about the
arrow speed claims of the bow manufacturers. I'm concerned because customers who have been loyal to BBC for years have begun to
question whether they can trust our arrow speeds. They suspect that all manufacturers are overstating their arrow speed ratings. Heck,
it is documented in virtually every online archery forum. Take a look, for example, at archerytalk.com. We're all being painted with
the same broad brush. I share in the customers' concerns, and I want to make sure our customers can trust that our bows deliver what
we say they deliveran honest to goodness 360-feet-per-second arrow speed. We have carefully constructed our quality control
processes to ensure that every bow is manufactured to the specified ratings. I want to cut to the point. My son, Brandon, recalls from
one of his elective university courses that there is some sort of service that public accountants can provide that increases the credibility
of numbers. Basically, what I want is for you to back up my claim that our bow shoots arrows at 360 feet per second. Actually, now

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1 Financial and Integrated Audits

that I think of it, maybe we should be more aggressive and assert that our bows shoot arrows faster than any of our competitors. What
do you think? Is there some sort of service you folks can do?
You: Let me look into this for you, Sammy. May I ask why you are interested in our firm?
Sammy: Well, you folks are accountants. Accountants know how to deal with numbers, and this arrow speed number in feet per
second is an important number to me and my customers. I figured you would know how to help me out. Also, I'm confident that your
firm has the necessary expertise. In fact, I know several of your colleagues from the local archery club. I believe Erich is a partner, and
Sarah and John have recently started with your firm, maybe a year or two ago. Unfortunately, Erich must have left early for the
weekend, because he wasn't available earlier. Let him know that I hope he is better at accounting than shooting!
You: I'll be sure to pass on the joke.
You promised to check into the situation and get back to Sammy on Monday. After Sammy left the office, you slouched back in your chair. You
believed that you would be considered for promotion to senior manager if you could secure BBC as a client to the firma client that Erich, the
office audit partner, would be eager to have. You accessed your online auditing and attestation standards, and also did some quick research on
compound bow dynamics and industry guidelines on bow speed ratings. You should access Data File 1-3 in iLearn for Exhibit 1, which
presents a picture of a compound bow; Exhibit 2, which presents notes on the dynamics of a compound bow, and Exhibit 3, which
presents notes on ATA and IBO criteria for Bow Speed Rating. You then started writing a memo to Erich striving to explain what specific
types of engagements the firm could provide BBC to meet its needs. Furthermore, you tried with your current limited knowledge of BBC's
business to outline anticipated complexities involved with the proposed engagement.

Required
Write a memo to Erich, the office audit partner, with regard to the following:
1. Explains what types of engagement your CPA firm should provide to BBC. Should it be auditing, attestation, assurance, or other types of
service?
2. What specific auditing, attestation, assurance, or other standards should you consider as a guide for this engagement?
3. Based on Exhibits 1, 2, and 3, and your current limited knowledge of BBCs compound bow, explain how would you test Sammys assertion
that his compound bow shoots at 360 feet per second?
Note: A document that may help you in answering SQ1-3 is PCAOB AT Section 101, Attest Engagement.

Financial and Integrated Audits - Frederick Choo

Chapter 2
The Auditors Professional Environment
Chapter Learning Outcomes (LOs) Checklist
After reading this chapter, you should be able to:
LO2-1 Understand the AICPAs influence on the auditors professional environment.
LO2-2 Describe four fundamental principles underlying an audit (AICPA).
LO2-3 Describe the AICPAs six elements of quality control.
LO2-4 Understand the Securities and Exchange Commissions (SECs) influence on the
auditors professional environment.
LO2-5 Summarize the duties of the Public Company Accounting Oversight Board
(PCAOB).
LO2-6 Understand multiple sets of standards for the audit of public, private, and foreign
companies
LO2-7 Explain the influence of the Corporate and Criminal Fraud Accountability Act of
2002.
LO2-8 Discuss the influence of the International Federation of Accountants (IFAC) and
the International Standards on Auditing (ISAs).
LO2-9 Identify some key changes required by the SEC that affect the audit committee.

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2 The Auditor's Professional Environment

Chapter 2 The Auditors Professional Environment


The American Institute of Certified Public Accountants (AICPA) and Securities Exchange Commission (SEC) are
the two major forces that influence the auditors professional environment. The AICPAs influence is depicted in
Figure 2-1.
Figure 2-1 AICPAs Influence on the Auditors Professional Environment
AICPA
Influences CPA firms and individual CPAs through

Auditing Standard
Board
(ASB)
Previously
promulgated
10 Generally
Accepted Auditing
Standards (GAAS)

CPA Firms Division


Professional Ethics
Peer Review Board
Executive Committee
(PEEC)
Directs

Peer
Review
Program

Quality Control
Standards Committee

Enforces

Code of
Professional
Conduct (CPC)

Establishes

6 Elements of
Quality Control

Audit Practice and


Quality Centers
(CAQ)
Improves

Audit Practice
Quality

Currently
replaced by
4 Fundamental
Principles
Detailed
guideline in
More than 100 Statements on Auditing Standards, labeled as AUs # in Topical Order

Organized into
6 topical contents

AU 200
AU 300-499
AU 500
AU 600
AU 700
AU 800-999

General Principles and Responsibilities


Risk Assessment and Response to Assessed Risks
Audit Evidence
Using the Work of Others
Audit Conclusions and Reporting
Special Considerations

AICPAs Influence on the Auditors Professional Environment


The AICPA is a national professional organization. Its membership is voluntary; however, a majority of CPAs are
members of AICPA. The AICPAs influence on the auditors professional environment is briefly discussed in Table
2-1.

Financial and Integrated Audits - Frederick Choo

Table 2-1 AICPAs Influence on the Auditors Professional Environment

Division/Committee

Auditing Standards Division


(ASB)

CPA Firms Division

Professional Ethics
Executive Committee (PEEC)

Quality Control Standards


Committee

Audit Practice and Quality


Center (CAQ)

Influence
An important arm of the Auditing Standards Division is the Auditing Standards Board (ASB), which
promulgates the 10 generally accepted auditing standards (GAAS) that guide the quality of audit
services. Compliance with the 10 GAAS is mandatory for members of AICPA who perform auditing
and other related professional services. See Table 2-2 for details.
Detailed guideline to the 10 GAAS are provided by more than 100 Statements of Auditing Standards
(AUs) issued by the ASB. The AUs are labeled by their AU numbers #, which are based on the topical
content with which they are issued. For example, the Statement on Auditing Standards, Consideration of
Fraud in a Financial Statement Audit, is labeled as AU 240.
As part of improving clarity and converging with international auditing standards, the ASB replaced the
previously promulgated 10 GAAS with a more comprehensive and coherent description of the
Principles Underlying an Audit in Accordance with Generally Accepted Auditing Standards. These
fundamental principles are grouped into four categories: (1) the purpose and premise of an audit, (2)
personal responsibilities of the auditor, (3) auditor actions in performing the audit, and (4) reporting.
They are referred to as the Four Fundamental Principles underlying an audit. See Table 2-3 for details.
In addition, as part of improving clarity and converging with international auditing standards, the more
than 100 AUs are reorganized into six groups in a new AU codification scheme: (1) AU 200 General
Principles and Responsibilities, (2) AU 300-499 Risk Assessment and Response to Assessed Risks, (3)
AU 500 Audit Evidence, (4) AU 600 Using the Work of Others, (5) AU 700 Audit Conclusions and
Reporting, and (6) AU 800-999 Special Considerations. For example, the Statement on Auditing
Standards, Consideration of Fraud in a Financial Statement Audit, is grouped under General Principles
and Responsibilities as AU 240 (previously AU 316). See Appendix A for details.
With the passage of the Sarbanes-Oxley Act of 2002, the auditing standards to be used in the audits of
public companies (integrated audits) are to be established and promulgated by the Public Company
Accounting Oversight Board (PCAOB). Consequently, the AICPA reconstituted the ASB as a body with
the authority to establish the auditing standard to be used in the audits of private companies (financial
audits). This means that a CPA practicing in the United States normally performs an integrated audit of
a public company in accordance with the auditing standards (ASs) established by the PCAOB, and
normally performs a financial audit of a private company in accordance with the auditing standards
(AUs) established by the ASB.
In addition, the PCAOB adopted and retained the ASBs previously promulgated 10 GAAS as part of its
interim auditing standards; thus, auditors performing an integrated audit for a public company must
continue to follow the 10 GAAS until they have been superseded by a PCAOB standard.
In the CPA Firms Division, membership is granted to CPA firms, not to individual CPAs. This division
consists of two sections: the Securities and Exchange Commission Practice Section (SECPS) and the
Private Companies Practice Section (PCPS). CPA firms voluntarily join either, or both, sections based
on the type of clients that they serve.
Each section promotes a high quality of services offered by the CPA firms. For example, the SECPS
requires audit partners on SEC audit clients to be rotated at least every seven years, mandatory peer (or
quality) review (every three years) and mandatory continuing education for firm personnel (120 hours
every three years).
The executive committees of the two sections have the power to sanction member firms for poor quality
services. These sanctions may include additional education requirements, special peer reviews, fines,
and suspension or expulsion from the CPA Firms Division.
The Professional Ethics Executive Committee (PEEC) enforces the Code of Professional Conduct
(CPC) and interprets Rules of Conduct (more discussion in Chapter 3). The CPC is essential because a
distinguishing mark of a profession is its acceptance of responsibility to the public.
The Quality Control Standards Committee monitors a peer (or quality) review program among the CPA
firms. Every three years, members of the CPA Firms Division must subject their practice to a Peer (or
Quality) Review Program.
A peer (or quality) review involves a study of the adequacy of the reviewed firm's established quality
control policies and procedures (see Table 2-5), and tests the extent of the reviewed firm's compliance
with these policies. Typically, these tests consist of a review of selected working paper files and audit
reports.
A peer (or quality) review may be performed by another CPA firm (a firm review), by a state CPA
society or association, the Quality Review Executive Committee (a committee-appointed review team),
or by a regional association of CPA firms (an association review). The reviewer issues a report stating
their conclusions and recommendations.
The AICPA has established audit practice and quality centers as resource centers to improve audit
practice quality. In addition to these resource centers for CPA firms, the AICPA has established audit
quality centers for governmental audits and employee benefit plan audits.

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TABLE 2-2 10 Generally Accepted Auditing Standards (PCAOB)


10 Generally Accepted Auditing Standards
General Standards
1. The audit must be performed by a person or persons having adequate technical training and proficiency as an auditor.
2. In all matters relating to the assignment, an independent mental attitude is to be maintained by the auditor or auditors.
3. Due professional care is to be exercised in the performance of the audit and the preparation of the report.
Standards of Field Work
1. The auditor must adequately plan the work and must properly supervise any assistants.
2. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of
material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit
procedures.
3. The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion
regarding the financial statements under audit.
Standards of Reporting
1. The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles.
2. The report shall identify those circumstances in which such principles have not been consistently observed in the current period in relation
to the preceding period.
3. Information disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding financial statements, taken as a whole, or an assertion to the effect that an
opinion cannot be expressed. When an overall opinion cannot be expressed, the reasons thereof should be stated. In all cases where an
auditor's name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor's work,
if any, and the degree of responsibility the auditor is taking.

Table 2-3 Four Fundamental Principles Underlying an Audit (AICPA)


Four Fundamental Principles
Purpose of an Audit and Premise upon which an Audit is Conducted
1. The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented
fairly, in all material respects, in accordance with the applicable financial reporting framework. An auditors opinion enhances the degree of
confidence that intended users can place in the financial statements.
2. An audit in accordance with generally accepted auditing standards is conducted on the premise that management and, where appropriate, those
charged with governance, have responsibility
a. for the preparation and fair presentation for the financial statements in accordance with the applicable financial reporting framework; this
includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial
statements that are free from material misstatement, whether due to fraud or error; and
b. to provide the auditor with
i. all information, such as records, documentation, and other matters that are relevant to the preparation and fair presentation of the financial
statements;
ii. any additional information that the auditor may request from management and, where appropriate, those charged with governance; and
iii. unrestricted access to those within the entity from whom the auditor determines it necessary to obtain audit evidence.
Responsibilities
3. Auditors are responsible for having appropriate competence and capabilities to perform the audit; complying with relevant ethical
requirements; and maintaining professional skepticism and exercising professional judgment, throughout the planning and performance of the
audit.
Performance
4. To express an opinion, the auditor obtains reasonable assurance about whether the financial statements as a whole are free from material
misstatement, whether due to fraud or error.
5. To obtain reasonable assurance, which is a high, but not absolute, level of assurance, the auditor
a. plans the work and properly supervises any assistants.
b. determines and applies appropriate materiality level or levels throughout the audit.
c. identifies and assesses risks of material misstatement, whether due to due to fraud or error, based on an understanding of the entity and the
environment, including the entitys internal control.
d. obtains sufficient appropriate audit evidence about whether material misstatements exist, through designing and implementing appropriate
responses to the assessed risks.
6. The auditor is unable to obtain absolute assurance that the financial statements are free from material misstatement because of inherent
limitations, which arise from
a. the nature of financial reporting;
b. the nature of audit procedures; and
c. the need for the audit to be conducted within a reasonable period of time and so as to achieve a balance between benefit and cost.
Reporting
7. Based on an evaluation of the audit evidence obtained, the auditor expresses, in the form of a written report, an opinion in accordance with the
auditors findings, or states that an opinion cannot be expressed. The opinion states whether the financial statements are presented fairly, in all
material respects, in accordance with the applicable financial reporting framework.

Financial and Integrated Audits - Frederick Choo

11 Attestation Standards (AICPA and PCAOB)


Other attestation services such as agreed-upon procedures services get little or no specific guideline from the 10
GAAS because those standards relate primarily to historical financial statements prepared in accordance with GAAP
for the auditing service. This problem has been addressed by the Auditing Standards Board through the issuance of
11 Attestation Standards that parallel the previously 10 GAAS. Following the same framework used for auditing
standards, detailed interpretations of the 11 Attestation Standards are provided in more than 10 Statements on
Standards for Attestation Engagements (ATs). For example, AT 501 An Examination of an Entitys Internal Control
Over Financial Reporting That Is Integrated With an Audit of Its Financial statements . Table 2-4 describes the 11
Attestation Standards. See Appendix C for a list of the ATs. In addition, the AICPAs Accounting and Review
Services Committee Auditing issued a number of Statements on Standards for Accounting and Review Services
(ARs) that provide guideline for other attestation services such as review services. For example, AR 50 Standards for
Accounting and Review Services. See Appendix D for a list of ARs. The PCAOB adopted and retained both the ATs
and ARs as part of its interim auditing standards.
Table 2-4 11 Attestation Standards (AICPA and PCAOB)
11 Attestation Standards
General Standards
1. The engagement shall be performed by a practitioner having adequate technical training and proficiency in the attest function.
2. The engagement shall be performed by a practitioner having adequate knowledge in the subject matter.
3. The practitioner shall perform an engagement only if he or she has reason to believe that the subject matter is capable of evaluation against
criteria that are suitable and available to users.
4. In all matters relating to the engagement, independence in mental attitude shall be maintained by the practitioner.
5. Due professional care shall be exercised in the planning and performance of the engagement.
Standards of Field Work
1. The work shall be adequately planned and assistants, if any, shall be properly supervised.
2. Sufficient evidence shall be obtained to provide a reasonable basis for the conclusion that is expressed in the report.
Standards of Reporting
1. The report shall identify the subject matter or assertion being reported on and state the character of the engagement.
2. The report shall state the practitioners conclusion about the subject matter or the assertion in relation to the criteria against which the
subject matter was evaluated.
3. The report shall state all of the practitioners significant reservations about the engagement, the subject matter, and, if applicable, the
assertion related thereto.
4. The report shall state the use of the report is restricted to specified parties, in certain circumstances.

Peer Review Program


CPA firms must be enrolled in the AICPAs Peer Review Program for members in the firm to be eligible for
membership in the AICPA. A peer review is the review, by a CPA firm, of another CPA firms compliance with its
quality control system. The purpose of a peer review is to determine and report whether the CPA firm being
reviewed has developed adequate quality control policies and procedures and follows them in practice.
The AICPA Peer Review Program is administered by the state CPA societies under the overall direction of
the AICPA peer review board. Reviews are conducted every three years by a CPA firm selected by the firm being
reviewed. CPA firms in the Securities and Exchange Commission Practice Section (the SECPS part) who are
reviewed (inspected) by the PCAOB must be reviewed by the AICPA National Peer Review Committee to evaluate
the non-SECPS part; i.e., the Private Companies Practice Section (PCPS) part of the firms accounting and auditing
practice which is not reviewed (inspected) by the PCAOB. After the review is completed, the reviewer CPA firms
issue a report stating their conclusions and recommendations. Results of the peer review are included in a public file
by the AICPA.
Code of Professional Conduct
The AICPA Code of Professional Conduct defines both ideal principles and a set of specific, mandatory rules
describing minimum levels of conduct a CPA must maintain. The Professional Ethics Executive Committee (PEEC)
enforces the Code of Professional Conduct (CPC) and interprets Rules of Conduct (more discussion in Chapter 3).
In addition, because the CPC has been adopted by most State Boards of Accountancy, which have authority to grant

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or revoke professional CPA licenses, violations of the CPC can result in suspension or revocation of a CPAs right
to practice.
Five Elements of Quality Control (PCAOB)
The Quality Control Standards Committee previously established five elements of quality control that CPA firms
should consider in setting up their policies and procedures in order to conform to professional standards. The five
elements of quality control are shown in Table 2-5 with a brief description of the requirements for each element.
The PCAOB adopted and retained the five elements of quality control as part of its interim auditing standards.
Table 2-5 Five Elements of Quality Control (PCAOB)

Element
Independence, integrity, and
Objectivity
Personnel management

Acceptance and continuation


of clients and engagement

Engagement performance

Monitoring

Brief Description of Requirements


All personnel on engagements should maintain independence in fact and in appearance, perform all
professional responsibilities with integrity, and maintain objectivity in performing their professional
responsibilities.
Policies and procedures should be established to provide the CPA firm with reasonable assurance that
(1) all new personnel should be qualified to perform their work competently, (2) work is assigned to
personnel who have adequate technical training and proficiency, (3) all personnel should participate in
continuing professional education and professional development activities that enable them to fulfill
their assigned responsibilities, and (4) personnel selected for advancement have the qualifications
necessary for the fulfillment of their assigned responsibilities.
Policies and procedures should be established for deciding whether to accept or continue a client
relationship. These policies and procedures should minimize the risk of associating with a client whose
management lacks integrity. They include inquiring of the prospective clients banker, legal counsel,
investment banker, underwriter, or other persons who do business with company for information about
the company and its management. Also, the CPA firm should only undertake engagements that can be
completed with professional competence.
Policies and procedures should exist to ensure that the work performed by engagement personnel meets
applicable professional standards, regulatory requirements, and the CPA firms standards of quality.
They include establishing procedures for (1) planning engagements, (2) maintaining the firms standards
of quality, and (3) reviewing engagement working papers and reports.
Policies and procedures should exist to ensure that the other four quality control elements are being
effectively applied.

Six Elements of Quality Control (AICPA)


The Quality Control Standards Committee of the AICPA replaced the previously established five elements of quality
control with six elements of quality control in Statement on Quality Control Standards (SQCS No.8), A Firms
System of Quality Control. Table 2-6 provides a brief description of the requirements for each element. A CPA
firms system of quality control should be designed to provide the firm with reasonable assurance that the firm and
its personnel comply with professional, legal, and regulatory requirements and that the partners issue appropriate
reports. The nature and extent of a CPA firms quality control policies and procedures depend on a number of
factors, such as the firms size, the degree of operating autonomy allowed, its personnel policies, the nature of its
practice and organization, and appropriate cost-benefit considerations. For example, a sole practitioner with small
professional staff members may use a simple checklist and conduct periodic informal discussions to monitor his or
her firms compliance with professional standards. On the other hand, a large international CPA firm may develop
in-house procedures and assign full- or part-time staff to oversee and ensure compliance with the firms quality
control system. While not required, communication of the firms quality control system normally should be in
writing, with the extent of documentation varying with the size of the firm. A firms quality control policies and the
Code of Professional Conduct should be covered in the firms training programs.
As mentioned earlier, the PCAOB adopted and retained the five elements of quality control as part of its
interim auditing standards. Thus, a CPA firm performing an integrated audit for a public company must continue to
follow the five elements of quality control until they have been superseded by a PCAOB element.
Table 2-6 Six Elements of Quality Control (AICPA)

Element
Leadership responsibilities
for quality within the firm

Brief Description of Requirements


The firm should promote a culture that quality is essential in performing engagements and should
establish policies and procedures that support that culture. For example, the firms training programs

Financial and Integrated Audits - Frederick Choo

Element

(tone at the top)


Relevant ethical
requirements

Acceptance and continuation


of clients and engagement

Human resources

Engagement performance

Monitoring

Brief Description of Requirements


emphasize the importance of quality work, and this is reinforced in performance evaluation and
compensation decisions.
All personnel on engagements should maintain independence in fact and in appearance, perform all
professional responsibilities with integrity, and maintain objectivity in performing their professional
responsibilities. For example, each partner and employee must answer an independence questionnaire
annually, dealing with such things as stock ownership and membership on boards of directors.
Policies and procedures should be established for deciding whether to accept or continue a client
relationship. These policies and procedures should minimize the risk of associating with a client whose
management lacks integrity. The firm should only undertake engagements that can be completed with
professional competence. For example, a client evaluation form, dealing with such matters as
predecessor auditor comments and evaluation of management, must be prepared for every new client
before acceptance.
Policies and procedures should be established to provide the firm with reasonable assurance that (1) all
new personnel should be qualified to perform their work competently, (2) work is assigned to personnel
who have adequate technical training and proficiency, (3) all personnel should participate in continuing
professional education and professional development activities that enable them to fulfill their assigned
responsibilities, and (4) personnel selected for advancement have the qualifications necessary for the
fulfillment of their assigned responsibilities. For example, each professional must be evaluated on every
engagement using the firms individual engagement evaluation report.
Policies and procedures should exist to ensure that the work performed by engagement personnel meets
applicable professional standards, regulatory requirements, and the firms standards of quality. For
example, the firms director of accounting and auditing is available for consultation and must approve all
engagements before their completion.
Policies and procedures should exist to ensure that the other quality control elements are being
effectively applied. For example, the quality control partner must test the quality control procedures at
least annually to ensure the firm is in compliance.

Audit Practice and Quality Centers (CAQ)


The AICPA has established audit practice and quality centers as resource centers to improve audit practice quality.
The Center for Audit Quality (CAQ) is an autonomous public policy organization affiliated with the AICPA serving
investors, public company auditors, and the capital markets. The Centers mission is to foster confidence in the audit
process and to make integrated audits even more reliable and relevant for investors. In addition to these resource
centers for CPA firms, the AICPA has established audit quality centers for governmental audits and employee
benefit plan audits.
SECs Influence on Auditors Professional Environment
The Securities and Exchange Commission (SEC) is a federal government agency that regulates the trading of
securities. It influences the auditors professional environment in: 1. Enforcement of the Securities Act of 1933 and
the Securities Exchange Act of 1934 and publication of important regulations such as Regulation S-X. 2.
Establishment of the Public Company Accounting Oversight Board (PCAOB) under the Sarbanes-Oxley Act of
2002. 3. Monitoring of corporate frauds under the Corporate Criminal Fraud Accountability Act of 2002. The SECs
influence on the auditors professional environment is shown in Figure 2-2.

29

30

2 The Auditor's Professional Environment

Figure 2-2 SECs Influence on Auditors Professional Environment


Securities and Exchange Commission (SEC)
Influences CPA firms and individual CPAs through

Securities Act 1933


Securities Exchange Act 1934

Sarbanes-Oxley Act 2002

Corporate and Criminal Accountability Act 2002

Require filing of

Publication of

Establishment of

Monitoring of Corporate Fraud

Forms S-1 to S-16


Form 8K
Form 10K
Form 10Q

Regulation S-X
Public Company Accounting Oversight Board (PCAOB)
Regulation S-K
Accounting Series Releases
Accounting & Auditing
Enforcement Releases

Register CPA firms Establish Standards Inspect CPA firms Take Disciplinary Actions

Enforce Compliance

The Securities Act 1933 and Securities Exchange Act 1934


The Securities Act of 1933 and Securities Exchange Act 1934 of the SEC impose a variety of reports to be filed by
its members. Auditors whose clients are members of the SEC must perform certain duties associated with these
reports and must make sure their clients have filed the appropriate reports. The SEC also exerts strong influence
over the Financial Accounting Standards Board (FASB) in the development of generally accepted accounting
principles (GAAP). Furthermore, the SEC publishes publications such as Accounting and Auditing Enforcement
Releases, which announce accounting and auditing matters related to the SEC's enforcement activities. Sanctions
against independent auditors include restrictions for specified periods against mergers with other firms and prohibits
for specified periods against undertaking new engagements. Table 2-7 provides brief comments on the SECs filing
requirements and publications.
Table 2-7 SECs Reporting Requirements and Publications
Filing Requirements
Of the Securities Acts

Forms S-1 to S-16

Form 8-K

Brief comments
A registration statement that consists of a prospectus and Forms S-1 to S-16 is to be filed whenever a
company plans to issue new securities. The auditor's responsibilities include auditing the accompanying
financial statements, performing a subsequent events review and issuing a comfort letter to the underwriters.
Form 8-K to be filed when one of the following significant corporate occurred: (1) changes in auditor; (2)
changes in control; (3) changes in code of ethics; (4) resignation of directors; (5) acquisition or disposition of
a significant amount of assets, and (6) bankruptcy or receivership. The auditor's responsibilities include
issuing a letter of agreement concerning a change of auditor.
Effective August 2004, the SEC adds eight new disclosure items which will trigger an 8-K filing: (1) entry
into a material agreement that is not in the ordinary course of business; (2) termination of such a material
non-ordinary course agreement; (3) creation of a material direct financial obligation or a material obligation
under an off-balance sheet arrangement; (4) triggering events that accelerate or decrease a material direct
financial obligation or a material obligation under an off-balance sheet arrangement; (5) material costs
associated with exit or disposal activities; (6) material impairments; (7) notice of the listing or failure to
satisfy a continued listing rule or standard; and (8) non-reliance on or restatements of previously issued
financial statements or a related audit report or completed interim review.
In addition, disclosures as to the sale of unregistered securities, modifications of shareholder's rights,

Financial and Integrated Audits - Frederick Choo

Filing Requirements
Of the Securities Acts

Form 10-K
Form 10-Q

Brief comments
departure or the election of directors or principal officers and amendments to the corporate charter or by-laws
were transferred from other periodic filings (forms) to trigger an 8-K filing. Finally, in view of the complexity
of some of the issues and computations involved in the new requirements, the SEC's requirement to file an 8K within two days was changed to four days.
Form 10-K to be filed annually that consists of detailed financial information. The auditor's responsibilities
include auditing the accompanying financial statements.
Form 10-Q to be filed quarterly. The auditor's responsibilities include issuing a letter to be filed with the
interim financial statements. The letter states whether, in the auditor's opinion, any change in accounting
principle or practice is preferable in the circumstances.

Publications of
Enforced Activities

Regulation S-X
Regulation S-K
Financial Reporting
Releases
Staff Accounting
Bulletins

Regulation S-X is the principle accounting regulation of the SEC and it covers the requirements for auditor's
independence, audit reports, and financial statements to be filed with the SEC.
Regulation S-K is the uniform disclosure regulation and it covers the disclosure requirements for nonfinancial statements or tax information.
Financial Reporting Releases announce the SEC's current positions on accounting and auditing rules and
regulations.
Staff Accounting Bulletins, which are unofficial interpretations of Regulation S-X and GAAP and they
provide guideline for handling events and transactions with similar accounting implications.

Sarbanes-Oxley Act 2002


In 2002, the SEC established the Public Company Accounting Oversight Board (PCAOB) under the Sarbanes-Oxley
Act of 2002. Many duties of the PCAOB influence the auditors professional environment. See Appendix B for the
POAOBs Rules and Standards relating to the various duties. Table 2-8 provides brief comments on the duties of the
PCAOB.
Table 2-8 Duties of the PCAOB

Duties
Register CPA firms

Establish, or adopt, by
rule,
auditing,
quality
control, ethics, independence,
and other standards relating
to the preparations of audit
reports for issuers

Conduct
inspections
(reviews) of CPA firms

Brief Description of Requirements


In order to audit a public company, a CPA firm must register with the PCAOB. Foreign CPA firms who audit
a U.S. company or perform some audit work in a foreign subsidiary of a U.S. company must also register with
the PCAOB.
The PCAOB is required to cooperate with designated standard-setting bodies, such as the AICPA, in setting
standards, and it has the legal authority to adopt, amend, modify, repeal, and reject any standards suggested by
those bodies. The PCAOB adopted and retained the 10 GAAS and the AUs established by the AICPAs
Auditing Standards Board (ASB) as its interim auditing standards. In addition, the PCAOB has issued a
number of its own auditing standards; refer to as Auditing Standards (ASs). For example, effective May 2004,
the PCAOBs Auditing Standard No.1 (AS 1), References in Auditors' Reports to the Standards of the Public
Company Accounting Oversight Board, requires that auditors' reports on integrated audits of public
companies include a reference that the engagement was performed in accordance with the standards of the
PCAOB. This replaces the previous reference that the engagement was performed in accordance with the
standards of the AICPA. See Appendix B for the POAOBs Rules and Standards
The PCAOB also requires (1) CPA firms to prepare and maintain audit working papers and other information
related to any audit report for a period of not less than seven years, (2) A second partner review and approval
of audit reports, (3) CPA firms must adopt quality control standards, (4) The partner-in-charge and the
reviewing partner of an audit must rotate off the audit every five years, and (5) The auditor must report to the
audit committee.
The PCAOB is required to conduct annual quality inspections (reviews) of CPA firms that audit more than
100 clients; all others must be inspected (reviewed) every three years. Moreover, the PCOAB planned to
inspect 5% of the Big 4s audit engagements, 15% of the next four largest (second-tier) audit firms audit
engagements, and 50% of the audit engagements of CPA firms with fewer than 100 audit clients.
It should be noted that the PCAOB does not make public certain results of its inspections. The SarbanesOxley Act of 2002 requires that the results of inspections be forwarded to the SEC, the appropriate state-level
licensing board, and, in a limited form, to the public. Specifically, the PCAOB is prohibited from releasing to
the public:
(1) Criticisms of, or potential defects in, a (CPA) firms quality control systems.
Problems relating to a CPA firms quality control systems will be made public only if, in the opinion of the
PCOAB, the CPA firm fails to correct the deficiencies within 12 months and the CPA firms likely appeal to
the SEC is denied. The PCOAB will also remove from the public portion of the inspection report any other
discussion of the firms quality control systems because discussing aspects of a firms quality controls, in a
context where criticisms and potential defects cannot be discussed, may create a distorted and misleading

31

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2 The Auditor's Professional Environment

Duties

Conduct investigations
and disciplinary proceedings,
and
impose appropriate
sanctions

Enforce
compliance
with the Sarbanes-Oxley Act
2002, the rules of the Board,
professional standards, and
the securities laws relating to
the preparation and issuance
of audit reports.

Brief Description of Requirements

impression.
(2) Specific information concerning issuers (audit clients) financial statements.
When the PCOAB identifies possible departures from GAAP, materiality will determine whether the client
needs to restate its financials. If the departure is not material, the PCOAB will advise the CPA firm to discuss
the matter with the audit client. If the departure is material, the PCOAB will notify the SEC the only agency
authorized to direct a restatement. Since restated financial statements are a matter of public record, the public
(investors) could face with a situation where a company (audit client) issues restated financial statements,
which have originally given an unqualified (clean) opinion by its auditor (CPA firm).
(3) Violations of law, rules, or professional standards triggering investigations, disciplinary action, or referral
to other regulators or law enforcement authorities.
Sometime the PCOABs inspection process will uncover information that results in an investigation,
disciplinary action, or referral to other regulatory/enforcement authorities. The Sarbanes-Oxley Act of 2002
requires that such proceedings be kept confidential unless all parties agree to public disclosure or until the
investigatory/disciplinary process has run its course and the SEC has ruled on any appeal.
The PCAOB must notify the SEC of pending investigation involving potential violations of the securities
laws, and coordinate its investigation with the SEC Division of Enforcement.
All documents and information prepared or received by the PCAOB as evidence in connection with a
disciplinary action are confidential and privileged.
The PCAOB may sanction a CPA firm if it fails to adopt quality control standards including temporary
suspension or permanent revocation to practice in respect of audits of public companies.
The PCAOB is to enforce compliance with the SEC rules such as the independent rule issued in November
2001. Chapter 3 discusses further this rule.
The PCAOB is to enforce compliance with the auditing standards including the audit report on internal
controls. The audit report (or a separate report) is to be expanded to address internal controls of the company
by attesting and reporting on managements control assessments, including whether such internal controls (1)
include the maintenance of records that in reasonable details accurately and fairly reflect the transactions and
dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of the financial statements in accordance with GAAP, and that receipts and
expenditures are being made only in accordance to authorizations of management and directors of the
company.

As described in Table 2-1, AICPA members (CPAs) who perform auditing and other related professional
services are required to comply with the Four Fundamental Principles and the Statements on Auditing Standards
(AUs) promulgated by the AICPAs Auditing Standard Board (ASB). However, as described in Table 2-7, as a
result of the passage of the Sarbanes-Oxley Act of 2002, the auditing standards to be used in the audits of public
companies (integrated audits) are to be established by the Public Company Accounting Oversight Board (PCAOB).
Consequently, the AICPA reconstituted its ASB as a body with the authority to establish the auditing standards to be
used in the audits of private companies (financial audit). This means that a CPA practicing in the United States
normally performs an integrated audit of a public company in accordance with the auditing standards (ASs)
established by the PCAOB, and normally performs a financial audit of a private company in accordance with the
auditing standards (AUs) established by the ASB. In addition, a CPA practicing in the United States normally
performs an integrated audit of a foreign public company in accordance with the International Standards on Auditing
(ISAs) promulgated by the International Auditing and Assurance Standards Board (IAASB) of the International
Federation of Accountants (IFAC) and the ASs established by the PCAOB. Likewise, a CPA practicing in the
United States normally performs a financial audit of a foreign company in accordance with the ISAs promulgated by
the IAASB and the AUs established by the ASB. Figure 2-3 shows the multiple sets of standards for the audit of
public, private, and foreign companies.

Financial and Integrated Audits - Frederick Choo

Figure 2-3 Multiple Sets of Standards for the Audit of Public, Private, and Foreign Companies

Multiple Sets of Standards

U.S. Public Companies

U.S. Private Companies

Foreign

Public Companies

Follow ASs

Follow AUs and ISAs

Issued by PCAOB

Follow ISAs and ASs Follow ISAs and AUs

Issued by ASB

Conduct Integrated Audit

Private Companies

Issued by IAASB

Conduct Financial Audit

Conduct Integrated
Audit for Foreign
Public Companies

Conduct Financial
Audit for Foreign
Private Companies

ASs = Auditing Standards


AUs = Statements of Auditing Standards
ISAs = International Standards on Auditing
Terms Used in Auditing Standards and Levels of Auditors Responsibility
Both the PCAOB and the ASB have issued auditing standards that define the use of certain terms in auditing
standards and the levels of auditors responsibility. The PCAOB issued PCAOB Rule 3101 Certain Terms Used in
Auditing and Related Professional Practice Standards that is very similar to AU 200 Defining Professional
Requirements in Statements on Auditing Standards issued by the ASB. For examples, if a standard issued by both
the PCAOB and the ASB states that an auditor must perform a particular procedure, there are no exceptions the
procedure must be performed on an audit. On the other hand, if a standard states that a procedure should be
performed, they may be circumstances in which alternate procedures may be performed instead. Table 2-9
summarizes the terms used and the levels of responsibility in both standards.
Table 2-9 Terms Used in Auditing Standards and Levels of Auditors Responsibility
Terms Used in
Auditing Standards

Levels of Auditors
Responsibility

Meaning

Unconditional responsibility

Auditors must fulfill the requirements in all cases.

should

Presumptively mandatory
responsibility

may

Responsibility to consider

Auditors must comply with the requirements unless the auditors


demonstrate and document that alternative actions were sufficient
to achieve the objectives of the standards.
Auditor should consider the requirements. Whether the auditors
comply with the requirements will depend on the exercise of
professional judgment in the circumstances.

must
is required
shall [by PCAOB
only]

might

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2 The Auditor's Professional Environment

Terms Used in
Auditing Standards

Levels of Auditors
Responsibility

Meaning

could
should consider [by
ASB only]

Corporate and Criminal Fraud Accountability Act 2002


In light of the ENRON scandal in 2001, the SEC steps up its monitoring of public companies under the Corporate
and Criminal Fraud Accountability Act of 2002. This act has significant influence on the auditors professional
environment concerning the detection of fraud. Table 2-10 summarizes some provisions of the act.
Table 2-10 Provisions of the Corporate and Criminal Fraud Accountability Act 2002

Provisions of the Corporate and Criminal Fraud Accountability Act 2002


Auditors are required to maintain all audit working papers for seven years.
It is a felony to knowingly destroy or create documents (including audit working papers) to impede, obstruct or influence any existing or
contemplated federal investigation.
The statute of limitations on securities fraud claims is extended to five years from the fraud, or two years after the fraud was discovered.
Employees of CPA firms (and audit clients) are extended whistleblower protection that would prohibit the employer from taking certain
actions against employees. Whistle blower employees are also granted a remedy of special damages and attorneys fee.
Securities fraud by CPAs (and audit clients) is punishable up to ten years in prison.

Other Forces that Influence the Auditors Professional Environment


Besides the AICPA and SEC, there are other forces that influence the auditors professional environment. A brief
description of these other forces and their influences is given in Table 2-11.
Table 2-11 Other Forces that Influence the Auditors Professional Environment

Other Forces
Financial Accounting Standards Board
(FASB)

Governmental Accounting Standards Board


(GASB)

International Federation of Accountants


(IFAC)

Their Influences
The Financial Accounting Standards Board is an independent private body that develops
generally accepted accounting principles (GAAP). The board consists of seven members
who are assisted by a large research staff and an advisory council. It issues Statements of
Financial Accounting Standards (SFASs) that are officially recognized by the AICPA.
See http://www.fasb.org/ for more information.
The governmental accounting standards board sets accounting and auditing standards for
the government sector. The board consists of five members who have the authority to
promulgate accounting and auditing standards for the state and local governmental
agencies, such as the Statement of Governmental Accounting Standards (SGASs).
See http://www.gao.gov/ for more information.
The International Federation of Accountants (IFAC) is a worldwide organization of
national accounting bodies (e.g. AICPA) that fosters a coordinated worldwide accounting
profession with harmonized standards. One of its committees, the International Auditing
and Assurance Standards Board (IAASB) issues international standards on auditing and
reporting practices that is intended to improve uniformity of auditing services throughout
the world. The pronouncements of the IAASB do not override its members' respective
national auditing standards. However, members from countries that do not have such
standards are encouraged to adopt IAASB standards while members from countries that
already have such standards are encouraged to compare them to IAASB standards and
seek to eliminate any material inconsistencies.
As mentioned earlier, members of AICPA who perform auditing and other related
professional services have been required to comply with the four fundamental principle
established by AICPA and the AUs promulgated by the AICPAs Auditing Standard
Board (ASB). However, as a result of the passage of the Sarbanes-Oxley Act of 2002, the
auditing standards to be used in the audits of public companies (integrated audits) are to
be established and promulgated by the PCAOB. Consequently, the AICPA reconstituted
its ASB as a body with the authority to establish the auditing standards to be used in the
audits of private companies (financial audit). This means that a CPA practicing in the
United States normally performs an integrated audit of a public company in accordance

Financial and Integrated Audits - Frederick Choo

Other Forces

Their Influences

State Society (or Association) of CPAs

State Board of Accountancy

Audit Committee

with the auditing standards (ASs) established by the PCAOB, and normally performs a
financial audit of a private company in accordance with the auditing standards (AUs)
established by the ASB. In addition, a CPA practicing in the United States normally
performs an integrated audit of a foreign public company in accordance with the
International Standards on Auditing (ISAs) promulgated by the International Auditing and
Assurance Standards Board (IAASB) of the International Federation of Accountants
(IFAC) and the ASs established by the PCAOB. Likewise, a CPA practicing in the United
States normally performs a financial audit of a foreign company in accordance with the
ISAs promulgated by the IAASB and the AUs established by the ASB. See Figure 2-3 for
the multiple sets of standards for the audit of public, private, and foreign companies.
See http://www.ifac.org/ for more information.
Each state has a State Society (or Association) of CPAs. Its membership is voluntary,
however, many CPAs are both members of a State Society (or Association) of CPAs and
the AICPA. Each State Society (or Association) has its own codes of professional ethics
that closely parallel the AICPA's Code of Professional Conduct.
See http://www.calcpa.org/ for more information.
Each state has a State Board of Accountancy. A State Board of Accountancy usually
consists of five to seven CPAs and at least one public member, who are generally
appointed by the governor of each state. The State Board of Accountancy works
independently of the AICPA and the State Society (or Association) of CPAs. It issues,
renews, suspends or revokes a CPA's licenses to practice.
See http://www.dca.ca.gov/ for more information.
An audit committee is a subcommittee of the board of directors that is composed of
independent, outside directors. The committee monitors audit activities and serves as a
surrogate for the interests of stockholders. In 1999, the SEC adopted a report from the
New York Stock Exchange and the National Association of Securities Dealers that
addresses the effectiveness of the audit committee. Table 2-12 describes some key
changes affecting the audit committee.
See http://www.pcaobus.org/ for more information.

Table 2-12 Key Changes Affecting the Audit Committee

Requirements

The audit committee should be


composed of outside independent
directors.

All members should be


financially literate, and at least one
member should have accounting or
related
financial
management
expertise.

The audit committee should be


responsible for
the selection,
evaluation, and replacement of the
external auditor.

The audit committee should be


responsible
for
assessing
the
independence of the external auditor.

The external auditor should


discuss with the audit committee the
auditors judgments about the quality,
the degree of aggressiveness or
conservatism, and the underlying
estimates
of
the
companys
accounting principles.

Brief Descriptions
The outside independent directors must have no material relationship with the company. Former
partners or employees of the external auditors who worked on the companys audit engagement are
not deemed independent. Restrict payment to the outside independent directors for audit committee
service to $60,000 or less. Each independent director is generally limited to three public company
audit committees.
Financially literate means that all audit committee members are able to read and understand
financial statements at the time of their appointment to the audit committee.
Financial expertise takes into account the following: (1) prior experience as a public accountant or
auditor, CFO, controller, chief accounting officer, or similar position; (2) an understanding of GAAP
and financial statements; (3) experience in the preparation or auditing of financial statements of a
similar company; (4) experience with internal accounting controls; (5) an understanding of
accounting for estimates, accruals, and reserves, and (6) an understanding of audit committee
functions.
Under Section 301 of the Sarbanes-Oxley Act, audit committees are now directly responsible for the
appointment, compensation, and oversight of the external auditor. Moreover, Section 202 of the
Sarbanes-Oxley Act amends section 10A of the Securities Exchange Act of 1934 to require that the
audit committee must also pre-approve all audit and non-audit services provided by the external
auditor.
The audit committee must endure compliance with Section 303 of the Sarbanes-Oxley Act, which
makes it unlawful for any officer or director of a company to fraudulently influence, coerce,
manipulate, or mislead any external auditor engaged in the performance of an audit.
Section 206 of the Sarbanes-Oxley Act makes it unlawful for a registered CPA firm to perform the
audit of a company if the CEO, CFO, chief accounting office, or controller (or equivalent) was
employed by the accounting firm and participated in the audit of the company during the one-year
period preceding the date of the audit engagement.
The audit committee should review with the external auditor any audit problems or difficulties and
managements response including: (1) Accounting adjustments noted or proposed but passed (as
immaterial or otherwise). (2) National office consultations. (3) Review with the external auditor of
the responsibilities, budget, and staffing of the internal audit function.

35

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2 The Auditor's Professional Environment

Requirements

Brief Descriptions

The external auditor should


review the companys quarterly
financial statements before they are
filed (10-Q filing) with the SEC.

The audit committee to review


specific accounting issues.

The audit committee


establish
procedures
whistleblower communication.

to
for

The audit committee must be informed of any significant matters identified during the quarterly
review of the financial statements by the external auditor.
The audit committee is also required to include in the proxy statement its Report to Shareholders,
which indicates the audit committee has reviewed and discussed the audited year-end financial
statements (10-K filing) including managements discussion and analysis (MD&A) with management
and the external auditor.
The audit committee to review the effect of regulatory and accounting initiatives, as well as offbalance-sheet structures, on the financial statements.
The audit committee or a comparable body of the board of directors to review and approve all
related-party transactions.
The audit committee to ensure that a going concern qualification issued by the external auditor is
disclosed by the company through the issuance of a press release.
Section 310 of the Sarbanes-Oxley Act requires the audit committee to establish procedures for the
receipt, retention, and treatment of complaints received by the company regarding accounting,
internal controls, or auditing matters. This must include the ability of the employees to submit, on a
confidential and anonymous basis, concerns regarding questionable accounting or auditing matters.

Financial and Integrated Audits - Frederick Choo

Multiple-Choice Questions
2-1

An individual's license to practice as a CPA may be revoked by


a. the State Boards of Accountancy.
b. the SEC.
c. the State Society of CPAs.
d. the AICPA.

2-2

Generally accepted auditing standards may not be followed by


a. every independent audit service.
b. every CPA who is a member of the AICPA.
c. every independent audit service on clients who are members of the SEC.
d. every compilation service.

2-3

The standards of field work of the Generally Accepted Auditing Standards emphasize
a. adequate training.
b. adequate planning.
c. informative disclosure.
d. independence.

2-4

Which of the following characteristics is not in the general standards of the Generally Accepted Auditing Standards?
a. Due professional care and independence.
b. Adequate training and due professional care.
c. Sufficient appropriate evidence and understanding internal controls.
d. Independence.

2-5

Which of the following is an element of a CPA firms quality control that should be considered in establishing its quality
control policies and procedures?
a. Independence, integrity, and objectivity.
b. Considering risk and materiality.
c. Complying with laws and regulations.
d. Using statistical sampling techniques.

2-6

In a situation where no specific guideline or standard exists, an auditor should look to which of the following authorities for
guideline:
a. Statements on Auditing Standards (AUs).
b. Statements on Standards for Accounting and Review Services (ARs).
c. Statements on Standards for Attestation Engagements.
d. The AICPA code of professional conduct (CPC).

2-7

The SEC requirements of greatest interest to CPAs are set forth in the SECs
a. Forms 8-K, 10K, and 10Q.
b. Directors newsletter.
c. S-1 through S-16 forms.
d. Regulation S-X and Accounting Series Releases.

2-8

Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (AUs) should be looked upon by
practitioners as
a. ideals to work towards, but which are not achievable.
b. maximum standards which denote excellent work.
c. minimum standards of performance, which must be achieved in each audit engagement.
d. benchmarks to be used on all audits, reviews, and compilations.

2-9

The AICPAs division for CPA firms has two sections: the SEC Practice Section and the Private Companies Practice
Section. Which one of the following is not a requirement for belonging to the Private Companies Section?
a. Adherence to quality control standards.
b. Mandatory peer review program.
c. Partner rotation after a period of seven consecutive years.
d. Continuing education.

37

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2 The Auditor's Professional Environment

2-10

A basic objective of a CPA firm is to provide professional services to conform to professional standards. Reasonable
assurance of achieving this basic objective is provided through
a. a system of quality control.
b. continuing professional education.
c. compliance with generally accepted reporting standards.
d. a system of peer review.

2-11

Which of the following best describes the purpose of attestation standards and GAAS?
a. Measures of quality for attestation and audit services.
b. Methods to discharge professional responsibilities in attestation and audit services.
c. Rules that represent the publics expectations on attestation and audit services.
d. Objectives used to select evidence for attestation and audit services.

2-12

An audit committee should do all of the following except


a. Recommend the retention or dismissal of the external auditor.
b. Determine whether material financial fraud ought to be reported in a companys financial statements.
c. Consult with the external auditor prior to the audit engagement to convey any special concerns the committee has and to request any
special investigations.
d. Review the audit fees for reasonableness and investigate the reasons why audit fees may be higher than proposed.

2-13

Which of the following is not a duty of the Public Company Accounting Oversight Board?
a. Conduct inspection of CPA firms.
b. Freeze the payment of audit fee to CPA firms during an investigation of possible violations of securities laws.
c. Establish auditing standards and quality control.
d. Enforce compliance with the Sarbanes-Oxley Act of 2002.

2-14

Which of the following is not a provision in the Corporate and Criminal Fraud Accountability Act of 2002?
a. It is a felony for auditors to destroy audit working papers.
b. Auditors must maintain audit working papers for seven years.
c. The status of limitation extended to two years after the fraud was discovered by the auditors.
d. Whistleblower auditors are not granted special damages and attorneys fees.

2-15

Which of the following is the authoritative body designated to promulgate attestation standards?
a. Auditing Standard Board.
b. Government Accounting Standard Board.
c. Financial Accounting Standard Board.
d. Government Accountability Office.

2-16

Which of the following is a conceptual difference between the attestation standards and generally accepted auditing
standards?
a. The attestation standards provide a framework for the attest function beyond historical financial statements.
b. The requirement that the practitioner by independent in mental attitude is omitted from the attestation standards.
c. The attestation standards do not permit an attest engagement to be part of a business acquisition standards.
d. None of the standards of field work in generally accepted auditing standards are included in the attestation standards.

2-17

Which of the following is not an attestation standard?


a. Sufficient evidence shall be obtained to provide a reasonable basis for the conclusion that is expressed in the report.
b. The report shall identify the assertion being reported on and state the character of the engagement.
c. The work shall be adequately planned and assistants, if any, shall be properly supervised.
d. A sufficient understanding of internal control shall be obtained to plan the engagement.

2-18

The third general standard states that due professional care is to be exercised in the planning and performance of the audit
and the preparation of the report. This standard requires
a. thorough review of the existing safeguards over access and records.
b. limited review of the indications of employee fraud and illegal acts.
c. objective review of the adequacy of the technical training and proficiency of firm personnel.
d. supervision of assistants by the auditor with final responsibility for the audit.

Financial and Integrated Audits - Frederick Choo

2-19

Which of the following is an element of a CPA firms quality control system that should be considered in establishing its
quality control policies and procedures?
a. Complying with laws and regulations.
b. Using statistical sampling techniques.
c. Managing personnel.
d. Considering audit risk and materiality.

2-20

The primary purpose of establishing quality control policies and procedures for deciding whether to accept a new client is
to
a. enable the CPA firm to attest to the reliability of the client.
b. satisfy the CPA firms duty to the public concerning the acceptance of new clients.
c. minimize the likelihood of association with client whose management lacks integrity.
d. anticipate before performing any field work whether an unqualified opinion can be expressed.

2-21

A CPA firms quality control procedures pertaining to the acceptance of a prospective audit client would most likely
include
a. inquiry of management as to whether disagreement between the predecessor auditor and the prospective client were
resolved satisfactorily.
b. consideration of whether sufficient appropriate evidential matter may be obtained to afford a reasonable basis for an
opinion.
c. inquiry of third parties, such as the prospective clients bankers and attorneys, about information regarding the
prospective client and its management.
d. consideration of whether internal control is sufficiently effective to permit a reduction in the extent of required
substantive tests.

2-22

Which of the following are elements of a CPA firms quality control that should be considered in establishing its quality
control policies and procedures?
a.
b.
c.
d.

2-23

Monitoring
Yes
Yes
Yes
No

Engagement Performance
No
Yes
Yes
Yes

The nature and extent of a CPA firms quality control policies and procedures depend on
a.
b.
c.
d.

2-24

Human resources
Yes
Yes
No
Yes

The CPA Firms Size


Yes
Yes
Yes
No

The Nature of the CPA Firms Practice


Yes
Yes
No
Yes

Cost-Benefit Consideration
Yes
No
Yes
Yes

A CPA firm should establish procedures for conducting and supervising work at all organizational levels to provide
reasonable assurance that the work performed meets the firms standards of quality. To achieve this goal, the firm most likely would
establish procedures for
a. evaluating prospective and continuing client relationships.
b. reviewing engagement working papers and reports.
c. requiring personnel to adhere to the applicable independence rules.
d. maintaining personnel files containing document related to the evaluation of personnel.

2-25

Which of the following statements best explains why the CPA profession has found it essential to promulgate ethical
standards and to establish means for ensuring their observance?
a. A distinguishing mark of a profession is its acceptance of responsibility to the public.
b. A requirement for a profession is to establish ethical standards that stress primarily a responsibility to clients and
colleagues.
c. Ethical standards that emphasize excellence in performance over material rewards establish a reputation for competence
and character.
d. Vigorous enforcement of an established code of ethics is the best way to prevent unscrupulous acts.

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2 The Auditor's Professional Environment

2-26

Which of the following is not required by the SEC regarding an outside independent member of an audit committee?
a. The member must be paid $60,000 or less for the audit committee service.
b. The member must have no material relationship with the company.
c. The member must be financially literate.
d. The member must be former outside auditor of the company.

2-27

Which of the following is not a correct statement regarding the composition of the members of an audit committee?
a. All audit committee members should be financially literate within a reasonable period of time after their appointment.
b. At least one member should have accounting or related financial management expertise.
c. All audit committee members should not be affiliated persons of the company or a subsidiary.
d. The audit committee should be composed of outside directors.

2-28

Which provision of the Sarbanes-Oxley Act of 2002 does not apply to the audit committees?
a. Under Section 301 of the Sarbanes-Oxley Act, audit committees are now directly responsible for the appointment,
compensation, and oversight of the external auditor.
b. Under Section 202 of the Sarbanes-Oxley Act, audit committees are now to pre-approve all audit and non-audit services
provided by the external auditor.
c. Under Section 310 of the Sarbanes-Oxley Act, audit committees are now to establish procedures for the receipt,
retention, and treatment of complaints received by the company regarding accounting, internal controls, or auditing
matters, including whistleblower communication.
d. Under Section 204 of the Sarbanes-Oxley Act, audit committees are now to receive reports on the results of all tests of
control and tests of balances conducted by the external auditor.

2-29

The Sarbanes-Oxley Act of 2002 expands an audit committees responsibilities concerning specific accounting issues.
Which of the following specific accounting issues is not part of the expanded responsibility?
a. The audit committee is responsible to review the effect of off-balance-sheet structures on the financial statements.
b. The audit committee is responsible to review the effect of subsequent events on the financial statements.
c. The audit committee is responsible to review and approve all related-party transactions.
d. The audit committee is responsible to disclose a going concern qualification issued by the external auditor through the
issuance of a press release.

2-30

Which of the following is not a characteristic of the Public Company Accounting Oversight Board (PCAOB)?
a. PCAOB is responsible to oversee the audits of public companies that are subject to the securities laws.
b. PCAOB is non-governmental, not-for-profit corporate entity that will be funded by fees imposed on all public
companies, and fees from CPA firms that must register with the PCAOB in order to audit public companies.
c. PCAOB may not regularly inspect a registered CPA firms operation and it may not sanction the CPA firm if it fails to
adopt quality control standards.
d. PCAOB consists of five board members, two of which must be or must have been CPAs, and the Chair may be held by
one of the two CPAs, but must not have practiced accounting during the five years preceding his or her appointment.

2-31

Which of the following is not a duty of the Public Company Accounting Oversight Board?
a.
b.
c.
d.

2-32

Register foreign CPA firms who audit a foreign subsidiary of a U.S. company.
Enforce compliance with the Sarbanes-Oxley Act of 2002.
Notify the SEC of pending investigation involving potential violations of the securities laws.
Require the partner-in-charge of an audit to rotate off the audit every seven years.

Which of the following is a correct statement concerning the auditing standards of the Public Company Accounting Oversight Board
(PCAOB)?
a. The PCAOBs auditing standards replace the AICPAs Generally Accepted Auditing Standards (GAAS).
b. The PCAOBs auditing standards supplement the AICPAs Generally Accepted Auditing Standards (GAAS).
c. The PCAOBs auditing standards and the AICPAs Generally Accepted Auditing Standards (GAAS) are one and the
same.
d. The PCAOBs auditing standards change the audit procedures performed by an auditor.

Financial and Integrated Audits - Frederick Choo

2-33

Effective August 2004, the SEC adds eight new disclosure items which will trigger an 8-K filing. Which of the following is not one of
the new requirements?
a. Entry into a material agreement that is in the ordinary course of business.
b. Creation of a material direct financial obligation under an off-balance sheet arrangement.
c. Material costs associated with exit or disposal activities.
d. Material impairments.

2-34

Regarding the quality inspection of CPA firms, the PCOAB is not prohibited from releasing to the public the following
information in its inspection reports:
a. Specific information concerning an audit clients financial statements.
b. Criticisms of, or potential defects in, an audit firms quality control systems.
c. Violations of law, rules, or professional standards triggering investigations, disciplinary action, or referral to other
regulators or law enforcement authorities.
d. Failure of an audit firm to perform and document sufficient audit procedures related to the existence and valuation of
reported inventories.

2-35

Which of the following is true as a result of the passage of the Sarbanes-Oxley Act of 2002?
a. The AICPA reconstituted the ASB (Auditing Standard Board) as a body with the authority to establish the GAAS
(generally accepted auditing standards) to be used in the audits of public companies in the United States of America.
b. A CPA practicing in the United States of America normally audits the financial statements of a public company in
accordance with the GAAS established by the ASB (Auditing Standard Board).
c. A CPA practicing in the United States of America normally audits the financial statements of a public company in
accordance with the ISAs (International Standards on Auditing) promulgated by the IAASB (International Auditing and
Assurance Standards Board) of the IFAC (International Federation of Accountants).
d. A CPA practicing in the United States of America normally audits the financial statements of a non-public company in
accordance with the GAAS established by the ASB and the International Standards on Auditing (ISAs) promulgated by
the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants
(IFAC).

2-36

A duty of the PCOAB is to ensure that:


a. The partner-in-charge and the reviewing partner of an audit must rotate off the audit every five years
b. The partner-in-charge and the reviewing partner of an audit must rotate off the audit every seven years
c. CPA firms to maintain audit working papers related to an audit report for more than seven years.
d. CPA firms to maintain audit working papers related to an audit report for two years on-site and five years off-site.

2-37

The ASB (Auditing Standard Board) issued AU 230 Audit Documentation, which states Audit
documentation should include abstracts or copies of significant contracts or agreements that were examined to evaluate the
accounting for significant transactions. With regard to this particular audit procedure:
a. Auditors must fulfill the procedure in all cases.
b. Auditors must comply with the procedure unless the auditors demonstrate and document that alternative actions were
sufficient to achieve the objectives of the standards.
c. Auditor should consider the procedure. Whether the auditors comply with the procedure will depend on the exercise of
professional judgment in the circumstances.
d. Auditors should consider the procedure and must comply with the procedure after the consideration.

2-38

With the passage of the Sarbanes-Oxley Act of 2002, the auditing standards to be used in the audits of public companies (integrated
audits) are to be established and promulgated by the
a. Auditing Standard Board (ASB).
b. Public Company Accounting Oversight Board (PCAOB).
c. International Auditing and assurance Standards Board (IAASB).
d. State Board of Accountancy.

2-39

With the passage of the Sarbanes-Oxley Act of 2002, auditors performing an integrated audit for a public company must
a. continue to follow the four fundamental principles of the AICPA until they have been superseded by a PCAOB principle.
b. continue to follow the six elements of quality control of the AICPA until they have been superseded by a PCAOB element.
c. continue to follow the 10 GAAS until they have been superseded by a PCAOB standard.
d. continue to follow the International Standards on Auditing (ISAs) until they have been superseded by a PCAOB standard.

41

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2 The Auditor's Professional Environment

2-40

Which of the following is not a correct statement of the four fundamental principles underlying an audit?
a. An auditors opinion enhances the degree of confidence that intended users can place in the financial statements.
b. To express an opinion, the auditor obtains reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud or error.
c. The auditor is unable to obtain absolute assurance that the financial statements are free from all misstatements because of inherent
limitations.
d. Based on an evaluation of the audit evidence obtained, the auditor expresses, in the form of a written report, an opinion in
accordance with the auditors findings, or states that an opinion cannot be expressed.

2-41

With regard to the six elements of quality control, the element of Engagement performance requires that
a. policies and procedures should be established to provide the firm with reasonable assurance that work is assigned to personnel who
have adequate technical training and proficiency.
b. policies and procedures should be established for deciding whether to accept or continue a client relationship.
c. policies and procedures should exist to ensure that the other quality control elements are being effectively applied.
d. policies and procedures should exist to ensure that the work performed by engagement personnel meets applicable professional
standards, regulatory requirements, and the firms standards of quality.

2-42

Which of the following is not a characteristic of the AICPAs Peer Review Program?
a. CPA firms in the Securities and Exchange Commission Practice Section (the SECPS part) who are reviewed (inspected) by the
PCAOB must also have their non-SECPS parts reviewed by the PCAOB.
b. After the review is completed, the reviewer CPA firms issue a report stating their conclusions and recommendations.
c. The AICPA Peer Review Program is administered by the state CPA societies under the overall direction of the AICPA peer review
board.
d. Reviews are conducted every three years by a CPA firm selected by the firm being reviewed.

2-43

A CPA practicing in the United States of America normally performs an integrated audit of a foreign public company in accordance
with
a. the auditing standards (AUs) established by the Auditing Standard Board (ASB).
b. the auditing standards (ASs) established by the Public Company Accounting Oversight Board (PCAOB).
c. the auditing standards (ISAs) established by the International Auditing and Assurance Standards Board (IAASB).
d. the auditing standards (ISAs) established by the IAASB and the auditing standards (ASs) established by the PCAOB.

Key to Multiple-Choice Questions


2-1 a. 2-2 d. 2-3 b. 2-4 c. 2-5 a. 2-6 c. 2-7 d. 2-8 c. 2-9 c. 2-10 a. 2-11 a.
2-12 b. 2-13 b. 2-14 d. 2-15 a. 2-16 a. 2-17 d. 2-18 d. 2-19 c. 2-20 c. 2-21 c.
2-22 b. 2-23 a. 2-24 b. 2-25 a. 2-26 d. 2-27 a. 2-28 d. 2-29 b. 2-30 c. 2-31 d.
2-32 c. 2-33 a. 2-34 d. 2-35 d. 2-36 a. 2-37 b. 2-38 b. 2-39 c. 2-40 c. 2-41 d.
2-42 a. 2-43 d.

Financial and Integrated Audits - Frederick Choo

Simulation Question 2-1


Simulation Question 2-1 is an adaptation with permission from a case by Knapp M.C. in Contemporary Auditing: Real Issues & Cases, a
publication of the South-Western, a division of Thomson Learning in Ohio. This simulation question is based upon a true set of facts; however,
the names and places have been changed.
Anna Chan graduated from San Francisco State University in the spring of 2003 with a bachelors degree in accounting. During her
study at the College of Business, Chan earned a 3.9 grade point average and participated in many extracurricular activities, including the Beta
Alpha Psi Chapter and Accounting Students Organization. During the fall semester of 2002, Chan participated in the on-campus Meet the
Firms night. Subsequently, she interviewed with several public accounting firms and large corporations and received six job offers. After
considering those offers, she decided to accept an entry-level position on the auditing staff of a Big Four CPA firm. Chan was not sure whether
she wanted to pursue a partnership position with her new employer. However, she believed that the training programs the CPA firm provided and
the breadth of experience she would receive from a wide array of client assignments would get her career off to a good start.
Chan spent the first two weeks on her new job at her firms regional audit staff training seminar in San Jose. On returning to her office
in San Francisco in early June 2003, she was assigned to work on the audit of UCSF Hospital. Chans immediate supervisor on the UCSF
Hospitals engagement was Amy Wright, a third year senior. On her first day on the UCSF Hospitals audit, Chan learned that she would audit
the hospitals cash accounts and assist with accounts receivable. Chan was excited about her first client assignment and pleased that she would be
working for Wright. Wright had a reputation as a demanding supervisor who pushed for her engagements to be completed under budget. She was
also known for having an excellent rapport with her audit clients, and for being fair and straightforward with her subordinates.
Like many newly hired staff auditors, Chan was apprehensive about her new job. She understood the purpose of independent audits
and was familiar with the work performed by auditors but doubted that one auditing course, ACCT506, and a two-week staff-training seminar
had adequately prepared her for her new work role. After being assigned to work under Wrights supervision, Chan was relieved. She sensed that
although Wright was demanding, the senior supervisor would be patient and understanding with a new staff auditor. More importantly, Chan
believed that she could learn a lot working under the direct supervision of Wright. Thus, Chan resolved that she would work hard to impress
Wright and had hopes that the senior supervisor would mentor her through the first few years of her career at the CPA firm.
During Chans second week of audit at UCSF Hospital, Wright casually asked her over lunch whether she had taken the CPA exam in
May. After a brief pause, Chan replied that she had not but planned to enroll in a CPA Review Course and study intensively for the exam during
the next five months and then take the exam in November. Wright agreed that was a good strategy and offered to lend Chan a set of CPA review
books an offer Chan declined. The truth is that Chan has returned to her home state of Arizona during the first week of May and sat for the CPA
exam. For fear of admitting failure, Chan decided not to tell her co-workers that she had taken the exam. Moreover, Chan realized that she and
her co-workers might not pass all parts of the exam on their first attempt. She did not want to be labeled with her co-workers as not a first timer
of the CPA exam for the rest of her career.
Chan continued to work on the USCF Hospital audit throughout the summer. She completed the cash audit within budget. Moreover,
she submitted very thorough documentations of her work in the working paper file. Wright was pleased with Chans work and frequently
complimented and encouraged her. As the audit of the UCSF Hospital was near completion in early August, Chan received her grades on the
CPA exam in the mail one Friday evening. To her surprise, she had passed all parts of the exam in her first attempt. She immediately called
Wright to let her know of the impressive accomplishment. To Chans surprise, Wright seemed irritated, if not disturbed, by the good news. Chan
then remembered having told Wright earlier on that she had not taken the exam in May. Chan immediately apologized and explained why she had
chosen not to tell the truth. Following her explanation, Wright still seemed annoyed, so Chan decided to drop the subject and pursue it later in
person.
The following week, Wright spent Monday through Wednesday with another audit client, while Chan and the other staff assigned to
the UCSF audit continued to wrap up the engagement. On Wednesday morning, Chan received a call from Robert Moore, the partner-in-charge of
the UCSF Hospital audit. Moore asked Chan to meet with him late that afternoon in his office. She assumed that Moore simply wanted to
congratulate her on passing the CPA exam.
The usually upbeat Moore was somber when Chan stepped into his office that afternoon. After she was seated, Moore informed her
that he had spoken with Amy Wright several times during the past few days and that he had consulted with the three other audit partners in the
office regarding a situation involving Chan. Moore told Chan that Wright was very upset by the fact that she (Chan) had lied regarding the CPA
exam. Wright had indicated that she would not be comfortable having a subordinate on future audit engagements whom she could not trust to be
truthful. Wright had also suggested that Chan be dismissed from the CPA firm because of the lack of professional integrity she had demonstrated.
After a brief silence, Moore told a stunned Chan that he and the other audit partners agreed with Wright. He informed Chan that she
would be given 60 days to find another job. Moore also told Chan that he and the other partners would not disclose that she had been counseled
out of the firm if contacted by employers interested in hiring her.

Required
1.
2.
3.
4.
5.

Which of the six elements of quality control identified by the AICPAs Quality Control Standards Committee applies to Wrights
rationale in dealing with Chans white lies? Explain.
How would you have dealt with the situation if you had been in Chans position? Explain.
How would you have dealt with the situation if you had been in Wrights position? Explain.
How would you have dealt with the situation if you had been in Moores position? Explain.
What lessons have you learned from this simulation question regarding the auditors professional environment discussed in Chapter 2?

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2 The Auditor's Professional Environment

Simulation Question 2-2


Simulation Question 2-2 is an adaptation with permission from a case by Knapp M.C. in Contemporary Auditing: Real Issues & Cases, a
publication of the South-Western, a division of Thomson Learning in Ohio. This simulation question is based upon a true set of facts; however,
the names and places have been changed.
After spending much of the prior three months working elbow-to-elbow with as many as six colleagues in a cramped and poorly
ventilated conference room, Kevin Nguyen was look forward to moving on to his next assignment. Nguyen was an in-charge accountant on the
audit staff of the San Francisco office of a large international CPA firm, the firm that had offered him a job two years earlier as he neared
completion of his accounting degree at San Francisco State University. His current client, Discovery & Things, Inc., a public company and the
second largest client of Nguyens office, owned a chain of retail stores in the western United States that stretched from Seattle to San Diego and
as far east as Denver and Albuquerque.
Although Discovery and Things stores operated under different names in different cities, each stocked the same general types of
merchandise, including briefcases and other leather goods, luggage and travel accessories, and a wide range of gift items, such as costume
jewelry, imported from Pacific Rim countries. The company also has a wholesale division that marketed similar merchandise to specialty retailers
throughout the United States. The wholesale division accounted for approximately 60 percent of the companys annual sales.
A nondescript building in downtown San Francisco, just one block from bustling Market Street, served as Discovery and Things
corporate headquarters. The companys fiscal year-end fell on the final Saturday of January. With the end of March just a few days away, Nguyen
and his fellow Dizzies the nickname that his office assigned to members of the Discovery and Things audit engagement team were quickly
running out of time to complete the audit. Nguyen was well aware that the audit was behind schedule since he collected, coded, and input into an
electronic spreadsheet the time worked each week by the individual Dizzies. He used the spreadsheet package to generate a weekly time and
progress report that he submitted to Jessica Lee, the senior who supervised the field work on the Discovery and Things audit.
In addition to Nguyen and Lee, another in-charge accountant, Melissa Wan, and four staff accountants had worked on the Discovery
and Things audit since early January. Nguyen and Wan knew each other well. They had shared the same start date with their employer and the
past two summers had attended the same weeklong staff and in-charge training sessions at their firms national education headquarters. Wans
primary responsibility on the current years audit was the receivables account but she also audited the PP&E (Property, plant, and equipment) and
leases accounts. Besides his administrative responsibilities, which included serving as the engagement timekeeper and maintaining the
correspondence file for the audit, Nguyen supervised and coordinated the audit procedures for inventory accounts payable, and a few smaller
accounts.
Nguyen was thankful that it was Friday afternoon. In recent weeks with the audit deadline looming, Jessica Lee had required the
Discovery and Things crew to work until at least 8 p.m. each weekday except Friday, when she allowed them to leave early at 5 p.m. The
engagement team had spent three consecutive Saturdays in the clients headquarters and would be spending both Saturday and Sunday of the
coming weekend hunched over their audit workpapers. Nguyen had just completed collecting and coding the hours worked during the current
week by the other members of the engagement team. Now it was time for him to enter in the electronic spreadsheet his chargeable hours, which
he dutifully recorded at the end of each work day in his little black book.
Before entering his own time, Nguyen decided to walk across the hall and purchase a snack in the employees break room. In fact, he
was stalling, trying to resolve a matter that was bothering him. Less than 30 minutes earlier, Melissa Wan had told him that during the current
week, which included the previous weekend, she had spent 31 hours on the receivables account, 18 hours on the leases account, and three hours
on PP&E. What troubled Nguyen was the fact that he knew Wan had worked several more hours during the current week on the Discovery and
Things audit.
This was not the first time Wan had underreported her hours worked. On several occasions, Nguyen had noticed her secretively
slipping workpaper files into her briefcase before leaving for home. The next morning, those files included polished memos or completed
schedules that had not existed the previous day. Nguyen was certain that Wan was not reporting the hours she spent working at home on her audit
assignments. He was just as certain that each week she consciously chose to shave a few hours off the total number she had spent working at the
clients headquarters. Collectively, Nguyen estimated that Wan had failed to report at least 80 hours she had worked on the audit.
Eating Time was a taboo subject among auditors. Although the subject was not openly discussed, Nguyen was convinced that many
audit partners and audit managers subtly encouraged subordinates to underreport their time. By bringing their jobs in near budget, those partners
and managers enhanced their apparent ability to manage engagements. The most avid time-eaters among Nguyens peers seemed to be the
individuals who had been labeled as fast-track superstars in the office.
After Wan had reported her time to Nguyen that afternoon, he had nonchalantly but pointedly remarked, Melissa, who are you trying
to impress by eating so much of your time? His comment had caused the normally mild-mannered Wan to snap back, Hey, Dude, you are the
timekeeper, not the boss. So just mind your own #$&! business. Immediately, Nguyen regretted offending Wan, whom he considered his friend.
But she stomped away before he could apologize.
Nguyen knew who Wan was trying to impress. Jessica Lee would almost certainly be promoted to audit manager in the summer and
then become the audit manager on the Discovery and Things engagement, meaning that there would be a vacancy in the all-important senior
position on the engagement team. Both Wan and Nguyen also anticipated being promoted during the summer. The two new seniors would be the
most likely candidates to take over the job of overseeing the field work on the Discovery and Things audit. The in-charge accountant who
handled the administrative responsibilities on the engagement was typically the person who had been tabbed to take over the seniors role. But
Nguyen worried that the close friendship that had developed between Wan and Lee might affect his chances of landing the coveted assignment.
Almost every day, Wan and Lee went to lunch together without extending even a token invitation to Nguyen or their other colleagues to join
them. Baron Davis , the audit engagement partner would choose the new senior for the Discovery and Things engagement, but Jessica Lee would
certainly have a major influence on his decision.
There was little doubt in Nguyens mind that Wan routinely underreported the time she worked on the Discovery and Things audit to
enhance her standing with Lee and Davis. Not that Wan needed to spruce up her image. She had passed the CPA exam on her first attempt, had a
charming personality that endeared her to her superiors and client executives, and, like both Lee and Davis, was a UC Berkeley graduate.
Nguyen, on the other hand, had suffered through three attempts at the CPA exam before finally passing, was shy by nature, and graduated from
San Francisco State University.
What irritated Nguyen the most about his subtle rivalry with Wan was that the past two weekends he had spent several hours helping
her research contentious technical issues for Discovery and Things complex lease contracts on its retail store sites. Earlier in the engagement,

Financial and Integrated Audits - Frederick Choo

Wan had also asked him to help analyze some tricky journal entries involving the clients allowance for bad debts. In each of those cases, Nguyen
had not charged any time to the given accounts, both of which were Wans responsibility.
Before entering his time for the week, Nguyen checked once more the total hours that he had charged to date to his major accounts.
For both inventory and accounts payable, he was already over budget. By the end of the audit, Nguyen estimated that he would bust the
assigned time budgets for those two accounts by 20 to 25 percent each. On the other hand, Wan, thanks to her superior time management skills,
would likely exceed the time budget on her major accounts by only a few hours and might even come in under budget, which was almost unheard
of, at least on the dozen or so audits to which Nguyen had been assigned.
After finishing the bag of chips he had purchased in the snack room, Nguyen reached for the computer keyboard in front of him. In a
few moments, he had entered his time for the week and printed the report that he would give to Jessica Lee the following morning. After briefly
glancing at the report, he slipped it into the appropriate workpaper file, turned off the light in the empty conference room, and locked the door
behind him as he resolved to enjoy his brief sixteen-hour weekend.

Required
1.
2.
3.
4.
5.
6.

Which of the six elements of quality control identified by the AICPAs Quality Control Standards Committee applies to Wans
rationale in underreporting the time she worked? Explain.
If you had been in Wans position, would you underreport the time you worked? Explain.
If you had been in Nguyens position, would you underreport the time you worked? Explain.
Suggest several measures that Nguyens CPA firms can take to ensure that time budgets do not interfere with the
successful completion of the Discovery and Things audit or become dysfunctional in other ways.
Suggest several measures that Nguyens CPA firms can take to reduce the likelihood that personal rivalries among auditors
of the same rank will become dysfunctional.
What lessons have you learned from this simulation question regarding the auditors professional environment discussed in Chapter 2?

Simulation Question 2-3


Simulation Question 2-3 is an adaptation with permission from a case by Knapp M.C. in Contemporary Auditing: Real Issues & Cases , a
publication of the South-Western, a division of Thomson Learning in Ohio. This simulation question is based upon a true set of facts; however,
the names and places have been changed.
It was nearly 8:30 p.m. on a Friday evening in early August. Fred Choo, an audit manager for a large international accounting firm,
had spent several minutes shuffling through the audit workpapers and correspondence stacked on his desk, trying to decide what work he should
take home over the weekend. Finally, only one decision remained. Choo could not decide whether to take the inventory file with him.
Compulsive by nature, Choo knew that if he took the inventory file home, he would have to complete his review of that file, which would
increase his weekend workload from 6 hours to more than 12 hours. As he stewed over his decision, Choo stepped to the window of his office
and idly watched the evening traffic on the downtown streets several stories below.
Choo had suffered through a tough week. His largest audit client was negotiating to acquire a competitors company within its
industry. For the past two months, Choo had supervised the field work on an intensive acquisition audit of the competitors accounting records.
The clients chief executive officer (CEO) suspected that the competitors executives had embellished their firms financial data in anticipation of
the proposed acquisition. Since the audit client was overextending itself financially to acquire the competitor company, the CEO wanted to be
sure that the competitor companys financial data were reliable. The CEOs principal concern was the valuation of the competitor companys
inventory, which accounted for 45 percent of its total assets. The clients CEO had requested that Choo be assigned to the acquisition audit
because he respected Choo and quality of his work. Normally, an audit manager spends little time on the trenches supervising day-to-day audit
procedures. Because of the nature of the this engagement, however, Choo had felt it necessary to spend 10 hours per day, six and seven days per
week, poring over the accounting records of the targeted takeover company with his audit staff assistants. As Choo stared at the gridlocked streets
below, he was relieved that the acquisition audit was almost complete. After he tied up a few loose ends in the inventory file, he would turn the
workpapers over to the audit engagement partner for a final review.
Choos tough week had been highlighted by several contentious meetings with client personnel, a missed birthday party for his young
daughter, and an early breakfast Thursday morning with his office managing partner, Ken Trotman. During that breakfast, Trotman had notified
Choo that he had been passed over for promotion to partner-for the second year in a row. The news had been difficult for Choo to accept. For
more than 10 years, Choo had been a hardworking and dedicated employee of the large accounting international accounting firm. He had never
turned down a difficult assignment, never complained about the long hours his work required, and made countless personal sacrifices, the most
recent being the missed birthday party. After informing Choo of the bad news, Trotman encouraged him to stay with the firm. Trotman promised
the following year he would vigorously campaign for Choos promotion and call in all favors owed to him by partners in other offices. Despite
that promise, Choo realized that he had only a minimal chance of being promoted to partner. Seldom were two-time losers ticketed for
promotion.
Although he had been hoping for the vest, Choo had not expected a favorable report from the Partner Selection Committee. In recent
weeks, he had gradually admitted to himself that he did not have the profile for which the committee was searching. Choo was not a rainmaker
like his friend and fellow audit manager, Kim Park, whose name appeared on the roster of new partners to be formally announced the following
week. Park was a member of several important civic organizations and had a network of well-connected friends at the local golf club. Those
connections had served Park well, allowing him to steer several new clients to the firm in recent years.
Instead of a rainmaker, Choo was a technician. If someone in the office had a difficult accounting or auditing issue to resolve, that
individual went first to Choo, not to one of the offices six audit partners. When a new client posed complex technical issues, the audit
engagement partner requested that Choo be assigned to the job. One reason Choo was a perfect choice for difficult engagements was that he
micromanaged his jobs, insisting on being involved in every aspect of them. Choos management style often resulted in his busting time
budgets for audits, although he seldom missed an important deadline. To avoid missing deadlines when a job was nearing completion, Choo and
the staff assistants in his audit engagement team would work excessive overtime, including long weekend stints.

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2 The Auditor's Professional Environment

Finally, Choo turned away from his window and slumped into his chair. As he sat there, he tried to drive away the bitterness that he
was feeling. If William Lee hadnt left the firm, maybe I wouldnt be in this predicament, Choo thought to himself. Three years earlier, William
Lee, an audit partner and Choos closest friend within the firm, had resigned to become the chief financial officer (CFO) of a large client. After
Lees resignation, Choo had no one within the firm to sponsor him through the tedious and political partner selection process. Instead, Choo had
been lost in the shuffle with the dozens of other hardworking, technically inclined audit manager within the firm who aspired to a partnership
position.
Near the end of breakfast Thursday morning, Trotman had mentioned to Choo the possibility that he could remain with the firm in a
senior manager position, IN recent years, Choos CPA firm had relaxed its up or out promotion policy. But Choo was not sure he wanted to
remain with the firm as a manager with no possibility of being promoted to partner. Granted, there were clearly advantages associated with
becoming a permanent senior manager. For example, no equity interest in the firm meant not absorbing any portion of its future litigation losses.
On the other hand, in Choos mind accepting an appointment as a permanent senior manager seemed equivalent to having career failure
stenciled on his office door.
Ten minutes till nine, time to leave. Choo left the inventory file lying on his desk s he closed his laptop and then stepped toward the
door of his office. After flipping off the light switch, Choo paused momentarily. He then grudgingly turned and stepped back to his desk, picked
up the inventory file, and tucked it under his arm.

Required
1.
2.
3.
4.
5.
6.

Which of the six elements of quality control identified by the AICPAs Quality Control Standards Committee applies to Choos
rationale in working excessive overtime to meet deadlines? Explain.
If you had been in Choos position, would you work excessive overtime to meet deadlines? Explain.
Which of the six elements of quality control identified by the AICPAs Quality Control Standards Committee applies to the up or
out promotion policy in Choos CPA firm? Explain.
If you had been in Choos position, would you remain with the CPA firm as a permanent senior audit manager? Explain.
Suggest several measures that Choos CPA firms can take to reduce the likelihood that aspiring audit managers will not be lost in the
shuffle through the tedious and political partner selection process.
What lessons have you learned from this simulation question regarding the auditors professional environment discussed in Chapter 2?

Financial and Integrated Audits - Frederick Choo

Chapter 3
The Auditors Ethical Environment
Chapter Learning Outcomes (LOs) Checklist
After reading this chapter, you should be able to:
LO3-1 Apply the American Institute of Certified Public Accountants (AICPAs) Rules
of Conduct.
LO3-2 Understand the interpretations of Rule 101 Independence.
LO3-3 Differentiate between the AICPA and the Public Company Accounting
Oversight Boards (PCAOBs) rules on independence.
LO3-4 Identify some threats to and examples of auditors non-independence.
LO3-5 Describe the enforcement mechanisms for the AICPAs Code of Professional
Conduct (CPC) and the PCAOBs Auditor Independence rules.

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3 The Auditor's Ethical Environment

Chapter 3 The Auditors Ethical Environment


The AICPA Code of Professional Conduct (CPC), labeled as ETs, provides the principles and rules an auditor
should follow in the practice of public accounting (see Appendix E for a list of ETs). The CPC consists of two
sections: Principles of Professional Conduct and Rules of Conduct. Additional guidance for applying the Rules of
Conduct is provided by the Interpretations of Rules of Conduct and Ethics Rulings. The guidance provided by the
CPC starts at a conceptual level with the principles and progressively moves to general rules and their interpretations
and then to specific rulings on individual cases. Figure 3-1 shows the four parts of the CPC.
Figure 3-1 Code of Professional Conduct
Not enforceable

Principles of Professional Conduct

Specifically enforceable

Rules of Conduct

Interpretations of Rules of Conduct

Not specifically
enforceable, but
departure must be
justified

Ethics Rulings

Principles of Professional Conduct


The Principles of the Code of Professional Conduct express the profession's recognition of its responsibilities to the
public, to clients, and to colleagues. They form the basis of ethical and professional conduct and guide members of
the AICPA in the performance of their professional responsibilities. Moreover, they demand from its members an
unswerving commitment to honorable behavior, even at the sacrifice of personal advantage. However, these
principles are not enforceable. Rather, they provide a framework for the Rules of Conduct, which are enforceable.
The six ethical principles and their requirements are shown in Table 3-1 below:
Table 3-1 Principles of Professional Conduct

Principles
Responsibilities

The public interest

Integrity

Objectivity and
independence

Due care

Requirements
Members of the AICPA have responsibilities to all those who use their professional services. They also
have a continuing responsibility to cooperate with each other to improve the methods of accounting and
reporting, to maintain the public confidence, and to carry out the profession's special responsibilities of
self-governance.
The accounting profession's public consists of clients, creditors, governments, employers, investors, and
the business and financial community. These groups of people rely on the CPAs' objectivity and
integrity to maintain the orderly functioning of commerce. This reliance imposes a public interest
responsibility on CPAs.
For the public to trust the accounting profession, members of the AICPA must act with integrity in
making all decisions. Integrity requires CPAs to be honest and that service and public trust not to be
subordinated to personal gain and advantage. Moreover, integrity can accommodate the inadvertent
error and the honest difference of opinion. However, it cannot accommodate deceit or subordination of
principle.
The principle of objectivity requires a CPA to be impartial, intellectually honest, and free of conflict of
interest. On the other hand, the principle of independent in fact and in appearance precludes
relationships that may appear to impair a CPA's objectivity in rendering attestation services. For a CPA
in public practice, the maintenance of objectivity and independence requires a continuing assessment of
client relationships and public responsibility.
The principle of due care requires CPAs to pursue excellence in providing professional services. In
doing so, CPAs must discharge their professional responsibilities with competence and diligence. A
CPA obtains competence through both education and experience. Competence also requires a CPA to
continue to learn throughout his/her career. Diligence imposes the responsibility to render services
promptly and carefully, to be thorough, and to observe applicable technical and ethical standards.

Financial and Integrated Audits - Frederick Choo

Principles
Scope and nature of services

Requirements
In determining whether or not to perform specific services, members of the AICPA in public practice
should consider whether such services are consistent with the principles of professional conduct for
CPAs. There are no hard-and-fast rules to help members in determining whether or not to provide
specific services in this regard; however, they must be satisfied that they are meeting the spirit of the
principles of professional conduct for CPAs.

Rules of Conduct
The bylaws of the AICPA require its members to adhere to the Rules of the Code of Professional Conduct. These
rules establish minimum standards of acceptable conduct in the performance of professional services. These Rules
are specifically enforceable in that the bylaws of the AICPA provide its Professional Ethics Executive Committee
(PEEC) the authority to discipline a CPA guilty of violating the Rules.
In addition to the Principles and Rules of Conduct, the AICPAs PEEC promulgates the Interpretations of
the Rules of Conduct and Ethics Rulings:
Interpretations of the Rules of Conduct
The Interpretations of the Rules of Conduct are promulgated by the PEEC to provide guidelines as to the scope and
applicability of specific rules. They are not specifically enforceable but CPAs must justify departures from the
Interpretations in disciplinary hearings.
Ethics Rulings
The PEEC also promulgates Ethics Rulings, which are questions and answers to specific ethical situations. They
indicate the applicability of the Rules of Conduct and Interpretations of the Rules of Conduct to a particular set of
factual circumstances. Ethics Rulings are not specifically enforceable but CPAs must justify departures from the
Ethics Rulings in disciplinary hearings.
Specific Rules of Conduct
Rule 101 - Independence
A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies
designated by Council.

Independence is the most important rule of conduct for CPAs. Without independence, a CPA's opinion on the
financial statements would be of little value. Owing to its importance, Rule 101 has been the subject of many
Interpretations of the Rules of Conduct and Ethics Rulings. An important interpretation of Rule 101 relates to the
phrase a member in public practice which simply means a CPA in practice. The interpretation of the Rules
relates the phrase a member in public practice to covered members who are in a position to influence an attest
engagement. Covered members include: 1. Individuals on the attest engagement team. 2. An individual in a position
to influence the attest engagement, such as individuals who supervise or evaluate the engagement partner. 3. a
partner or manager who provides non-attest services to the client. 4. A partner in the office of the partner responsible
for the attest engagement. 5. The firm and its employee benefit plans. 6. An entity that can be controlled by any of
the covered members listed above or by two or more of the covered individuals or entities operating together.
SECs Auditor Independence Rules
The Sarbanes-Oxley Act of 2002 establishes the Public Company Accounting Oversight Board (PCAOB), whose
responsibilities are to oversee the audits of public companies that are subject to the securities laws. These
responsibilities include overseeing SECs Auditor Independence Rules under Section 103 of the Act; specifically,
the PCAOBs Auditor Independence Rule 3520. The PCAOB Rule 3520 is summarized as follows:

Services Outside the Scope of Practice of Auditors


The PCAOB uses the following general principles to evaluate the effect of non-audit services on auditor
independence: 1. an auditor cannot function in the role of management; 2. an auditor cannot audit his or her own
work, and 3. an auditor cannot serve as an advocate for the client. Based on these general principles, it is unlawful
for a registered CPA firm to provide non-audit services to an a public company, including: 1. bookkeeping or other
services related to the accounting records or financial statements of the audit client; 2. financial information systems

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design and implementation; 3. appraisal, valuation, and actuarial services; 4. internal audit outsourcing services; 5.
management functions or human resources; 6. various investment services such as broker or dealer, investment
adviser, or investment banking services; 7. legal services and expert services unrelated to the audit, and 8. any other
services that the PCAOB determines, by regulation, to be impermissible such as certain tax services.
Auditor Communicates to Audit Committee
Before accepting a new or continuing audit engagement, the audit firm must communicate in writing to the audit
committee all relationships between the audit firm and the client that may reasonably be thought to bear on the audit
firms independence.
Auditor Reports to Audit Committee
The auditing firm must report to the audit committee all: 1. critical accounting policies and practices to be used, and
2. all alternative treatments of financial information within GAAP that have been discussed with management,
ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the accounting
firm.
Conflicts of Interest
The CEO, Controller, CFO, Chief Accounting Officer or person in an equivalent position cannot have been
employed by the companys audit firm during the 1-year period preceding the audit. In other words, an auditing firm
is not independent of a client that employs the auditing firms employees (auditors) within the one year period
preceding the audit.
Partner Rotation
A lead (coordinating) partner and a review (concurring) partner must rotate off of an engagement after five
consecutive years.
Audit Committee Pre-approve
Audit committee to pre-approve audit services and non-audit services, unless non-audit service fees are less than 5
percent of total audit fees. For example, certain non-audit services, such as tax services, may be provided if they are
pre-approved by the audit committee, or their fees are less than 5 percent of total audit fees. The audit committee
must disclose to investors in periodic reports its decision to pre-approve non-audit services.
Partner Compensation
An auditing firm is not independent of an audit client if any audit partner is compensated for securing with the client
billable work for services other than audit or attestation.
Expanded Disclosure
Public companies disclose audit fees and fees for an explanation of audit-related, tax, and all other services.
Study of Mandatory Rotation of Registered Public Accountants
The PCOAB is to conduct a study on the potential effects of requiring the mandatory rotation of audit firms.
In addition, the SEC issued Regulation S-X Rule 2-10 to strengthen requirements of the PCAOBs Auditor
Independence Rule 3520 regarding auditor independence. The Regulation S-X Rule 2-01 describes four overarching
independence principles indicating that a relationship between the accountant and the audit client should not:
1. Create a mutual or conflicting interest between the accountant and the audit client;
2. Place the accountant in the position of auditing his or her own work;
3. Result in the accountant acting as management or an employee of the audit client; or
4. Place the accountant in the position of being an advocate for the audit client.
Rule 2-01 also prohibits specific relationships including financial relationships, employment relationships, business
relationships, relationships whereby the audit firm provides non-audit services to the audit client, and relationships
involving contingent fees. Finally, Rule 2-01 includes requirements regarding partner rotation and audit committee
administration of the engagement.
CPAs who audit non-public (private) companies must follow AICPAs Independence Rule 101. On the
other hand, CPAs who audit public companies must follow PCAOBs Auditor Independence Rule 3520. When there
is a different requirement between the two set of rules; for example, a CPA applies both AICPA and PCAOBs
independence rules to a non-public audit client, PCAOB Independence Rules takes precedent over the AICPAs
Independence Rules. One example of such different requirement is that AICPAs Independence Rules requires an
engagement partner to rotate off an engagement every seven years, whereas PCAOB Independence Rules require the
partner to rotate off every five years. In this situation, PCAOBs five years rotation requirement applies.
It is difficult to interpret the independent rules because independence is primarily a state of mind. The
AICPA Conceptual Framework for Independence Standards suggests that CPAs interpret the independent rules by
evaluating whether a particular threat would lead to a reasonable person, aware of all the relevant fats, to conclude

Financial and Integrated Audits - Frederick Choo

that s/he is not independent. Table 3-2 describes some of these threats and examples of non-independence. Based on
this threat framework, Table 3-3 provides interpretations and brief comments of AICPAs Rule 101 Independence
and the different requirements of the PCAOBs Auditor Independence Rule 3520.
Table 3-2 Threats and Examples of Non-independence
Threat

(1) Financial Interest A potential benefit to an auditor from a


financial interest in, or some other financial relationship with,
an audit client.
(2) Familiarity An auditor has a close or longstanding
relationship with client personnel or with individuals who
performed non-audit services to the same client.

(3) Undue Influence An audit clients management coerces


the auditor or exercises excessive influence over the auditor.

(4) Management Participation An auditor taking on the role of


client management or perform client management functions.
(5) Adverse Interest Actions between the auditor and the audit
client that are in opposition.
(6) Advocacy Actions taken by the auditor to promote the
audit clients interest or position.
(7) Self-audit As a part of an audit engagement, an auditor
uses evidence that results from non-audit services provided to
the audit client.

Examples
(a) An auditor has a direct financial interest or a material indirect financial
interest in the audit client.
(b) An auditor has a loan from the audit client.
(c) An auditor is excessively relied on revenue from a single audit client.
(d) An auditor has a material joint venture with the audit client.
(a) A spouse of the auditor holds a key position with the client, e.g., CEO.
(b) An auditor has provided audit services to the same client for a prolonged
period.
(c) An auditor performs insufficient audit procedures because of his/her
familiarity with the client.
(d) An auditor for the CPA firm recently was a director or officer of the
audit client.
(a) Managements threat to replace the auditor over a disagreement on the
application of an accounting principle.
(b) Managements pressure to reduce audit procedures for purpose of
reducing audit fees.
(c) An auditor receives a gift from the audit client that is significant.
(a) An auditor serves as an officer or director of the audit client.
(b) An auditor establishes and maintains internal controls for the audit
client.
(c) An auditor hires, supervises, or terminates the audit clients employees.
(a) Threatened or actual litigation between the auditor and the audit client.
(a) An auditor promotes the audit clients securities as part of an initial
public offering.
(b) An auditor represents the audit client in U.S. tax court.
(a) An auditors CPA firm has provided non-audit services relating to the
audit clients information system and the auditor is now considering results
obtained from that information system in the audit of the same client.

Table 3-3 Interpretations of Rule 101 Independence

Interpretation
Auditor and client relationship

Financial interests

Brief Comments
Rule 101 prohibits a CPA from auditing a client while holding a position as director, officer, or
employee of that client. However, a CPA may serve as an honorary director or a trustee of a not-forprofit organization while auditing the same not-for-profit organization (not-for-profit client). In such
a case, independence is not impaired if the CPA's position is purely honorary (and identified as
honorary in all letterheads and externally circulated materials), the CPA restricts involvement to the
use of his/her name only (that is, only lends the prestige of his/her name to the not-for-profit
organization), and the CPA must not vote or participate in the management functions of the not-forprofit organization.
It should be noted that PCAOB Rules prohibit a public company from employing the CEO,
Controller, CFO, Chief Accounting Officer or person in equivalent position from the companys
audit firm during the 1-year period preceding the audit.
It should also be noted that PCAOB Rules require the lead and reviewing partner to rotate off an
audit engagement after five consecutive engagements. In contrast, Rule 101 requires the partner to
rotate off an audit engagement after seven consecutive engagements.
Lastly, before accepting a new or continuing audit engagement, PCOAB Rule 3526 requires the
audit firm to communicate in writing to the audit committee all relationships between the audit firm
and the client that may reasonably be thought to bear on the audit firms independence.
Rule 101 prohibits a CPA (including immediate family members of the CPA who are defined as
spouse, spousal equivalent, and dependents) from having a direct financial interest (e.g., owning any
stock) in the audit client.
Note: Materiality of the direct financial interest is not relevant here.
It also prohibits a CPA (including close family relatives of the CPA who are defined as parent,
siblings, and non-dependent children) from owning material indirect financial interest in the audit
client. Examples of indirect financial interests are: a CPA has investments in a bank that loans
money to an audit client, or a CPA owns stock in a mutual fund that, in turn, owns stock in the audit
client, or a CPA's own stock in an audit client. Independence is impaired in the foregoing examples

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Interpretation

Joint investor or investee


Relationship with client

Auditing and accounting


services for the same client

Auditing and management


advisory services to the same
client

Brief Comments
only if either the CPA's investments in the bank or the mutual fund's holdings in the audit client are
material in relation to the CPA's personal wealth, or the close family relative's financial interest in
the audit client is material to his or her own personal wealth and the CPA has knowledge of the
interest. As a rule of thumb, a financial interest is presumed to be material if it exceeds 5% of the
CPA's personal net worth or the personal net worth of the CPA's close family relatives.
See Table 3-4 for a summary of the effect of Rule 101 on family members, relatives, and friends.
It should be noted that PCAOB Rules clearly define immediate family members and close family
relatives as: (1) immediate family members a persons spouse, spousal equivalent (including
cohabitant), and dependents (i.e., person who received half or more support), and (2) close family
members a persons parents (including adoptive parents and step-parents), dependents (i.e.,
person who received half or more support), nondependent children (including step-children), and
brothers and sisters (excluding grandchildren, grand-parents, parents-in-law, and the spouses of each
of these).
Finally, a CPA is not permitted to have any loan to or from audit clients; however, home mortgages
and most secured loans from financial institution clients are permitted if made under normal lending
procedures and negotiated prior to audit engagement. The phrase "financial institution client" is
defined in the Interpretation as an entity that, as part of its normal business operations, makes loans
to the general public. The phrase normal lending procedures implies that the terms of the loans
should be made without any favoritism to the CPAs.
It should be noted that PCAOB Rules consider a CPA not independent of an audit client if any audit
partner received compensation based on the partner securing with the client billable work for
services other than audit or attestation.
A CPA is not permitted to have any joint or closely held business investment, i.e., joint investor or
investee relationship, with the client. For example, a CPA owns stock in a non-audit client, ABC
Co., and XYZ Co., which is an audit client, also owns stock in ABC Co. Interpretations of the joint
investor or investee relationship when an audit client is either an investor or investee of a non-audit
client in which a CPA has investment are as follows:
(1) A client invested in a non-client the CPA is a joint investor with the client.
If the clients investment in the non-client is material, the CPA violates Rule 101 for having any
direct/material indirect investment in the non-client. However, if the clients investment in the nonclient is immaterial, the CPA violates Rule 101 only for material direct/indirect investment.
(2) A non-client invested in a client - the CPA is a joint investee with the client.
If the non-client investment in the client is material, the CPA violates Rule 101 for having any
direct/material indirect investment in the non-client. However, if the non-clients investment in the
client is immaterial, the CPA violates Rule 101 only when the CPAs investment in the non-client
allows the CPA to exercise significant influence over the non-client.
A rule of thumb for determining materiality in a joint investor-investee relationship is (1) A
CPAs investment is presumed to be material if it exceeds either 5% of the CPA's net worth or the
net worth of the CPA's firm, whichever is more restrictive. (2) A client/non-clients investment is
presumed to be material if it exceeds either 5% of the client/non-clients total assets or 5% of the
client/non-clients income before taxes, whichever is more restrictive.
Rule 101 permits a CPA to provide both auditing and accounting services for the same client if
several conditions are met:
(1) The auditor must not have any relationship with the client or any conflict of interest;
(2) The client must accept responsibility for the financial statements;
(3) The auditor must not assume the role of employee or management, and
(4) The auditor must perform the engagement in accordance with generally accepted auditing
standards.
However, in practice, a CPA must also be aware of the SEC's regulations (Securities Exchange Act
1934) which do not permit a CPA to perform auditing and accounting services for the same SEC
client. Therefore, in practice, a CPA may provide both accounting and auditing services to non-SEC
clients provided the foregoing four conditions are met.
A CPA may provide auditing and management advisory services to the same client if (1) the CPA
just advises client and does not assume a decision-making role in the client's management, (2) the
CPAs engagement in both services is fully disclosed to the Audit Committee. Advisory services
that would not entail a CPA assuming a decision-making role include conducting special studies and
investigations, making suggestions to management, pointing out the existence of weaknesses,
outlining various alternative corrective measures, and making recommendations.
It should be noted that PCAOB Rules indirectly prohibit auditing and management advisory
services to an audit client by prohibiting eight types of non-audit services to an audit client. These
are (1) bookkeeping services (2) information system design and implementation services (3)
appraisal, valuation, and actuarial services (4) internal audit services (5) management functions or
human resources (6) various investment services (7) legal services and (8) any other services that
the PCAOB determines, by regulation, to be impermissible such as certain tax services.
It should also be noted that PCAOB Rules require audit committee to pre-approve all audit and nonaudit services a CPA provides unless non-audit fees are less than 5% of total audit fees. Specifically,
preapproved non-audit services include tax services under PCAOBs Rule 3524, Audit Committee
Pre-approval of Certain Tax Services, and internal control services under Rule 3525, Audit

Financial and Integrated Audits - Frederick Choo

Interpretation

Brief Comments

Actual or threatened litigation

Unpaid fees

Committee Pre-approval of Non-audit services Related to Internal Control Over Financial


Reporting.
Accordingly, the PCAOB Rules that indirectly prohibit auditing and management advisory services
to an audit client do not apply if the auditing and other non-audit services provided to an audit client
are pre-approved by the audit committee. Moreover, this pre-approval requirement is waived if the
aggregate fee of all such non-audit services constitutes less than 5% of the total audit fee paid to the
auditor.
Lastly, an exception to the preapproved tax services is that the auditor is not independent of the
audit client if the preapproved tax services were to provide for persons in financial reporting
oversight roles (e.g., the CEO) under PCAOBs Rule 3523, Tax Services for Persons in Financial
Reporting Oversight Roles. However, an amendment to this Rule in 2008 clarifies that if the auditor
provides such tax services for persons in financial reporting oversight roles preceding the beginning
of the audit engagement, the auditor is independent.
See Table 3-5 for a comparison of PCAOB and AICPAs rules regarding management advisory
services.
The relationship between the auditor and the client is characterized by the auditor's objectivity in
attesting the client's financial statements on one hand and the client's willingness to full disclosure
on the other hand. Actual or threatened litigation against the auditor by the client or against the
client by the auditor places the auditor and the client in an adversary position, thereby raising the
questions about the client's willingness to disclose, about the auditor's objectivity and self-interest,
and therefore about auditor independence. Consequently, in all cases in which an auditor is involved
in actual or threatened litigation, he or she should carefully evaluate independence.
Independence is considered impaired if billed or unbilled audit fees remain unpaid for auditing
services provided to the client more than one year before the date of the report. Such unpaid fees are
deemed to be a loan from the auditor to the client and are therefore a violation of Rule 101. Unpaid
audit fees from a client in bankruptcy do not violate Rule 101.
It should be noted that PCAOB Rules require public companies to disclose audit fees, audit related,
tax, and all other services.

Table 3-4 A Summary of the Effect of Rule 101 on Family Members, Relatives, and Friends

Relative

Effect of Rule 101

Immediate Family Members


AICPA: Spouse, spousal equivalent, and
dependents (whether or not related).
PCAOB: Spouse, spousal equivalent (including
cohabitant), and dependents (i.e., persons who
received half or more support).

Close Family Relatives


AICPA: Parent, siblings, and non-dependent
children.
PCAOB: Parents (including adoptive parents and
step-parents), dependents (i.e., person who
received half or more support), nondependent
children (including step-children), and brothers
and sisters (excluding grandchildren, grandparents, parents-in-law, and the spouses of each of
these)

Immediate family members are under the same restrictions as is the CPA. Accordingly,
if a member violates a rule, interpretation, or ruling that applies to the CPA, the CPA is
not independent. For example, if an immediate family member the CPA owns some
stocks (i.e. direct financial interest/investment) in the CPAs audit client, the CPA is
not independent.
The CPA and CPA firm independence is impaired if an individual on the audit team has
a close family relatives who has 1. A key position with the audit client, or 2. A material
indirect financial interest in the audit client of which the CPA has knowledge.

Independence is only impaired when a reasonable person aware of all relevant facts
relating to a situation would conclude that there is an unacceptable threat to
independence. This evaluation is made based on the AICPA Conceptual Framework for
Independence Standards.

Other Relatives and Friends

Table 3-5 A Comparison of PCAOB and AICPAs Rules Regarding Management Advisory Services
PCAOBs Position

AICPAs Position

(1) Prohibits bookkeeping or other services related to the


accounting records or financial statements of the audit client.

Allowed, providing the auditors do not:


(a) Determine or change journal entries without client approval.
(b) Authorize or approve transactions.
(c) Prepare source documents.
(d) Make changes to source documents without client approval.
Auditors are allowed to:
(a) Implement a system not developed by the auditor (e.g., off-the shelf
accounting software packages).
(b) Assist in setting up chart of accounts and financial statement format.

(2) Prohibits financial


implementation.

information

systems

design

and

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3 The Auditor's Ethical Environment

PCAOBs Position

(3) Prohibits appraisal, valuation, and actuarial services.

(4) Prohibits internal audit outsourcing services.

(5) Prohibits management functions or human resources.


(6) Prohibits various investment services such as broker or dealer,
investment adviser, or investment banking services.
(7) Prohibits legal services and expert services unrelated to the
audit.
(8) Prohibits any other services that the PCAOB determines, by
regulation, to be impermissible such as certain tax services, which
include tax planning for potentially abusive tax transactions and
providing individual tax services for client officers in financial
reporting oversight roles.
Note: PCAOB allows non-audit services (including tax services
and ICFR) providing:
a. the services are preapproved by the audit committee, and
b. the aggregate non-audit services fee is less than 5% of the total
audit services fee.
Note: PCAOB prohibits preapproved tax services that are to
provide for persons in financial reporting oversight roles.
However, an amendment to this Rule in 2008 clarifies that if the
auditor provides such tax services for persons in financial
reporting oversight roles preceding the beginning of the audit
engagement, the auditor is independent.

AICPAs Position
(c) Design, develop, install, or integrate an information system unrelated
to the financial statements or accounting records.
(d) Provide training to client employees on the information and control
system.
Allowed, providing the services do not:
(a) Relate to a material portion of the financial statements, and
(b) Involve a significant degree of subjectivity.
Allowed, providing the client understands its responsibility for internal
control and:
(a) Designates competent individual(s) within company to be responsible
for internal audit.
(b) Determines scope, risk, and frequency of internal audit activities.
(c) Evaluates findings and results.
(d) Evaluates adequacy of audit procedures performed.
Auditors may provide various types of advice but may not perform
management functions.
Certain investment services are allowed, including:
(a) Assisting in developing corporate finance strategies.
(b) Recommending allocation of funds to investments.
Legal services are not directly addressed; various other services are
allowed if auditors do not make management decisions.
No specific restrictions.

Financial and Integrated Audits - Frederick Choo

Figure 3-2 provides a summary of the interpretations of Rule 101 Independence.


Figure 3-2 Interpretations of Rule 101 Independence

Auditor

Auditing

Client
XYZ Co.

No direct investment (e.g., stocks)


Note: Include immediate family members
Materiality not relevant

Be an accountant of the client?


AICPA Yes, if fulfills 4 requirements
PCAOB No, under the Securities Exchange
Act
Be an officer or employee of the client?
No, except honorary position/trustee for not-for
profit organization
Note: PCAOB No hiring of auditor 1 year
precedes the audit engagement

No indirect investment (e.g., mutual funds)


Exception: Immaterial based on personal
net worth
Client
Note: Include close family relatives
Invested
PCAOB No compensation for audit partner
securing non-auditing services
5 years engagement partner rotation
(7 years in Rule 101)

Non-client
Invested

Management Consulting services?


AICPA Yes, but not to make decision for the
client and full disclosure to the
audit committee
PCAOB Indirectly prohibits
Exception: Preapproved by audit committee and
< 5% of audit fee
Exception: Preapproved tax services to persons in
financial reporting roles preceding the
audit engagement.

No loan to or from the client


Exception: Home mortgages and secured loans
Note: No favoritism
Client is in loan business
Loan negotiated prior to audit engagement
Unpaid audit fee > 1 year is a loan
Investing

Non-client
ABC Co.

Joint Investor Client

Joint Investee Client

If Clients investment

If Non-clients investment

Material
Auditor
violation for
Any direct/material indirect
investment in Non-client

Not Material
Auditor
violation for
Material direct/indirect
investment in Non-client

Material
Auditor
violation for
Any direct/material indirect
investment in Non-client

Not Material
Auditor
violation for
Investment in Non-client
that has significant influence

55

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3 The Auditor's Ethical Environment

Rule 102 - Integrity and Objectivity


In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall
not knowingly misrepresent facts or subordinate his or her judgment to others.

Under Rule 102, a CPA shall not knowingly misrepresent facts. An Interpretation of Rule 102 states that a CPA who
knowingly makes - or directs another to make - false or misleading entries in an entity's financial records is
considered to be knowingly misrepresent facts. Another interpretation of Rule 102 states that a CPA can be a client's
advocate in tax and management services but not in auditing service. Moreover, in auditing services an auditor shall
not subordinate his or her judgment to the client's best interest.

Rule 201 - General Standards


A member shall comply with the following standards and with any interpretations thereof by bodies designed by Council.
A. Professional Competence. Undertake only those professional services that the member or the member's firm can reasonably expect to be
completed with professional competence.
B. Due Professional Care. Exercise due professional care in the performance of professional services.
C. Planning and Supervision. Adequately plan and supervise the performance of professional services.
D. Sufficient Relevant Data. Obtain sufficient relevant data to afford a reasonable basis for conclusions or recommendations in relation to any
professional services performed.

Rule 201 reinforces the importance of compliance with the Generally Accepted Auditing Standards for all CPAs in
auditing services. The requirements for professional competence and due professional care relate to the first and
third of the General Standards of the Generally Accepted Auditing Standards, while the requirements for planning
and supervision, and sufficient relevant data relate to the first and third of the Standards of Field Work of the
Generally Accepted Auditing Standards.
Rule 202 - Compliance with Standards
A member who performs auditing, review, compilation, management consulting, tax, or other professional services shall comply with standards
promulgated bodies designated by Council.

Rule 202 broadens CPAs' responsibilities to comply with all professional standards beyond that associated with
auditing services in Rule 201. Under Rule 202, CPAs must comply with all relevant professional standards in all
types of CPA services.
Rule 203 - Accounting Principles
A member shall not (1) express an opinion or state affirmatively that the financial statements or other financial data of any entity are presented in
conformity with generally accepted accounting principles or (2) state that he or she is not aware of any material modificatio ns that should be
made to such statements or data in order for them to be in conformity with generally accepted accounting principles, if such statements or data
contain any departure from an accounting principle promulgated by bodies designated by Council to establish such principles that has a material
effect on the statements or data taken as a whole. If, however, the statements or data contain such a departure and the member can demonstrate
that due to unusual circumstances the financial statements or data would otherwise have been misleading, the member can comply with the rule
by describing the departure, its approximate effects, if practicable, and the reasons why compliance with the principle would result in a
misleading statement.

An auditor shall not express unqualified opinion if a client's financial statements depart from GAAP. This means
that departures from FASB Statements of Financial Accounting Standards, GASB Statements of Government
Accounting Standards, Opinion of the Accounting Principles Board, and Accounting Research Bulletins are all
prohibited under Rule 203. An interpretation of Rule 203 recognizes the difficulty for authoritative accounting
bodies to anticipate all of the circumstances to which accounting principles might apply. Accordingly, a CPA may
allow a client's financial statements to depart from GAAP due to unusual circumstances, for example, new
legislation and the evolution of a new form of business transaction.

Financial and Integrated Audits - Frederick Choo

Rule 301 - Confidential Client Information


A member in public practice shall not disclose any confidential client information without the specific consent of the client.
This rule shall not be construed (1) to relieve a member of the member's professional obligations under rules 202 and 203, (2 ) to affect in any
way the member's obligation to comply with a validly issued and enforceable subpoena or summons, (3) to prohibit review of a member's
professional practice under AICPA or state CPA society authorization, or (4) to preclude a member from initiating a compliant with or
responding to any inquiry made by a recognized investigative or disciplinary body.
Members of a recognized investigative or disciplinary body and professional practice reviewers shall not use to their own advantage or disclose
any member's confidential client information that comes to their attention in carrying out their official responsibilities. However, this prohibition
shall not restrict the exchange of information with a recognized investigative or disciplinary body or affect, in any way, compliance with a validly
issued and enforceable subpoena or summons.

Rule 301 prohibits an auditor from disclosing any confidential client information, e.g. officers' salaries, unreleased
advertisements, production cost information, tax returns etc. For the CPA to have the client in trust, the auditor must
assure the client that matters discussed will be held in confidence.
Closely related to the ethical concept of confidential client information is the legal concept of privileged
communication. In contrast to attorney and physician, information communicated between a CPA and a client is not
privileged under federal law. Therefore, the information can be requested as evidence by a court of law. Although,
auditor-client confidential information is not privileged in federal jurisdiction, the information may be privileged in
the status of some states. Rule 301 states four important exceptions:
1. A CPA's adherence to GAAS overrides confidentiality (e.g. subsequent discovery of facts by the auditor after the
audit report has been issued).
2. The confidentiality rule does not apply when subpoenas or summonses enforceable by order of the court exist.
3. A CPA shall provide audit working papers requested by the Professional Ethics Executive Committee (PEEC) of
AICPA or state CPA society (or association) for peer review (or quality review) programs. In doing so, the CPA is
indirectly disclosing confidential client information. In addition, the CPA may release the working papers for peer
reviews without the client's consent; presumably it would be a time burden to all concerned if permission from each
client is needed for every peer review. It should be noted that AU 210), Terms of Engagement, requires a successor
(incoming) auditor to request the client's consent in order to gain access to a predecessor (outgoing) auditor's
working papers. Moreover, the successor auditor should also request the client to authorize (i.e., consent) the
predecessor to release working papers to the successor auditor. Finally, in the case that a CPA sells the practice to
another CPA, the buyer auditor must request the client to authorize the seller auditor to release audit working papers
to the buyer auditor.
4. A CPA is permitted to disclose confidential client information in the event of initiating a complaint with or
responding to any inquiry made by a recognized investigative or disciplinary body such as the Joint Trial Board or
the Public Company Accounting Oversight Board.
Figure 3-3 provides a summary of the interpretations of Rule 301 Confidential Client Information.
Figure 3-3 Interpretations of Rule 301 Confidential Client Information
Auditor

Working
Papers

Auditing

Client
XYZ Co.

No disclosure of confidential client information to anyone without the consent of the client
Exceptions: Shipment of audit working papers under Peer Review Program (no client consent is needed)
Successor/buyer auditor to request the clients consent for predecessor/seller auditor to
release audit working papers
Working papers subpoenaed under law suits
AUs overwrites CPC (e.g., reporting of known fraud under AUs)
Working papers examined by the Professional Ethics Executive Committee (PEEC)

Note: PCAOB has no specific rule on auditor and confidential information.


SEC requires the auditor to communicate confidential information on illegal acts.

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3 The Auditor's Ethical Environment

SEC on Confidential Information


An amendment to the Securities Exchange Act of 1934, the Private Securities Reform Act of 1995, includes a
provision for whistleblowing by the auditor on confidential information. This law applies when the auditor obtained
confidential information (e.g., obtained from an employee whistle blower) that the client has committed an illegal
act and 1. It has a material effect on the financial statements. 2. Senior management and the board of directors have
not taken appropriate remedial action. 3. The failure to take remedial action is reasonably expected to warrant a
departure from standard unqualified audit report, or resignation by the auditor. In these circumstances, the auditor
must, as soon as practical, communicate their conclusions based on the confidential information directly to the
clients board of directors. Within one day, the management of the client must send a notification to the SEC of
having received such a communication from the auditor, and a copy of the notification should be sent to the auditor.
If the auditor does not receive the copy within the one-day period, they have one day to directly communicate the
matter to the SEC. The auditors responsibilities for illegal acts are further discussed in Chapter 6. Chapter 23
further discusses the auditors responsibilities for illegal acts under the Single Audit Act.
Currently, the PCOAB has no specific rule concerning confidential client information and the auditor.
Although Section 806 of the Sarbanes-Oxley Act of 2002 provides civil and criminal protections to employees of the
audit client who whistleblow confidential information, such protections do not extend to the auditor.
Rule 302 Contingent Fees
A member in public practice shall not
(1) Perform for a contingent fee any professional services for, or receive such a fee from a client for whom the member or the members firm
performs
(a) an audit or review of financial statements; or
(b) a compilation of a financial statement when the member expects, or reasonably might expect, that a third party will use the financial
statement and the members compilation report does not disclose a lack of independence; or
(c) an examination of prospective financial information; or
(2) Prepare an original or amended tax return or claim for a tax refund for a contingent fee for any client.
The prohibition in (1) above applies during the period in which the member or members firm is engaged to perform any of the services listed
above and the period covered by any historical financial statements involved in any such listed services.
Except as stated in the next sentence, a contingent fee is a fee established for the performance of any service pursuant to a n arrangement in
which no fee will be charged unless a specific finding or result is attained, or in which the amount of the fee is otherwise dependent upon the
finding or result of such service. Solely for purpose of this rule, fees are not regarded as being contingent if fixed by courts or other public
authorities, or, in tax matters, if determined based on the results of judicial proceedings or the findings of governmental agencies.
A members fee may vary depending, for example, on the complexity of the services rendered.

In 1990, the AICPA and the Federal Trade Commission reached an agreement that would eliminate the restriction
on contingent fees for non-attestation services, unless a CPA was also performing attestation for the same client. The
agreement also continues to prohibit tax return preparation on a contingent fee basis. An example of a prohibited
contingent fee for attestation service is when a CPAs audit is free (i.e., no audit fee is charged) contingent upon an
unqualified audit report is issued to the client. An example of a prohibited contingent fee for tax return preparation is
when a CPAs tax return preparation is free (i.e., no preparation fee is charged) contingent upon a tax refund is
obtained for the client. Under the agreement, an example of a prohibited contingent fee when a CPA performs both
attestation and non-attestation services for the same client is when the CPA charges a client consulting service fees
on a percentage of a bond issue while the CPA also performs audit service for the same client. Another example is
when the CPA charges fees as an expert witness based on the amount awarded to the plaintiff (client) while the CPA
also performs audit service for the same client. In addition, the agreement does not prohibit a CPA from charging an
audit fee based on (contingent upon) the complexity or number of hours or days needed to complete the audit
service.
An exception to the rule is when courts or regulatory agencies fix the contingent fee. An example is when a
court-appointed liquidator in the case of client liquidation fixes an audit fee. Another example is when the IRS fixes
the contingent fee for an auditor who represents an audit client in an examination (i.e., a federal tax probe) of the
clients federal tax return by an IRS agent. However, this particular example is no longer valid (meaning it is no
longer an exception to the rule) under the SECs Financial Reporting Release No. 65 in 2004.
In 2004, the SECs Financial Reporting Release No. 65 prohibits the use of contingent fees for tax
preparation services when a CPA performs both attestation and non-attestation services for the same client. The
release also states it is not a contingent fee if it is fixed by courts or other public authorities, or, in tax matters, if
determined based on the results of judicial proceedings or the findings of governmental agencies. Under this
definition, the AICPA has argued that a tax preparation services fee is not "contingent" because it is "considered

Financial and Integrated Audits - Frederick Choo

determined based on the findings of government agencies if the member can demonstrate a reasonable expectation,
at the time of a fee arrangement, of substantive consideration of an agency with respect to the member's client."
However, the SEC rejects this argument and clarifies that, "the release makes clear that the exception would apply
only when the determination of the fee is taken out of the hands of the accounting firm and its auditor client and is
made by a body that will act in the public interest, with the result that the accounting firm and client are less likely to
share a mutual financial interest in the outcome of the firm's advice or service," and because "the fact that a
government agency might challenge the amount of the client's tax savings and thereby altering the amount of the fee
paid to the firm heightens, not lessens, the mutuality of interest between the firm and client. Accordingly, such fees
impair an auditor's independence." In sum, the AICPAs exception to its Rule 302 on contingent fee does not apply
for tax preparation services fee that is fixed by the courts or regulatory agencies.
Currently, PCOABs Independent Rule 3521 makes it very clear that a CPA firm is not independent of its
audit client if the firm provides any service or product to the audit client for a contingent fee or a commission. See
Figure 3-4 for an overview of Rule 302 Contingent Fees.
Figure 3-4 An Overview of Rule 302 Contingent Fees

Attestation Services
and
Non-attestation Services

Client
XYZ Co.

Prohibit contingent fee for auditing


Exception: Allow contingent fee fixed by courts or
regulatory agencies for auditing
Allow audit fee contingent on hours and
complexity of audit
Prohibit contingent fee for tax services and other
non-attestation services
Exception: Allow contingent fee fixed by courts or
regulatory agencies for non-attestation
services (but not for tax services)

Auditor

Note: PCAOB Rule 3521 prohibits contingent fees for attestation & non-attestation services to the same client.

Non-attestation Services only

Client
XYZ Co.

Allow contingent fee for tax services


Allow contingent fee fixed by courts or regulatory
agencies for tax services and other non-attestation
services

Note: PCAOB Rule 3521 allows contingent fees for non-attestation services only to the client.

Rule 501 - Acts Discreditable


A member shall not commit an act discreditable to the profession.

The term "discreditable" is not defined in the Rule. Eight Interpretations of Rule 501 define acts that would be
considered to be discreditable:
1. A CPA retains client records after the client has demanded those records, especially in a situation where the client
has not paid the CPA's audit fee. Audit fee outstanding for more than a year becomes a loan to the client, which is
prohibited by Rule 101 Independence. Note that a CPAs working papers, including analyses, schedules, and records
prepared by the client at the request of the CPA, are not client records and need not be made available to the client.
Note also that analyses, schedules, and records prepared by the CPA for the client, such as tax returns, are client
records and need not be made available to the client. An exception exists in case the client experiences a loss of
records due to a natural disaster or an act of war. In those situations, the auditor should make such records available
to the client.
2. Discrimination by a CPA on the basis of race, color, sex, age, or national origin in hiring, promotion, salary, or
other employment practices constitutes an act discreditable to the profession.

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3 The Auditor's Ethical Environment

3. A CPA fails to follow standards and/or procedures in auditing governmental agencies unless the CPA discloses in
the report the fact that such standards were not followed and reasons thereof.
4. Failure to follow the requirements of government bodies, commissions, or other regulatory agencies in
performing attest or similar services.
5. Negligence in the preparation of financial statements or records.
6. Failing to file tax returns or remit payroll and other taxes collected for others (e.g., employee taxes withheld).
7. Making, or permitting others to make, false and misleading entries in records and financial statements.
8. Soliciting or disclosing CPA Examination questions and answers from the closed CPA Examination.
One of the AICPA's bylaws states that a CPA's membership will be terminated if he/she commits a crime punishable
by imprisonment for more than a year. Therefore, the one year jail term may be a yardstick for deciding whether an
act is discreditable to the profession. Using this yardstick, unprofessional acts committed by a CPA such as
fraudulently prepared tax returns, criminal offenses, excessive drinking, and rowdy behavior would be considered as
discreditable acts if they resulted in more than a year's jail term.
Rule 502 - Advertising and Other Forms of Solicitation
A member in public practice shall not seek to obtain clients by advertising or other forms of solicitations in a manner that is false, misleading, or
deceptive. Solicitation by the use of coercion, overreaching, or harassing conduct is prohibited.

In the 1970s, the U.S. Justice Department and the Federal Trade Commission pressurized AICPA to relax
advertising rules for the purpose of opening up competition among CPAs. In 1978, Rule 502 allows advertisement
and solicitation that are not false, misleading, or deceptive. The Rule also states that the CPAs shall not use
coercion, over-reaching, or harassment in conducting their advertisement and solicitation.
An Interpretation of Rule 502 identifies four instances of false, misleading, or deceptive advertisement that a CPA
must avoid:
1. Advertisement that creates false expectations of favorable results.
2. Advertisement that implies an ability to influence any court, tribunal, or regulatory body.
3. Advertisement that states a specific service will be performed for a stated fee or estimated fee when it is likely
that the fee will be increased substantially.
4. Advertisement that contains and has other representation that would cause a reasonable person to misunderstand
or be deceived.
Rule 503 Commissions and Referral Fees
1. Prohibited commissions. A member in public practice shall not for a commission recommend or refer to a client any product or service, or for
a commission recommend or refer any product or service to be supplied by a client, or receive a commission, when the member or the
member's firm also perform for that client:
a. An audit or review of a financial statement.
b. A compilation of a financial statement when the member expects, or reasonably might expect, that a third party will use th e financial
statement and the member's compilation report does not disclose a lack of independence.
c. An examination of prospective financial information.
This prohibition applies during the period in which the member is engaged to perform any of the services listed above and the period covered by
any historical financial statements involved in such listed services.
2. Disclosure of permitted commission. A member in public practice who is not prohibited by this rule from performing services for or receiving a
commission and who is paid or expects to be paid a commission shall disclose that fact to any person or entity to whom the me mber
recommends or refers a product or service to which the commission relates.
3. Referral fees. Any member who accepts a referral fee for recommending or referring any service of a CPA to any person or entity or who pays
a referral fee to obtain a client shall disclose such acceptance or payment to the client.

Rule 503 prohibits a CPA from receiving or paying a commission for service or product referrals to or from a client
when the CPA is performing an attestation service for the same client. This is to prevent potential conflicts of
interest. However, Rule 503 allows such a commission for any non-attestation service client provided disclosure is
made to the client. Part 3 of Rule 503 permits referral fees. However, the CPA must disclose such fees to the client.
Figure 3-5 provides a summary of the interpretations of Rule 503 Commissions and Referral Fees.

Financial and Integrated Audits - Frederick Choo

Figure 3-5 Interpretations of Rule 503 Commissions and Referral Fees

Commissions received
Violation

e.g., Supplier
Goods
(e.g., computers)

Auditor

Auditing

Client
XYZ Co
Services
(e.g., legal work)

Referral fees received


No violation

e.g., CPA of a
Law firm

Rule 505 - Form of Organization and Name


A member may practice public accounting in a form of organization permitted by state law or regulation whose characteristics conform to
resolutions of Council.
A member shall not practice public accounting under a firm name that is misleading. Names of one or more past owners may be included in the
firm name of a successor organization. Also, an owner surviving the death or withdrawal of all other owners may continue to practice under such
name which includes the name of past owners for up to two years after becoming a sole practitioner.
A firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless all of its owners are members of
the institute.

An audit firm shall practice only in the form of a proprietorship, a partnership, or a professional corporation. A
professional corporation represents a corporation in form, but a partnership in substance, that is, it has no limited
liability. A professional corporation provides a tax advantage to the individual CPAs by avoiding double taxation
(i.e., corporate taxes to the professional corporation and individual taxes to the CPA shareholders). In 1991, the
AICPA permits an audit firm to practice in the form of a limited liability partnership (LLP), which limits an
individual partners liability to his/her investment in the firm, except in litigation, where a litigant can make claims
against a partners personal assets for liability linked directly to his/her own negligent act (e.g., a partner-in-charge
of an audit client issued a wrong audit opinion for that client).
Under Rule 505, the name of a CPA firm can be fictitious or indicate a specialization, provided that the
firm name or specialization is not deceptive or misleading. For example, "International Tax Specialists" is
acceptable if the CPAs indeed specialized in International Tax Services. However, "International Tax Free
Specialists" is unacceptable because the word "Free" may be misleading.
Rule 505 states that a successor partnership or professional corporation may continue to include the names
of one or more past partners or shareholders in its firm name. However, a sole successor of a partnership or
corporation may do the same for up to two years after becoming a sole practitioner. Moreover, all partners or
shareholders of a CPA firm must be members of AICPA if the firm wants to carry the designation "Members of the
AICPA".
Enforcers of the CPC
The AICPA has two key avenues by which members can be disciplined for violating the CPC. For violations that are
not sufficient to warrant formal actions, the Professional Ethics Executive Committee (PEEC) can direct a member
to take remedial or corrective actions. The committee can also refer a member to the Joint Trial Board. Furthermore,
the State Board of Accountancy may revoke a CPAs license for very serious violations of the CPC.

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In general, there are three levels of enforcement and disciplinary action as follows:
1. Less serious violations are handled by the PEEC of the AICPA and/or state society/association. Disciplinary
actions are usually in the form of corrective actions e.g., to attend a number of continuing education hours.
2. More serious violations are handled by the Joint Trial Board. Disciplinary actions include suspension or expulsion
of membership from AICPA and the name of the offending CPA published in the CPA Newsletter. It should be
noted that expulsion of membership does not stop one from practicing as an accountant.
3. Very serious violations are handled by the State Boards of Accountancy. Disciplinary actions include suspension
or revocation of a CPA certificate and/or the license to practice.
Figure 3-6 shows the enforcers of the CPC and their disciplinary action.
Figure 3-6 Enforcers of the CPC and Disciplinary Action

Enforcers of the CPC

AICPA

State Board of Accountancy

Professional Ethics Executive Committee

Joint Trial Board

Disciplinary action

Expulsion

Revoke CPA license

Enforcer of SECs Auditor Independent Rules


If the PCAOB determines that any registered CPA firm has engaged in practices in violation of the PCAOBs
Auditor Independent Rules, the Board may impose sanctions, including temporary suspension or permanent
revocation of registration or association of individuals with a registered firm, monetary penalties, censure, and
additional education or training.

Financial and Integrated Audits - Frederick Choo

Multiple-Choice Questions
3-1

Which of the following principles is not in the CPC?


a. To serve the public interests.
b. To exercise professional care.
c. To be a responsible profession.
d. To provide expert advice.

3-2

Which part(s) of the CPC is(are) enforceable?


a. Interpretations.
b. Ethical rulings.
c. Rules of conduct.
d. Principles.

3-3

Which of the following statements is a violation of the rule on independence in fact and independence in appearance?
a. A CPA acquired immaterial indirect investment in an audit client.
b. A CPA holds a honorary directorship in a not-for- profit religious organization.
c. A CPA secured a franchise loan from an audit client.
d. A CPA disengaged from an audit client.

3-4

A CPA will not be independence in fact and in appearance if s/he is


a. an honorary secretary of a not-for-profit client.
b. a trustee of a not-for-profit client's pension fund.
c. a part time accountant of an non-audit client.
d. an immaterial direct investor in an audit client.

3-5

The rule on confidential client information will be violated if a CPA


a. provides working papers to a succeeding auditor without the consent of an audit client.
b. provides working papers of an audit client to internal revenue service who requested them.
c. provides working papers of an audit client to a court of law which subpoenas them.
d. provides working papers of an audit client to an AICPA peer review program without the consent of the client.

3-6

A CPA will violate the rule on contingent fees if s/he


a. charges a fee according to what is stated in the engagement letter.
b. charges a fee that is the same as the previous year's audit fee.
c. charges a fee that is different from the previous year's audit fee.
d. charges a fee that is based on the type of audit opinion to be issued.

3-7

The CPC prohibits a CPA to


a. advertise for potential clients.
b. pay commission to others for client referrals when the CPA is auditing the same client.
c. charge a fee based on a particular outcome of the audit.
d. receive commission from others for client referrals when the CPA is auditing the same client.

3-8

Very serious violations of the CPC by a CPA are handled by


a. the National Joint Trial Board.
b. the National Ethics Committees.
c. the State Boards of Accountancy.
d. the National and State Ethics Committees.

3-9

The interpretations of the Rules of Conduct, Rule 101, define materiality for investor-investee relationships as:
a. 5% of audit clients total assets,
b. 5% of audit clients operating income before taxes.
c. either 5% of audit clients total assets or 5% of income before taxes, whichever is more restrictive.
d. 5% of audit clients net income after taxes.

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3-10

Generally, loans between a CPA and an audit client are prohibited because they create a financial relationship. Which of
the following is not an exception to this rule?
a. Secured automobile loans.
b. Fully collateralized loans.
c. Home mortgages.
d. Unpaid credit card balances not exceeding $10,000.

3-11

Which of the following is not defined as an act discreditable in either the Rules or the Interpretations of the AICPAs Code
of Professional conduct?
a. A CPA firm issued a standard unqualified audit report after auditing a governmental agency, although GAAS was not
followed because the government required procedures different from GAAS.
b. A CPA firm discriminates in its hiring practices based on the age of the applicant.
c. A CPA retains a clients books and records to enforce past-due payment of the CPAs audit fee.
d. A CPA was arrested on his way home from the CPA firms holiday party. He was a passenger in a car driven by his wife
and she was charged with driving while intoxicated. He was also charged with lewd and indecent gestures towards an
officer of the law.

3-12

In which of the following instances would the independence of the CPA not be considered to be impaired? The CPA has
been retained as the auditor of a
a. charitable organization in which an employee of the CPA serves as treasurer.
b. municipality in which the CPA owns $250,000 of the $2,500,000 indebtedness of the municipality.
c. cooperative apartment house in which the CPA owns an apartment and is not part of the management.
d. company in which the CPAs investment club owns one-tenth interest.

3-13

In connection with a lawsuit, a third party attempts to gain access to the auditors working papers. The clients defense of
privileged communication will be successful only to the extent it is protected by the
a. auditors acquiescence in use of this defense.
b. common law.
c. AICPA Code of Professional Conduct, Rule 301 on client confidential information.
d. state law.

3-14

The AICPA Code of Professional Conduct requires compliance with accounting principles promulgated by the body
designated by AICPA Council to establish such principles. The pronouncements comprehended by the code include all of
the following except
a. AICPA Accounting Research Bulletins.
b. AICPA Accounting Research Studies.
c. opinions issued by the Accounting Principles Board.
d. interpretations issued by the Financial Accounting Standards Board.

3-15

A CPA is allowed to accept a referral fee for recommending a client to another CPA if
a. the client approves of the transaction either before or after the event.
b. payment of the referral fee is disclosed to the client.
c. the client pre-approves the transaction.
d. None of the above because referrals are never acceptable.

3-16

Rule 505 of the AICPAs Code of Professional Conduct permits CPA firms to organize as
a. single proprietorships or partnerships only.
b. single proprietorships, partnerships, or professional corporations.
c. single proprietorships, partnerships, professional corporations or regular corporations if permitted by state law.
d. single proprietorships, partnerships, professional corporations if permitted by state law, or regular corporations.

3-17

The interpretations to the Rules of Conduct permit a CPA to do both bookkeeping and auditing for the same client if three
important requirements are satisfied. Which of the following is not one of those requirements?
a. The CPA must conform to generally accepted auditing standards.
b. The CPA must not assume the role of employee or of manager.
c. The client must accept full responsibility for the financial statements.
d. The client must file audited financial statements with the SEC.

Financial and Integrated Audits - Frederick Choo

3-18

The AICPAs Code of Professional Conduct states that a CPA should maintain integrity and objectivity. The Term
objectivity in the Code refers to a CPAs ability
a. to choose independently between alternate accounting principles and auditing standards.
b. to distinguish independently between accounting practices that are acceptable and those that are not.
c. to be unyielding in all matters dealing with auditing procedures.
d. to maintain an impartial attitude on all matters that come under the CPAs review.

3-19

Which of the following activities is not prohibited for the CPA firms attestation service clients?
a. Competitive bidding on audit jobs.
b. Contingent fees on audit jobs.
c. Commissions for obtaining client services on audit jobs.
d. None of the above.

3-20

A violation of the AICPAs Code of Professional Conduct would most likely have occurred when a CPA
a. make arrangements to charge a client audit fee based on the complexity of the clients accounting systems.
b. make arrangements with a bank to collect notes issued by a client in payment of fees due.
c. whose name is Choo formed a partnership with two other CPAs and uses Choo & Associates as the firm name.
d. issued an unqualified opinion on the 2001 financial statements when audit fees for the 2000 audit were unpaid.

3-21

A CPA is permitted to disclose confidential client information without the consent of the client to
I. Another CPA who has purchased the CPAs tax practice.
II. Another CPA if the information concerns suspected tax return irregularities.
III. A state CPA societys quality control review board for the purpose of a peer review program.
a. I and III
b. II and III
c. II
d. III

3-22

In which of the following situations would a CPAs independence be considered to be impaired?


I. The CPA maintains a checking account that is fully insured by a government deposit insurance agency at an audit
clients financial institution.
II. The CPA has a financial interest in an audit client, but the interest is maintained in a blind trust.
III. The CPA owns a commercial building and leases it to an audit client. The rental income is material to the CPA.
a. I, II, and III.
b. I and III
c. II and III
d. I and II

3-23

A CPA purchased stock in a client and placed it in a trust as an educational fund for the CPAs dependent child. The trust
securities were not material to the CPA but were material to the childs personal net worth. Would the independence of
the CPA be considered impaired with respect to the client?
a. Yes, because the stock would be considered a direct financial interest and, consequently, materiality is not an issue.
b. Yes, because the stock would be considered an indirect financial interest that is material to the CPAs child.
c. No, because the CPA would not be considered to have a direct financial interest in the client.
d. No, because the CPA would not be considered to have a material indirect financial interest in the client.

3-24

Which of the following would probably not be considered an act discreditable to the profession:
a. Failing to file the CPAs own tax return.
b. Soliciting CPA Examination questions and answers.
c. Numerous moving traffic violations.
d. Refusing to hire Asian-Americans in an accounting practice.

3-25

According to the CPC, which of the following acts is generally prohibited?


a. Purchasing a product from a third party and reselling it to a client.
b. Writing a financial management newsletter promoted and sold by a publishing company.
c. Accepting a commission for recommending a product to an audit client.
d. Accepting engagements obtained through the efforts of third parties.

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3-26

Which of the following is required for a CPA firm to designate itself as Members of the American Institute of Certified
Public Accountants on its letterhead?
a. All partners of the CPA firm must be member of AICPA.
b. The partners whose names appear in the firm name must be members.
c. At least one of the partners must be a member.
d. The firm must be a dues-paying member.

3-27

The concept of materiality would be least important to an auditor when considering the
a. adequacy of disclosure of a clients illegal act.
b. discovery of weaknesses in a clients internal control.
c. effects of a direct financial interest in the client on the CPAs independence.
d. decision whether to use positive or negative confirmations of accounts receivable.

3-28

A violation of the CPC most likely would have occurred when a CPA
a. expressed an unqualified opinion on the current years financial statements when audit fees for the prior years audit
were unpaid.
b. recommended a controllers position description with candidate specifications to an audit client.
c. purchased a CPA firms practice of monthly write-ups for a percentage of fees to be received over a 3-year period.
d. made arrangements with a financial institution to collect notes issued by a client in payment of audit fees due for the
current years audit.

3-29

According to the CPC, which of the following circumstances will prevent a CPA performing audit engagements from being
independent?
a. Obtaining a collateralized home loan from a financial institution client.
b. Litigation with a client relating to billing for consulting services for which the amount is immaterial.
c. Employment of the CPAs spouse as a clients internal auditor.
d. Acting as an honorary trustee for a not-for-profit.

3-30

According to the CPC, which of the following events may justify a departure from a Statement of Financial Accounting
Standards?
a.
b.
c.
d.

3-31

New Legislation
No
Yes
Yes
No

Evolution of a New Form of Business Transaction


Yes
No
Yes
No

According to the CPC and prior to the SECs Financial Reporting Release No.65, which of the following acts is not generally
prohibited?
a. Issuing a modified report explaining a failure to follow a governmental regulatory agencys standards when conducting
an attest service for a client.
b. Revealing confidential client information during a peer review of a professional practice by a team from the state CPA
society.
c. Accepting a contingent fee for representing a client in an examination of the clients federal tax return by an IRS agent.
d. Retaining client records after an engagement is terminated prior to completion and the client has demanded their return.

3-32

With respect to client records in a CPAs possession, the CPC provides that (Hint: Consider Rule 501)
a. an auditor may retain client records if fees due with respect to a completed engagement have not been paid.
b. worksheets in lieu of general ledger belong to the auditor and need not be furnished to the client upon request.
c. extensive analyses of legal expenses prepared by the client at the auditors request are working papers that belong to the
auditor and need not be furnished to the client upon request.
d. the auditor who returns client records must comply with any subsequent requests to again provide such information.

3-33

Which of the following is a violation of the SECs auditor independence rule on non-audit services?
a. A CPA firm provides certain non-audit services that they are pre-approved by the audit committee.
b. A CPA firm provides certain non-audit services that are not pre-approved by the audit committee but the aggregate fee
of all such non-audit services constitutes less than 5% of the total audit fee paid to the CPA firm.
c. A CPA firm provides tax services to an audit client that are not pre-approved by the audit committee.
d. The audit committee disclose to investors in periodic reports its decision to pre-approved non-audit services.

Financial and Integrated Audits - Frederick Choo

3-34

Which of the following is not a general principle used by the Public Company Accounting Oversight Board (PCAOB) in
evaluating the effect of other services on auditor independence?
a. The fee for the additional services must be less than the audit fee.
b. An auditor cannot function in the role of management.
c. An auditor cannot audit his or her own work.
d. An auditor cannot serve in an advocacy role for the client.

3-35

In which of the following situations would a CPA be considered not independent with respect to an audit client under the
independence Rules of the Sarbanes-Oxley Act?
a. The CPA firm provides tax planning services to the audit client that were pre-approved by the audit committee.
b. The audit client hires a partner of a CPA firm as its CFO who left the CPA firm one month earlier, and who was in
charge of the most recent audit of that audit client.
c. The audit partner-in-charge of an audit client has served in that capacity for the past four years.
d. The CPA firm provides general business consulting services that were pre-approved by the audit committee.

3-36

In which of the following situations would a CPA be in violation of the AICPA Code of Professional Conduct on commissions and
referral fees?
a. A CPA discloses to a non-attestation service client that he has received a commission from one of the
suppliers of that client.
b. A CPA discloses to an attestation service client that he has received a referral fee from one of the
lawyers of that client.
c. A CPA discloses to an attestation service client that he has received a commission from one of the
suppliers of that client.
d. A CPA discloses to a non-attestation service client that he has received a referral fee from one of the lawyers of that
client.

3-37

Contrast the requirements of AICPAs Independent Rule 101 and PCAOBs Auditor Independent Rules, which of the
following is a correct statement?
a. SEC requires the lead partner to rotate off the audit every seven years, whereas AICPA requires a rotation every five
years.
b. AICPA does not prohibits providing audit and management services to the same client, whereas SEC directly prohibits
providing audit and management services to the same client.
c. PCAOB allows a public company to employ a member of its external audit team one year after the audit engagement,
whereas AICPA allows a public company to employ a member of its external audit team one year preceding the audit
engagement.
d. PCAOB requires audit committee to pre-approve non-audit services unless the non-audit service fees are less than 5
percent of the total fees. In contrast, AICPA contains no such requirement.

3-38

With regard to enforcement and disciplinary action, very serious violations of the ethical rules are ordinarily handled by
a. AICPAs Professional Ethics Executive Committee.
b. AICPAs joint trial board.
c. AICPAs quality control standards committee.
d. State Board of Accountancy.

3-39

Which of the following is not a correct statement regarding auditors independent?


a. An auditors spouse, spousal equivalent (i.e., cohabitant), and dependents are prohibited from having a direct financial
interest in the audit client.
b. An auditor is not independent of the audit client if any audit partner received compensation based on the partner securing
with the client billable work for services other than audit or attestation.
c. An auditor is not permitted to have a home mortgage loan from the audit client.
d. An auditor is prohibited from being employed by the audit client one year preceding the audit engagement.

3-40

Which of the following is an example of a familiarity threat to an auditors independence?


a. An auditor has a material joint venture with the audit client.
b. An audit has provided audit services to the same client for a prolonged period.
c. An auditor establishes and maintains internal controls for the audit client.
d. An auditor represents an audit client in U.S. tax court.

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3-41

In which of the following situations would a CPA be in violation of the PCAOBs rules on providing auditing and management
advisory services to the same audit client?
a. The auditing and management advisory services provided to the same audit client are pre-approved by the audit
committee .
b. The aggregate fee of the auditing and management advisory services constitutes less than 5% of the total audit fee paid
to the CPA. .
c. The auditing and management advisory services are provided to the same audit client that is a non-public company.
d. The auditing and management advisory services provided to the same audit client are not pre-approved by the audit
committee.

3-42

The PCAOBs Auditor Independence Rule defines a CPAs nondependent step-child as


a. a close family relative.
b. another relative.
c. an immediate family member.
d. neither an immediate family member nor a close family relative.

3-43

With regard to an auditor providing auditing and tax services to the same audit client, there would be a violation of the
PCAOBs Auditor Independence Rules if
a. The total tax services fee is less than 5% of the total audit fee.
b. The tax services are provided for the clients officers in financial reporting oversight roles after the audit engagement has
begun.
c. The tax services are preapproved by the audit committee.
d. The tax services are provided for the clients officers not in financial reporting oversight roles.

3-44

Which of the following is not a correct statement concerning both the PCAOB and AICPAs independence rules?
a. PCAOB prohibits actuarial service whereas AICPA allows it provided the service does not relate to a material portion of
the financial statements.
b. PCAOB prohibits implementing a financial information system whereas AICPA allows it provided the system is not
developed by the auditor.
c. PCAOB prohibits bookkeeping services whereas AICPA allows it provided the auditor does not authorizes or approves
transactions.
d. PCAOB prohibits internal audit outsourcing services whereas AICPA allows it provided the audit client is not
responsible for internal control.

3-45

Under the current Federal laws, which of the following does not apply to an auditor who has obtained certain confidential
information about an illegal act committed by the client?
a. The illegal act has a material effect on the financial statements and warranted a qualified audit report, the auditor must
communicate the act and confidential information to the clients board of directors.
b. Upon communicated of the illegal act and confidential information, the management must send a notification to the SEC
of having received such a communication from the auditor, and a copy of the notification to be sent to the auditor.
c. The SEC provides civil and criminal protections to employees of the audit client who whistleblow confidential
information and provides the same protections to auditor who possesses such confidential information from the
whistleblowers.
d. Upon communicated of the illegal act and confidential information, if the management did not send the auditor a copy of
the notification to the SEC of having received such a communication, the auditor must directly communicate the matter
to the SEC.

3-46

With regard to contingent fees, which of the following is not an appropriate interpretation of Rule 302 Contingent fees
when an auditor provides both attestation and non-attestation services to the same client?
a. It prohibits contingent fee for audit services provided to the client.
b. It prohibits contingent fee fixed by courts or regulatory agencies for audit services provided to the client.
c. It prohibits contingent fee for tax services and other non-attestation services provided to the client.
d. It prohibits contingent fee fixed by courts or regulatory agencies for tax services provided to the client.

Financial and Integrated Audits - Frederick Choo

Key to Multiple-Questions
3-1 d. 3-2 c. 3-3 c. 3-4 d. 3-5 a. 3-6 d. 3-7 c. 3-8 c. 3-9 c. 3-10 d. 3-11 d.
3-12 c. 3-13 b. 3-14 b. 3-15 b. 3-16 c. 3-17 d. 3-18 d. 3-19 a. 3-20 d. 3-21 d.
3-22 c. 3-23 a. 3-24 c. 3-25 c. 3-26 a. 3-27 c. 3-28 a. 3-29 c. 3-30 c. 3-31 c.
3-32 c. 3-33 c. 3-34 a. 3-35 b. 3-36 c. 3-37 d. 3-38 d. 3-39 c. 3-40 b. 3-41 d.
3-42 a. 3-43 b. 3-44 d. 3-45 c. 3-46 b.

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Simulation Question 3-1


Simulation Question 3-1 is an adaptation with permission from a case by Cullinan C.P. and G.B. Wright in Cases From The SEC Files, a
publication of the Pearson Education, Inc. in New Jersey. This simulation question is based upon a true set of facts from the SEC files.

SEC Findings

SEC Sanctions

SEC found PricewaterhouseCoopers (PwC) failed to comply with Rule2-01(b) of Regulation S-X, GAAS, SEC Independence Rules,
and AICPA Code of Professional Conduct which require, among other things, that public accounting firms and their partners and certain
professionals not have any direct or material indirect financial interest in their audit client. Details of the findings are as follows:
1. Professionals who owned securities of publicly held audit clients for which they provided professional services.
During the period 1996 through 1997, three Coopers & Lybrand (C&L) CPAs owned the securities of four publicly-held audit clients
for which they provided professional services. First, in December 1996, a senior tax associate of C&Ls Tampa, Florida, office (Tampa Tax
Associate) owned the securities of a company (Company A) for which he provided professional tax services relating to certain engagements
that were transferred from C&Ls Jacksonville, Florida, office. Second, during November 1996 through April 1997, the Tampa Tax Associate
also owned the securities of another company (Company B) for which he provided professional tax services relating to Company Bs initial
public offering and other tax projects. Third, during December 1996 through February 1997, the Tampa Tax Associate also owned the securities
of another company (Company C) for which he provided professional tax services relating to tax accrual in Company Cs 1996 financial
statements. In addition, during October 1997 through July 1998, a consultant in C&Ls Human Resource Advisory Group also owned securities
of Company C for which the consultant provided one hour of professional consulting services relating to a 401(K) plan offered by Company C.
Fourth, during October 1996 through February 1997, another senior tax associate of C&Ls Tampa office (Second Tampa Tax Associate)
owned the securities of a company (Company D) for which he provided professional tax services relating to pending IRS audits of Company
D.
2. Partners who owned securities of publicly held audit clients for which the partners provided no professional services and managers who owned
securities of publicly-held audit clients of their office for which the managers provided no professional services.
During the period 1996 through 1998, five C&L partners or their spouses owned securities of, or had another direct or material
indirect financial interest in, 31 publicly held audit clients for which the partners provided no professional services. In addition, three C&L
managers or their spouses owned securities of, or had another direct or material indirect financial interest in, three publicly-held audit clients of
their office for which the managers provided no professional services.
3. Investments by C&Ls retirement plan in securities of publicly-held audit clients of C&L and PwC.
During the period of 1996 through 1998, C&Ls retirement plan owned securities of 45 publicly held audit clients in three types of
instances. First, during the period 1977 through 1988, an independent fund manager that was not a C&L employee and that was retained to
manage certain of C&Ls pension fund assets made 15 purchases of the securities of 11 different publicly held audit clients of C&L. C&L
annually provided its fund manager with a list of its audit clients (independent list), the securities of which were not to be purchased. However,
C&Ls procedure of monitoring the fund managers compliance with C&Ls prohibition consisted of only a periodic comparison by personnel in
its pension department of the fund holdings to C&Ls independent list. Second, during the period of 1966 through 1998, the same fund manager
made three purchases of the securities of three different publicly held audit clients of C&L. The fund manager made these purchases prior to
being provided by C&L with an updated independent list which identified these three clients. Third, from July 1, 1998, the date of the Price
Waterhouse (PW) and C&L merger, through November 1998, C&Ls retirement plan held the securities of 32 PwC publicly held audit clients
that had been clients of PW before the merger. Former C&L pension personnel, who became employees of PwC, failed to provide three different
fund managers with a list of PWs clients.

(a)
(b)
(c)
(d)
(e)
(f)

SEC accepts PwCs offer of Settlement and orders that:


PwC is censured.
PwC takes measures to provide reasonable assurance that it will comply with SECs Regulation S-X and Independent Rules to be
independent, in fact and appearance, of their audit clients.
PwC takes measures to provide reasonable assurance that it will comply with AICPAs GAAS and Code of professional Conduct
requiring CPA firms not have any direct or material indirect financial interest in their audit clients.
Prior to accepting a new audit engagement, PwC checks its Securities Held List to determine whether any partner owns the securities
of that prospective audit client.
Annual reports to be filed by all PwC partners and professional staff indicating whether, over the prior year, they had acquired, or
were committed to acquire, any direct financial interest or any material indirect financial interest in any securities on its Restricted
Entity List.
All PwC partners and professional staff complete a course of professional education and training on independence issues.

Required
1. Cite and discuss the specific part(s) of (i) Regulation S-X, (ii) GAAS, (iii) SEC Independence Rules, and (iv) AICPA Code of Professional
Conduct that PwC failed to comply with professional independence. You should access Data File 3-1 in iLearn, which contains the SarbanesOxley Act of 2002. You should also search any relevant websites for more information. For example, search
http://www.aspenpublishers.com/SECRULES/Regsx.pdf for Regulation S-X.

Financial and Integrated Audits - Frederick Choo

Simulation Question 3-2


Simulation Question 3-2 is an adaptation with permission from a case by Knapp, M. C. and C.A. Knapp in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts that was
drawn from United States of America V. Charles I. Covey, No. 00-1768, United States Court of Appeals for the Eighth Circuit, 232 F.3d 641,
2000 U.S.

A Prospective Client

An Unusual Proposal

Peter Kanah spent the early years of his professional career in a large city working on the auditing staff of a major accounting firm,
and then serving as an assistant controller for a municipal hospital. In 1995, Kanah and his wife decided they wanted a different lifestyle for
themselves and their three young children. After several months of searching for a new job, Kanah decided to accept an offer made to him by a
CPA with whom he had become acquainted at local professional meetings. Kanah agreed to purchase the CPAs accounting practice that was
located in a small suburb approximately 30 miles from the downtown business district where Kanah had worked for more than a decade. The
purchase agreement required the former sole practitioner to remain with the firm during a three-year transitional period to minimize client
turnover. In 1998, when Kanah assumed complete ownership of the firm, he had six full-time employees, including a receptionist and five
accountants, three of whom were CPAs. Tax, compilation, and bookkeeping services accounted for the bulk of Kanahs revenues.
Computer manufacturers, e-commerce start-ups, and other high-tech businesses dominated the greater metropolitan area in which
Kanahs firm was located. As a result, the economy of that area was hit hard by the recession that rocked the nations high-tech sector shortly
after the turn of century. In a span of 18 months, Kanah lost nearly one-third of his clients, forcing him to lay off two of his professional
employees. Making matter worse, over that same time frame, Kanah lost more than 80 percent of his personal savings. He had invested those
funds in the stocks of major e-commerce firms whose prices tanked in late 2000 and early 2001.
On a late Friday afternoon in June 2001, while Kanah sat at his desk contemplating his seemingly bleak future, his receptionist brought a
potential client to his door. Hello, Mr. Kanah. I am Robin Ornan. Ornan was a tall man with a sturdy physique and a firm handshake. He was
wearing a starched white shirt, blue jeans, and a frayed baseball cap. Immediately catching Kanah;s attention were large, diamond-encrusted rings
in the shape of a horseshoe that Ornan wore on the pinkie finger of each hand.
What can I do for you, Mr. Ornan?
Im looking for some accounting help.
Well, you certainly came to the right place.
Ornan proceeded to tell Kanah that he had recently inherited a good deal of money from his grandmother and planned to set up a
business in his hometown that was some 60 miles away, on the other side of the metropolitan area. When Kanah seemed surprised that Ornan was
searching for an accounting firm a considerable distance from his proposed business, Ornan quickly added that the planned to visit several
accounting firms in the metropolitan area before choosing one.
Because he had worked several years for an electrical contractor, Ornan believed that he had sufficient experience and contacts in that
field to quickly develop a profitable electrical contracting business. Coleman Services was the name he intended to use for his new company.
Ornan has settled on the generic name Coleman was his grandmothers maiden name - because he hope to expand into other lines of business
in the future.
As soon as Ornan paused, an anxious Kanah seized the opportunity to sell his firm to the prospective a client. Kanah described the
types of services he could offer a new business, including taxation, bookkeeping, and general consulting services. He also stressed the importance
of a new entrepreneur having a close relationship with his accountant. Because of his firms small size, Kanah assured Ornan that he would
receive prompt and personalized service.
Ornan listened politely to Kanahs sales pitch, put the business card Kanah offered him in his shirt pocket, and then excused himself.
As Ornan walked out the door, Kanah decided that he would likely never see Ornan again. Since Ornan had failed to ask any questions about
Kanahs services or fees, he had obviously been unimpressed with the small accounting firm. Kanah realized that Ornan had likely sensed that he
was desperate to acquire new clients, which he was. A few minutes later, the disconsolate Kanah told his employees they begin their weekend
early there was little for them to do anyway.
When Peter Kanah walked into his office the following Monday morning, he had a voice message waiting for him. Robin Ornan has
selected his firm over several others. In the brief message, Ornan told Kanah that he would drop by the office that afternoon to get the ball
rolling.
During their conversation later that day, it soon became apparent to Kanah that Ornan had little understanding of what steps were
necessary to set up a new business. Most of the questions Kanah directed to Ornan produced either a blank stare or an indifferent shrug of the
shoulders. Finally, Kanah decided to take the initiative.
Robin, I think we should start by developing a business plan for you. Ornan seemed bored by the length explanation of the nature
and purpose of a business plan and only glanced momentarily at the example that Kanah spread out on his desk.
When Kanah attempted to goad him into talking about the specific services his firm would provide, the restless Ornan finally spoke.
We dont need to talk about that. What you really need to know is that I want to put together a business big enough to clear about $20,000 per
month.
Kanah was surprised by the nave nature of Ornans remark. Im not sure what you mean, Robin. Do you mean $20,000 of revenues
per month or $20,000 of profits per month or $20,000 of net cash flow per month?
I mean $20,000 of cash, cash money, each month. I expect to operate on a cash basis and I want to know how much business I have
to bring in every month to clear that much cash.
Even more confused now, Kanah responded, You mean you arent going to extend credit to your customers?
No. No credit. Just cash. Im going to make them pay hard, cold cash.
Now, Kanah was just as frustrated as Ornan, but for a different reason. Over the previous few minutes, Kanah had realized that this
promising new client was not so promising after all. Clearly, Ornan had no idea what was involved in operating a business, any type of business.
Are you sure that you have the background necessary to start a business, Robin?
Yep. All I know is that the key to having a successful business is having customers willing to pay cash. And I have a lot of customers
lined up who are willing to pay me cash.

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Kanah put down his pen and leaned back in his chair for several moments before responding. Well, exactly what do you want me to
do to help you? Ill have to rely on you to tell me because I have to admit, Im a little confused at this point.
Okay, thats fair. Why dont we start like this? Finally, Ornan seemed interested in the proceedings. Over the next couple of days,
you can set up a business on paper that would produce $20,000 of cash, or what did you say, net cash flow per month. Why dont you fix up a
set of financial statements or whatever you call them for a company of that size that does electrical contracting work. And, I think you should put
together a list of documents that the company would need to have and the types of reports that it would have to file with the IRS and any other of
those government-type organizations.
Arent you going about this backward? Shouldnt we
Ornan cut off Kanah in midsentence. Now wait a minute. You asked me what I wanted, didnt you? Kanah reluctantly nodded,
which prompted Ornan to speak again. Somewhere, you can find information on a typical electrical contracting business. And, you already know
what types of documents and reports that a business like that would have to prepare every year. Soon as you get all of that information put
together, then we can go from there.
GO? Go where? a flustered Kanah asked.
Go about getting the business started, Ornan shot back quickly. Now, whats so hard about that? You said youre a CPA. I know
you can put together all of that stuff.
Well, youre right. I can do what you asked. I just hope that is what you really need.
Good, the suddenly upbeat Ornan replied. Now, what do you charge for your services?
Well, for this type of work I would have to charge $100 an hour. Kanah expected that the first mention of his houly fee would
stop Ornan in his tracks and possibly bring their awkward discussion to an abrupt conclusion.
Sound fair to me, Ornan replied nonchalantly. How about I start out by paying you $2,500 upfront. Its called a retainer, isnt it?
As Kanah sat dumbfounded and silent at his desk, Ornan stood and reached into his right front pocket and extracted a large roll of
crisp $100 bills. He then counted out 25 of the bills and laid them in a neat pile in front of Kanah. There you are. Ill be back on Friday
afternoon around 1:00 to get that report. Without offering to shake Kanahs hand, Ornan turned and left, leaving his newly hired accountant
gawking at the stack of money in front of him.

An Atypical Business

An Unexpected Outcome

The always prompt Ornan returned to Kanahs office at 1:00 PM on Friday. Thomas, do you have my report?
Yes, I do. Here you are.
Ornan spent several minutes thumbing through the 15-page report after Kanah had completed his explanation of the key items
included in it. He then shook his head and tossed the report on the corner of Kanahs desk. Whew, I didnt know that starting a business
involved this much stuff.
It gets more complicated all the time, Kanah responded.
After taking off his baseball cap and scratching his head for several moments, Ornan stood and closed the door to Kanahs office.
Ornan then sat down and learned forward as he began speaking in a forceful and unapologetic tone. Listen here, Peter. Im going to come clean
with you. Over the next several minutes, Ornan explained that the money he had inherited from his grandmother had been in the form of cash
cash that she had literally hidden under a mattress, buried in cans in her backyard, and stashed in remote corners of remote cubbyholes of her
large home. Dang it, she had told me where it was all hid. But, I may have forgotten some of the spots. I spent the better part of two days tearing
that old house apart. I just hope I got it all. After a brief pause, Ornan shook his head and smiled. That old lady was quite a hoot. Didnt trust
bankers a lick.
Kanah was too shocked to interrupt his new client or to provide any commentary on the sudden and unexpected revelation.
Anyway, why dont we just forget about you helping me set up the business. I think I can do that myself. And, I really dont need an
accountant. My brother has a friend who knows how to keep the books for a cash business. Ornan paused for a moment as if to allow Kanah to
recover. Are you with me now? Peter, you with me? Kanahs gape-mouthed expression didnt change, but when he blinked his eyes and took a
breath, Ornan continued. What I really need to do is run my money through a business. Any business. Heres my plan.
The plan was for Kanah to loan Ornan $120,000 on a one-year promissory note. Ornan would use the cash flow from his business
to make 12 monthly payments of $11,000, meaning that Kanah would earn approximately 10 percent interest on the loan. The loan agreement
would indicate that the assets of Ornans business would serve as the collateral for the loan. But, to persuade Kanah to go along with the plan,
Ornan would give him cash of $135,000 as the true collateral for the loan. Ehen the loan was paid off, Kanah would return only $120,000 of the
cash, he would keep the remaining $15,000 as a loan origination fee.
By the time Ornan had finished laying out his proposal, Kanhs head was spinning. Finally, he mustered enough breath to speak.
Robin, I cant go along with this
Cmon, Peter. Theres nothing wrong here. Uncle Sam will be taken care of since Ill be paying a lot of taxes on my money. And,
you are going to make out like a bandit. Youll get $12,000 in interest plus another $15,000. For what? For nothing. youre not taking any risk
whatsoever. If I dont pay off the loan, you keep the cash collateral. Again, Ornan waited to allow Kanahs brain to catch up. And then, after
one year, we can do it all over again. Youll be making nearly $30,000 a year for the next several years. I know you can use it. I know your
business isnt doing well. You basically admitted that the other day.
During the tedious pause that followed, Kanah stared at the wall to his left. He then leaned forward, propped his elbows on his desk,
and clasped his hands together as if he was seeking divine guidance. At that point, Ornan stood and took his wad of $100 bills out of his pocket .
He slowly deliberately counted out 50 of the bills. Here you are, Peter. Heres a bonus for doing the deal. Thats $5,000. Now. Do we have a
deal?
After studying the large stack of bills for several moments, Kanah extended his right to Ornan and meekly said,Deal.
Peter Kanah liquidated his remaining investments and borrowed $25,000 from his parents to finance the $120,000 loan to Robin
Ornan. True to his word, Ornan delivered a large bundle of $100 bills held together with rubber bands as collateral for the loan. For nine months,
Ornan made the monthly payments on the first day of each month. But, in the spring of 2002, two FBI agents arrived at Kanahs firm to tell him
that Ornan would not be making any further payments on the loan since he had been arrested for selling a variety of illegal drugs including
marijuana and methamphetamines. The agents then informed Kanah he was being charged with conspiracy to commit money laundering and
aiding and abetting money laundering. Kanah was then handcuffed, read his Miranda rights, and taken to the local county courthouse to be
arraigned.

Financial and Integrated Audits - Frederick Choo

The principal witness against Kanah during his criminal trial was Ornan. With the coaxing of federal prosecutors, Ornan recounted the
series of meeting himself and Kanah that had eventually led to the loan agreement between the two men. Under cross-examination by Kanahs
legal counsel, Ornan testified that he had never told Kanah the actual source of his cash inheritance. When given the opportunity to testify on
his own behalf, Kanah insisted repeatedly that he did not know or suspect that Ornan was attempting to launder money from an illicit drug
operation, but did admit that he had failed to report the receipt of more than $10,000 in cash to the IRS as required by a federal status. Kanahs
denials had little impact on the jury. Kanah was convicted on both federal charges files against him. He was sentenced to six years in federal
prison, fined $19,000, and was required to forfeit $70,000 of cash he had received from Ornan that had been confiscated by la w enforcement
authorities.

Required
1. Use the internet to search for information and answer the following parts:
a. Explain what does the phrase money laundering mean?
Note: A useful site is http://en.wikipedia.org/wiki/Money_laundering
b. Briefly describe six methods that are commonly used to money laundering.
Note: A useful site is http://money.howstuffworks.com/money-laundering1.htm
c. With regard to the particular money laundering method used by Robin Ornan, briefly explain:
i. How would the Bank Secrecy Act of 1970 prevent/detect the money laundering by Robin Ornan.
ii. How would the Bank Secrecy Act of 1970 not prevent/detect the money laundering by Robin Ornan.
Note: A useful site is http://www.irs.gov/businesses/small/article/0,,id=152532,00.html
d. With regard to the criminal charges against Robin Ornan and Peter Kanah, briefly explain the criminal penalties that can be imposed on
individuals and organizations that are convicted of money laundering under the Money Laundering Control Act of 1986.
Note: A useful site is http://www.ffiec.gov/bsa_aml_infobase/documents/regulations/ML_Control_1986.pdf
2. Assume you were Peter Kanah. How would you have responded differently to the loan proposal laid out by Robin Ornan?
Note: You must response appropriately as a professional CPA; not simply a yes or no answer.
3. Robin Ornan goaded Peter Kanah into becoming an active participant in his money laundering scheme. Discuss three general strategies that
individual CPAs can use to prevent themselves from stepping onto a slippery slope that eventually result in them becoming involved in
unethical and possibly illegal conduct. For example, you may discuss the self-awareness of greed as one possible general strategy.
Note: A useful site is http://www.philforhumanity.com/Money_Can_Not_Buy_Happiness.html

Simulation Question 3-3


Simulation Question 3-3 is an adaptation with permission from a case by Grambling, A. A. and V. Karapanos in the Issues in Accounting
Education, a publication of the American Accounting Association in Sarasota, Florida.

The SEC Regulation S-X Rule 2-01 on Auditor Independence

On January 28, 2003, in response to SOX 2002, the SEC adopted amendments to strengthen requirements regarding auditor
independence. The current SEC independence requirements, which include the 2003 amendments, are found in Regulation S-X Rule 2-01. The
Rule applies to public company auditors and their close family members, public company auditing firms and their associated entities, and
publicly held companies and their affiliates. Rule 2-01 describes four overarching independence principles indicating that a relationship between
the accountant and the audit client should not:
1. Create a mutual or conflicting interest between the accountant and the audit client;
2. Place the accountant in the position of auditing his or her own work;
3. Result in the accountant acting as management or an employee of the audit client; or
4. Place the accountant in the position of being an advocate for the audit client.
Rule 2-01 prohibits specific relationships including financial relationships, employment relationships, business relationships,
relationships whereby the audit firm provides non-audit services to the audit client, and relationships involving contingent fees. Finally, Rule 2-01
includes requirements regarding partner rotation and audit committee administration of the engagement.

Required
Review Regulation S-X Rule 2-01 on Auditor Independence published by the University of Cincinnati College of Law at
http: //www.law.uc.edu /CCL/ regS-X/SX2-01.html
Based on your review of Regulation S-X Rule 2-01, answer the questions in each of the following two scenarios. Each scenario is to be
considered separately.
Scenario 1
Izumi, a public company, has a financial investment, 30 percent ownership, in Pearl, a private company. The investment in Pearl is not
material to Izumi. Axiom Auditors audits Izumi and also has a financial investment, 15 percent ownership, in the same private company, Pearl.
The investment in Pearl is not material to Axiom Auditors.
Both Axiom Auditors and Izumi have invested in Pearl for the purpose of benefiting from the stock appreciation of Pearl, are not in
business with Pearl, do not promote Pearl or its products, and do not receive any of Pearls operating revenues. You should access Data File 3-3
in iLearn for Figure 1, which depicts the relationships among the three parties in scenario 1.

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3 The Auditor's Ethical Environment

1. Does the case represent an example of a violation of an SEC independence rule? If so, which rule and why? If not, why not?
Note: Specifically consider whether Axiom Auditors independence is impaired because of its investment in Pearl.
Scenario 2
Mills Corporation, a public company, purchased Clarke Company, another public company. Both companies are similar and operate in
the same industry. A new holding company, Marathon Corporation, was created and owns all the stock of Mills and Clarke. After the
merger, Marathons shares began public trading and shares of Mills and Clarke ceased trading.
Marathon has a newly formed board of directors. None of the original board members of Mills or Clarke are part of Marathons new
board. The management team from Mills will manage Marathon. After the merger, Mills constitutes 40 percent of the consolidated revenues and
assets of Marathon; Clarke constitutes 60 percent of the consolidated revenues and assets of Marathon.
Audit firm Favor and Hamilton had been the auditor of Mills for the last 15 years. Audit firm Kastor and Kastor had been the auditor
of Clarke for the last 15 years. Marathon wants to hire Kastor and Kastor as the auditor of the newly formed holding company, Marathon.
D. Drossin, an audit partner at Kastor and Kastor, has been the lead engagement partner of Clarke for the last 4 years. Drossin has a
great deal of experience in the industry, and Kastor and Kastor wants him as the lead audit partner on the Marathon engagement.
You should access Data File 3-3 in iLearn for Figure 2, which provides a diagram that depicts Scenario 2.
1. Would allowing Drossin to become the lead partner of Marathon Corporation result in a violation of the SEC independence rules? If so, which
rule and why? If not, why not?
2. If your answer to Question 1 indicates that it would not be a violation of the independence rules to allow Drossin to become the lead partner of
the Marathon audit, for how many years might Drossin be allowed to be the lead partner of the Marathon audit engagement?
3. The current SEC independence rules require partner rotation, but not audit firm rotation. In your opinion, should the SEC also require audit
firm rotation? Why yes or why not?
Note: Specifically consider the SEC independence rules on lead partner rotation.

Financial and Integrated Audits - Frederick Choo

Chapter 4
The Auditors Legal Environment
Chapter Learning Outcomes (LOs) Checklist
After reading this chapter, you should be able to:
LO4-1 Understand the auditors litigious environment.
LO4-2 Explain the auditors liability to client under common law.
LO4-3 Explain the auditors liability to third parties under common law.
LO4-4 Differentiate between the auditors defense in client and third party law suits.
LO4-5 Explain the auditors civil liability under the statutory law.
LO4-6 Differentiate between the auditors defense in common and statutory law suits.
LO4-7 Explain the auditors criminal liability under the statutory law.
LO4-8 Discuss the Private Securities Litigation Reform Act of 1995 and its subsequent
and future legal development.

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4 The Auditor's Legal Environment

Chapter 4 The Auditors Legal Environment


In the current legal environment, auditors may be sued under the common law and statutory law. Figure 4-1
provides an overview of the applicable law and legal concept.
Figure 4-1 Applicable Law and Legal Concept
3. Public Law Suits
-Under Statutory law
-File civil/criminal action
-Specific SA1933, SEA1934,
-SOX2002 etc. for violating
Federal laws

Stockholders &
Other 3rd parties

2. 3rd parties Law Suits


-Under Common Law
-File civil action
-Specific Tort law for
professional negligence

Client
XYZ Co.

1. Client Law Suits


-Under Common Law
-File civil action
-Specific Contract law
for breach of contract

SEC

Auditor

Engagement letter
(privity of contract)

Table 4-1 provides a summary of the applicable law and legal concept.
Table 4-1 Applicable Law and Legal Concept
Common Law

Statutory Law

Common law is unwritten law that evolves from legal precedent, that
is, in deciding a case, the court looks to judgments in prior court cases.
Over time, the principles of common law are determined by the social
needs of the community.
Common law is state dependent. However, a court in one state may
look to cases decided in another state but is not obligated to follow
such cases. Lower courts in a state are obligated to follow the legal
precedents set by the higher state courts. However, the highest state
court is not bound by its own legal precedents.
A client or a third party may file a civil action against an auditor under
the Common Law of Contract (or Contract Law) or the Common Law
of Tort (or Tort Law):

Statutory law is written law that is established by Congress at the


federal level or by state legislative bodies at the state level. Federal
and state courts are bound by federal and state status, unless the statute
violates the federal or state constitution. A third party may file a civil
action against an auditor under the statutory law. In addition, federal
or state government may file a criminal action against an auditor under
the statutory law. A comparison of civil with criminal action is as
follows:

Contract Law
A civil action in contract is based on the privity of contract, that is, a
contractual relationship that exists between two or more contracting
parties. For example, an auditor is liable to a client for breach of
contract when s/he does not deliver the audit report by the agreed-upon
date.
When a breach of contract occurs, the plaintiff usually seeks one or
more of the following remedies:
(1) Specific performance of the contract by the defendant.
(2) Direct monetary damages for losses incurred due to the breach.
(3) Incidental and consequential damages that are an indirect result of
nonperformance.

Tort Law
A civil action in tort is based on one of the followings:
(1) Ordinary negligence

Characteristic
Who brings the
action?

Civil action
The plaintiff

Criminal action
The government

Trial by whom?

Trial by jury

Trial by jury

What kind of
Burden of proof?

Preponderance
of the evidence

Beyond a
reasonable doubt

How does jury


vote?

Judgment for
plaintiff requires
specific jury vote,
e.g., 9/12 jurors

Conviction
requires
unanimous jury
vote

What type of
Monetary damages,
sanctions/penalties? equity remedies,
e.g., injunction,
specific performance

Imprisonment,
capital
punishment, fine,
probation

Financial and Integrated Audits - Frederick Choo

Common Law

Statutory Law

Failure to exercise a degree of care that an ordinary prudent person (a


reasonable person) would exercise under similar circumstances.
Failure to perform an audit in accordance with generally accepted
auditing standards might be interpreted as ordinary negligence. In
auditing, ordinary negligence may be viewed as "failure to exercise
due professional care".
(2) Gross negligence
Failure to exercise even a slight care in the circumstances. Substantial
failure to perform an audit in accordance with generally accepted
auditing standards might be interpreted as gross negligence. Reckless
behavior towards ones professional responsibilities is a form of gross
negligence.
(3) Fraud
Intentional deception, such as the misrepresentation, concealment, or
nondisclosure of a material fact, that results in injury to another
person. For example, an auditor intentionally misrepresents his/her
audit report.

Auditors Liability to Client under Common Law


In auditing, a CPA typically enters a direct relationship with the client by agreeing to perform an independent audit
service for the client. The agreed-upon independent audit service to be performed by the auditor is detailed in an
engagement letter and signed by both the auditor and the client. Accordingly, a contractual relationship or privity of
contract exists between the two parties. Given this contractual relationship, the auditor is liable to the client for
breach of contract when he/she: 1. Issues a standard unqualified audit report when the audit engagement has not
been conducted in accordance with GAAS. 2. Does not deliver the audit report by the agreed-upon date. 3. Violates
the client's confidential relationship. Key cases involving an auditor's liability to client (client law suits) are
summarized in Table 4-2 and Table 4-3.
Table 4-2 1136 Tenants Corporation Case (1976)
1136 Tenants Corporation Case (1976)
Facts:
A CPA was orally engaged to perform accounting and auditing services for the 1136 Tenants Corporation. The CPA misunderstood the contract
thinking that he was engaged to prepare accounting records only. Therefore, the CPA only prepared financial statements and related tax returns
for the client.
In the course of preparing the accounts for the client, the CPA came across some missing invoices which showed over $40,000 of disbursements
that did not have supporting documents. However, the CPA, thinking that he was not engaged in auditing, did not follow-up the missing invoices
and did not inform the plaintiff of the missing invoices.
As it turned out, the management of the cooperative apartment embezzled significant funds of over $110,000. The tenants of the cooperative
apartment sued the CPA for breach of contract and negligence for failure to detect the fraud.

Outcome:
The court concluded that the CPA was liable because regardless of the type of services performed by the CPA (even if he misunderstood them),
the standard of due professional care required him to follow-up the fraud and to inform the client of known wrongdoing.

Lesson:
The AICPA issues a letter to strongly recommend a written contract (i.e., an engagement letter) to be signed by the auditor and the client that
clearly defines the intention and scope of each audit engagement.

Table 4-3 Cenco Incorporated Case (1982)


Cenco Incorporated V. Seidman & Seidman (1982)
Facts:
A massive fraud was committed by the former top management of Cenco Incorporated by inflating inventory values to $25M. The new
management of Cenco sued the auditors, Seidman & Seidman, for breach of contract. They claimed that the auditors failed to detect the fraud
committed by the former top management in accordance with GAAS.

Outcome:
The Seventh Circuit Court of Appeals in Chicago concluded that "auditors' aren't detectives hired to ferret out fraud" and although the auditors
were responsible to follow-up any indications of fraud, in this case, the former management made fraud difficult to detect by turning the
company "into an engine of theft against outsiders." The auditors were not negligent in the face of a well-orchestrated management fraud.

Lesson:
The AICPA issues AU 316 Consideration of Fraud in a Financial Statement Audit that clarifies and reinforces the auditor's responsibility for the
detection of fraud in accordance with the four fundamental principles underlying an audit (AICPA).

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4 The Auditor's Legal Environment

Auditors Liability to Third Parties under Common Law


Under common law, a third party is defined as an individual who is not in privity with the parties to a contract.
There are two classes of third parties:
1. A primary beneficiary. Anyone specifically identified to the auditor prior to the audit who is to be the primary
beneficiary of the auditor's report. For example, a client informs the auditor prior to the audit that the audit report is
to be used to obtain a loan from a specified bank; the specified bank becomes a primary beneficiary.
2. Other beneficiary. Anyone not specifically identified to the auditor prior to the audit who may rely on the
auditor's report, such as creditors and potential investors. A key case that establishes auditor's liability to a primary
beneficiary is summarized in Table 4-4.
Table 4-4 Ultramares Corporation Case
Ultramares Corporation V. Touche (1931)
Facts :
The auditor, Touche, discovered that its client, Fred Stern & Co, overstated assets and stockholders equity by $700,000 through fictitious
transactions. However, Touche failed to report the fictitious transactions in the audit report.
Relying on Touche's audited financial statements, Ultramares lent Stern money that Stern was unable to repay because it was actually insolvent.
Ultramares sued Touche for negligence and fraud.

Outcome:
The court ruled that a privity of contract did not extend to a third party unless the third party is a primary beneficiary. In this case, the court found
that Touche was guilty of ordinary negligence but not gross negligence or fraud; and Touche was not liable to Ultramares for ordinary negligence
because Ultramares was not a primary beneficiary.

Lesson:
This case establishes the Ultramares doctrine by which auditors are not liable to a third party for negligence in the absence of a privity of
contract. In addition, under the Ultramares doctrine, auditors are not liable for ordinary negligence but may be liable for gross negligence or fraud
if the third party is a primary beneficiary.

The Ultramares doctrine remained unchallenged for many years, and it is still followed today in jurisdictions of
some states. However, there has been a trend to broaden the auditor's liability in the case of other beneficiaries based
on Section 552 of the Restatement (2nd) of Torts. Under this Restatement (2nd) of Torts, the other beneficiaries are
separated into two categories:
1. A foreseen party. A user of a reasonably limited class or group of users of financial statements who have relied on
the auditor's work; for example, if the client informed the auditor that the audit report is to be used to obtain a bank
loan from a specified bank, all banks are foreseen parties but trade suppliers would not be part of the foreseen group.
One identifiable (specific) user from a limited class or group of users must be known to the auditors, and the class or
group of users to which he/she belonged must be reasonably limited. Furthermore, the foreseen party concept
applies to past foreseen parties; it does not apply to a present or future foreseen parties. A key case that extends the
auditor's liability to foreseen third parties is summarized in Table 4-5.
Table 4-5 Rusch Factors Inc. Case
Rusch Factors Inc V. Levin (1968)
Facts:
Rusch Factor, a New York banker, asked the auditor to audit the financial statement of a Rhode Island corporation seeking a loan. Based on the
auditor's unqualified opinion on the financial statements, Rusch Factor lent $300,000 to the corporation which subsequently went into
receivership. Rusch Factor sued the auditor for negligence and intentional misrepresentation.

Outcome:
The court held that the auditor was liable for ordinary negligence in the case of a foreseen third party. The court ruled that the auditor should be
liable "in negligence for careless financial misrepresentation relied upon by actually foreseen and limited class of people."

Lesson:
The auditing profession is exposed to a broadened interpretation of the Utramares doctrine whereby foreseen third parties can successfully sue
the auditors for ordinary negligence.

2. A foreseeable party. A user whom the auditor either knew or should have known would rely on the audit report in
making business and investment decisions. A foreseeable party extends the auditor's liability to any unspecified
party, such as a creditor, stockholder, and investor, who relies on the auditor's report and suffers a loss as a

Financial and Integrated Audits - Frederick Choo

consequence. Furthermore, the foreseeable party concept applies to all past, present or future foreseeable parties. A
key case that extends the auditor's liability to foreseeable third parties is summarized in Table 4-6.
Table 4-6 Rosenblum Case
Rosenblum V. Adler (1983)
Facts:
Rosenblum acquired common stock of Giant Stores Corporation. The stock subsequently proved to be worthless after Giant's audited financial
statements were found to be fraudulent. Rosenblum sued Alder (a partner of Touche) for negligence and that the auditor's negligence was a
proximate cause to their loss.

Outcome:
The court found the auditor liable in gross negligence for any third party whom he either knew or should have known (i.e., a reasonably
foreseeable third party) would rely on his report in making investment decision.

Lesson:
The auditing profession is exposed to an even more broadened interpretation of the Utramares doctrine whereby foreseeable third parties can
successfully sue the auditors for gross negligence and fraud.

Throughout the 80s, the Rosenblum case typifies the application of the foreseeable party concept to the auditors
liability in the United States. However, in 1985, in a landmark case in New York, Credit Alliance Corp V Arthur
Andersen & Co., the New York Court of Appeals reversed a lower courts decision that prevented the defendant
auditor from using lack of privity of contract as a defense. In doing so, the appellate court seemed to move back to
the basic concept of privity established in the Ultramares doctrine. To date, four states Arkansas, Illinois, Kansas,
and Utah have adopted legislation that follows the Credit Alliance approach in making an auditor liable for
ordinary negligence only to those persons whom the auditor acknowledged in writing were known to be relying on
the audit report. A summary of the Credit Alliance case is provided in Table 4-7. Moreover, starting in the 90s,
California courts also seem to move away from the foreseeable party concept back to the Ultramares doctrine. A
key case to illustrate this legal movement in California is Bily V Arthur Young (1990) shown in Table 4-8.
Table 4-7 Credit Alliance Corp. Case
Credit Alliance Corp. V Arthur Andersen & Co. (1986)
Facts:
Credit Alliance Corp., a lending institution in New York, brought suit against Arthur Andersen & Co., who was the auditor of one of its
borrowers. Credit Alliance Corp. alleged that it relied on the audited financial statements of the borrower, who was in default, in granting the
loan. Thus, Arthur Andersen & Co was liable to Credit Alliance Corp., who was a foreseeable third party to the auditor.

Legal Issue:
The New York appellate court rejected the foreseeable party concept and moved back to the Ultramares doctrine by establishing three criteria for
determining whether a plaintiff can bring a claim against an auditor for ordinary negligence: (1) the plaintiff did in fact rely on the auditors
report, (2) the auditor knew that the plaintiff intended to rely on the audit report, and (3) the auditor, through some actions on his or her own part,
evidenced understanding of the plaintiffs intended reliance. Since this ruling, the AICPA has been promoting the passage of legislation
embodying the Credit Alliance approach in all jurisdictions.

Table 4-8 Bily Case


Bily V. Arthur Young (1990)
Facts:
Osborne Computer Corporation obtained a $2.3 million loan from Security Pacific National Bank (later merged with the Bank of America) in
1983. To provide for the loan, several warrant investors executed irrevocable letters of credit in favor of Security Pacific, which guaranteed
payment if Osborne did not repay the loan. Also, several stock investors purchased sizable blocks of Osborne stock. Both the warrant investors
and stock investors relied on Arthur Young's unqualified audit opinions of Osborne's financial statements. Osborne went into bankruptcy in 1983.
The warrant investors were called upon to repay the bank loan and the stock investors lost their investment. The investors sued Arthur Young for
negligence.

Legal issue:
The California Court of Appeals applied the foreseeability test for holding Arthur Young liable to foreseeable third parties. The Jury found
Arthur Young liable and awarded the plaintiffs over $3 million in damages. However, in 1992, the California Supreme Court reversed the Court
of Appeals decision against Arthur Young by moving back to the Ultramares doctrine. In its decision, the Supreme Court stated that an auditor
owes no general duty of care regarding the conduct of an audit to persons other than the client, and reasoned that the potential liability to
auditors under the foreseeable party concept would be distinctly out of proportion to fault.

A diagrammatic summary of the legal concepts in third parties law suits is shown in Figure 4-2.

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4 The Auditor's Legal Environment

Figure 4-2 Legal Concepts in Third Parties Law Suits

3rd parties

Ultramares Case
Established Ultramares Doctrine that
no contract between auditor and 3rd
parties, therefore, no liabilities

Reinstatement (2nd) of Torts

Foreseen 3rd parties

Foreseeable 3rd parties

Rusch Factors Case


Established auditor liabilities when
one identifiable (specific) user from
a limited class or group of users
is known to the auditor

Rosenblum Case
Established auditor liabilities when
any unidentifiable (non-specific)
user whom the auditor knew
or should have known

The auditors have four possible defenses in client law suits and three possible defenses in third party law suits. A
brief description of these defenses is provided in Table 4-9.
Table 4-9 Auditors Defenses

Lack of duty

Nonnegligent performance

Auditors Defense in Client Law Suits

An auditor can argue that the duty in question is not explicitly stated
in the audit engagement letter. In this case, the scope and
responsibilities detailed in the audit engagement letter are critical for
a successful defense.

An auditor can argue that the audit is performed in according to


GAAS. In particular, the audit gives no complete assurance that
material errors or irregularities will be detected. According to AU
240 Consideration of Fraud in a Financial Statement Audit , the
auditor is responsible for designing the audit to provide "reasonable
assurance of detecting errors and fraud that are material to the
financial statements". In addition, it states, "Because of the
characteristics of frauds, particularly those involving forgery and
collusion, a properly designed and executed audit may not detect a
material fraud." The auditor's working papers are critical in this
defense. Furthermore, the auditor hopes to convince the court that
s/he has only a secondary responsibility to detect and report errors
and frauds. The auditor's prime responsibility is to form an opinion
about the fair presentation of the client's financial statements.

Lack of privity of contract

Nonnegligent performance

Auditors Defense in 3rd Parties Law Suits

A lack of privity of contract defense is in effect invoking the


Ultramares doctrine as a defense. Application of the Ultramares
doctrine by the judicial jurisdiction varies across states. Therefore, a
successful defense will depend very much on a particular state's
judicial jurisdiction. Also, note that a lack of duty defense in suits by
clients is in essence a lack of privity of contract defense in suits by
third parties.
Although nonnegligent performance is a defense available to the
auditor in third party law suits, it is often difficult to convince a jury
of laypeople that the professional auditor is nonnegligent in an audit
simply by following the GAAS. Also, note that a contributory
negligent defense in suits by clients is generally not available to the
auditors in suits by third parties because the latter is not in a position
to contribute to the misstatement of the financial statements.

Financial and Integrated Audits - Frederick Choo

Contributory negligence (best defense)

Absence of causal connection

Auditors Defense in Client Law Suits

An auditor can argue that the client's management contributes to its


own loss by its own negligence, e.g., the management has withheld
critical accounting information from the auditor during the audit. In
such a case, there is no basis for recovery because the negligence of
one party nullifies the negligence of the other party. It should be
noted that in most states, contributory negligence is a defense for
the auditor only when the negligence directly contributes to the
auditor's failure to detect misstated financial statements, e.g., Cenco
Case.

Contributory negligence

None-proximate cause (best defense)

Auditors Defense in 3rd Parties Law Suits

A contributory negligent defense is generally not available to the


auditors in suits by third parties

An auditor can argue that there is a lack of a close causal connection


between the auditor's breach of contract and the resultant damages
suffered by the client, e.g., the loss of a client's major supplier is not
directly related to the fact the auditor has not issued his/her audit
report on time.

Even though an auditor might have been negligent in performing an


audit, the auditor will not be liable for the client's loss if the auditor's
negligence was not the proximate cause of the loss. Under Tort law,
a negligent party is not necessarily liable for all damages set in
motion by his/her negligent act. The law establishes a point along
the damage chain after which the negligent party is no longer
responsible for the consequences of his/her negligent act. This
limitation on liability is referred to as the proximate cause. A noneproximate cause defense is perhaps the best defense available to the
auditors in third party law suits. Also, note that a defense of an
absence of causal connection in client law suits is in essence a
defense of none-proximate cause in third party law suits.

Auditors Liability for Civil Action under Statutory Law


Federal or state legislative bodies establish statutory law. Congress enacts federal statutes. The two most important
federal statutes affecting auditors are the Securities Act of 1933 and the Securities Exchange Act of 1934 that
regulate the issuing and trading of securities within a state. A brief description of the auditors liability under these
two federal statutes is given in Table 4-10.
Table 4-10 Auditors Liability under the Securities Act of 1933 and Securities Exchange Act of 1934
Securities Act of 1933

Securities Exchange Act of 1934

The Securities Act of 1933 was enacted by Congress and administered


by SEC. It is designed to regulate new securities offered by a
company. Under this Act, a company intending to issue new securities
must file a registration statement and prospectus with the SEC.
Accompanying the registration statement is the audited financial
statements.
Auditors are usually sued under Section 11 of the 1933 Act, which
states, in part "In case any part of the registration statement, when such
part becomes effective, contained an untrue statement of a material fact
or omitted to state a material fact, the auditors are liable to any third
parties (purchasers) for losses resulting from the auditors' ordinary
negligence, gross negligence or fraud relating to material false or
misleading financial statements contained in the registration
statement. In addition, the auditor (the defendant) has the burden of
proof that there is non-negligent (i.e., there is due diligence) and there
is non-reliance by the plaintiff on (i.e., no loss to the plaintiff resulted
from) the false or misleading registration statement. However, it
should be noted that the plaintiff (purchaser) must bring a law suit
within 1 year of the discovery of the misstatement or omission and
within 3 years after the security was offered to the public (i.e., the
statutes of limitations applies here). Finally, the auditors liability
extends to the effective date of the registration statement.

The Securities Exchange Act of 1934 was enacted by Congress and


administered by SEC. It is designed to regulate the public trading of
securities on a national exchange or over the counter. The Act requires
companies to file quarterly reports (Form 10-Q which include
unaudited financial statements) and annual reports (Form 10-K which
include audited financial statements) with SEC.
Auditors are usually sued under Section 10 (b) and Rule 10b- 5 of the
1934 Act. Rule 10b-5 states, in part that it is unlawful for any person,
directly or indirectly, to
(1) employ any device, scheme, or artifact to defraud,
(2) make any untrue statement of material fact or omit to state a
material fact, and
(3) engage in any act, practice, or course of business that operates, or
would operate, as a fraud or deceit on any person in connection with
the purchase or sale of any security.
Under Rule 10b-5 of the 1934 Act, auditors are not liable to any seller
or buyer (investor) of the securities for ordinary negligence but for
losses resulting from the auditor's reckless behavior (a form of gross
negligence) if the element of scienter (i.e. an intent to manipulate,
deceive, or defraud the third parties) can be proven.
Under Rule 10b-5 of the 1934 Act, the investor (the plaintiff) has the
burden of proof that (1) there is reliance on the misstatement or
omission; (2) the transaction involved interstate commerce, the mail,
or a national securities exchange; (3) there is the element of scienter,
and (4) there is a loss resulted from the scienter element.

A key case on auditors liability for civil action under the Securities Act of 1933 is shown in Table 4-11.
Table 4-11 Escott case

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4 The Auditor's Legal Environment

Escott V. Bar Chris (1968)


Facts:
Bar Chris filed a registration statement in 1961 for the issuance of new debentures. In connection with the audit of Bar Chris, the auditor (Peat,
Marwick and Mitchell, now KPMG Peat Marwick) needed to perform an S-1 review of events subsequent to balance date for the SEC. The
purpose of the review was to ascertain whether, subsequent to the balance sheet date, any material changes had occurred that needed to be
disclosed to prevent the balance sheet from being misleading. Seventeen months after the registration Bar Chris filed for bankruptcy. The
purchasers of the debentures filed suit against the auditor under Section 11 of the 1933 Act.
Outcome:
The court concluded that the PMM's review program was in accordance to GAAS, but PMM was found liable because the senior who performed
the S-1 review did not establish due diligence (i.e. the standard of reasonable care of a prudent man in the management of his own property)
required under the 1933 Act.

Lesson:
The AICPA issues AU 560 Subsequent Events and Subsequently Discovered Facts. This auditing standard helps auditors to avoid being sued
under Section 11 of the 1933 Act.

A key case on auditors liability for civil action under the Securities Exchange Act of 1934 is shown in Tables 4-12.
Table 4-12 Hochfelder Case
Ernst & Ernst V. Hochfelder (1976)
Facts:
Ernst and Ernst (now Ernst and Young), the auditors of First Securities Co., a small brokerage firm, were sued by the investors (Hochfelder) in
nonexistent escrow accounts allegedly kept by the president, Lester Nay. To prevent detection, all investors were instructed to make their checks
payable to Nay and to mail them directly to him at First Securities. Nay imposed a "mail rule" that such mails were to be opened by him. The
funds were not recorded on First Securities' book. Instead, he misappropriated the funds. The fraud was uncovered in Nay's suicide note. The
investors sued Ernst & Ernst under Rule 10b-5 of the 1934 Act for negligence in their audit because they have not detected and reported the "mail
rule".

Outcome:
The supreme court ruled that the auditors were not liable under Rule 10b-5 for reckless behavior (a form of gross negligence) in the absence of
scienter (i.e. the auditors had no intent to deceive, manipulate or defraud the investors).

Lesson:
Auditors should not commit the element of scienter if they were to avoid being charged for violation of Rule 10b-5 under the 1934 Act. In
addition, although the auditors are not liable for ordinary negligence under the 1934 Act, they may be liable for recklessness (a form of gross
negligence) and fraud if the element of scienter exists under those circumstances.

The Hochfelder case (1976) clearly indicates that an auditor is liable for recklessness (a form of gross negligence)
only if scienter is present. However, in subsequent cases, there is a movement away from the presence of scienter.
Two key subsequent cases show that an auditor is liable for recklessness even though scienter is absent. Tables 4-13
and 4-14 show these two cases.
Table 4-13 Mclean Case
Mclean V. Alexander (1979)
Facts:
An investor purchased all the stock in a company based on the company's strong sales figure. However, the sales figure was based, in part, on 16
accounts receivable that were not true sales. The auditors did not conduct a thorough investigation of the accounts receivable. A thorough
investigation of the accounts receivable would require the auditor to perform accounts receivable confirmation and to follow-up non-responses.

Outcome:
The lower court held that the auditors were liable for reckless behavior (i.e. gross negligence under Rule 10b-5) in performing the audit even
though the element of scienter was absent. Although the lower court's decision on reckless behavior was subsequently overturned by the court of
appeals, this case indicates that the court (in this case the lower court) would hold auditor liable in the absence of scienter.

Lesson:
Auditors should not conduct their audit in a reckless manner because they might be charged for gross negligence under the 1934 Act even though
they have no intention to deceive, manipulate or defraud the buyers or sellers of securities.

Table 4-14 Howard Sirota case


Howard Sirota V. Solitron Devices, Inc. (1982)
Facts:
Solitron overstated its earnings by more than 30% by overstating its inventory account for the purpose of inflating its stock price issued on the
American Stock Exchange. The scheme has apparently helped Solitron's management in acquiring new companies. The investors sued the

Financial and Integrated Audits - Frederick Choo

Howard Sirota V. Solitron Devices, Inc. (1982)


auditor for reckless behavior in their audit of Solitron Devices, Inc.

Outcome:
The lower court did not find the auditors guilty of reckless behavior because the case of reckless behavior required proof that the auditors had
knowledge of the fraud by the management. The court of appeals established that the auditors knew about the fraud and that they failed to follow
it up. The auditors were therefore found guilty of reckless behavior under rule 10b-5.

Lesson:
An auditor is acting in a reckless manner if s/he knows about fraud and fails to follow it up. The auditor will be held liable for gross negligence
under the 1934 Act even though the element of scienter is absent.

An auditors defense under the Securities Act 1933 and Securities Exchange Act 1934 is shown in Table 4-15.
Table 4-15 Auditors Defense under the Securities Act 1933 and Securities Exchange Act 1934
Defense under the Securities Act 1933

Defense under the Securities Exchange Act 1934

The "lack of privity of contract" defense in common law suits by third


parties is not available to the auditors under the 1933 Act because the
privity of contract concept is not relevant under this Act. However, the
"nonnegligent performance" and the "none-proximate cause" defenses
in common law suits are available to the auditors.
When an auditor uses nonnegligent performance as a defense, he/she
must prove that he/she has made a reasonable investigation and
accordingly had reasonable ground to believe that there were no
material false or misleading financial statements contained in the
registration statement. The test of reasonable investigation under the
1933 Act is due diligence, that is, the standard of reasonable care of a
prudent man in the management of his own property. The auditor's
defense is referred to as the due diligence defense. However, in
contrast to common law cases, in which the plaintiff has to prove that
the auditor was negligent, the auditor has to prove that he/she
performed the audit work with due diligence.
When an auditor uses the none-proximate cause as a defense, the
auditor (the defendant) must establish that the third parties loss
resulted in whole or in part from causes other than the false or
misleading financial statements contained in the registration statement.

The same two defenses available to auditors in suits by third parties


under the 1933 Act are also available for suits under the 1934 Act.
These are the "nonnegligent performance" and the "none-proximate
cause" defenses.
When an auditor uses "nonnegligent performance" as a defense under
the 1934 Act, s/he must prove the absence of reckless behavior. The
test of reckless behavior under the 1934 act requires the auditor to
prove that he/she performed in good faith and had no knowledge that
the financial statements were false or misleading, that is, there is no
element of scienter. This means that the minimum basis for liability is
similar to gross negligence in common law.
When an auditor uses the "none-proximate cause" as a defense under
the 1934 Act, the third parties (the plaintiff) must prove reliance on the
false or misleading financial statements and damages resulting from
such reliance.

A summary of auditors liability in relation to negligence is provided in Table 4-16.


Table 4-16 Auditors Liability in Relation to Negligence

Source of Law

Tort Law Ultramares doctrine


Tort Law Foreseen 3rd parties
Tort Law Foreseeable 3rd parties
The Securities Act of 1933
The Securities Exchange Act of 1934

Ordinary Negligence
(or Due Diligence)

Auditor Liable For


Gross Negligence
(or Reckless Behavior)

Fraud

No
Yes
No
Yes
No

Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
Yes

A summary of auditors defenses in common law and statutory law suits is provided in Table 4-17
Table 4-17 Auditors Defense in Common Law and Statutory Law Suits
Source of Law

Plaintiff

Contract Law

Client

Tort Law

Third Party:
1. Primary beneficiary
2. Other beneficiary:
a. Foreseen (past)
b. Foreseeable (past, present and future)

Auditors (defendants) Defense


1. Lack of duty
2. Nonnegligent performance
3. Contributory negligence
4. Absence of causal connection
1. Lack of Privity
2. Nonnegligent performance
3. None-proximate cause

Burden of Proof
Plaintiff

Plaintiff

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Source of Law

Plaintiff

The Securities Act 1933

Any person acquiring new securities

The Securities Exchanges


Act 1934

Any person buying or selling securities

Auditors (defendants) Defense


1. Nonnegligent performance
2. None-proximate cause
1. Nonnegligent performance
2. None-proximate cause

Burden of Proof
Defendant (Auditor)
Plaintiff

Auditors Liability for Criminal Action under State and Federal Statutes
The Securities Act 1933, the Securities Exchange Act 1934, the Racketeer Influenced and Corrupt Organization Act
(RICO), as well as several other federal statutes such as the Federal Mail Fraud Statutes and the Federal False
Statements Status, are federal laws that make it a criminal offense for an auditor to defraud another person through
knowingly being involved with false financial statements (i.e., guilty of knowing complicity).
Auditors may be sued under Section 24 of the 1933 Act which makes it a criminal offense for any person
to:
1. Willfully make any untrue statement of material fact in a registration statement filed with the SEC,
2. Omit any material fact necessary to ensure that the statements made in the registration statements are not
misleading, or
3. Willfully violate any other provision of the Securities Act of 1933 or rule or regulation adopted there under.
Auditors may also be sued under Section 32(a) of the 1934 Act which makes it a criminal offense for any person
willfully and knowingly to make or cause to be made any false or misleading statement in any application, report, or
other document required to be filed with the SEC pursuant to the Securities Exchange Act of 1934 or any rule or
regulation adopted there under.
Criminal Action under the Securities Act 1933 and Securities Exchanges Act 1934
There have been relatively few criminal actions involving auditors in securities-related litigation; a majority of cases
have been for civil actions. A leading criminal case that involves auditors is U.S. v Simon 1969 (or Continental
Vending Machine Case). Table 4-18 provides a brief description of this case.
Table 4-18 U.S V Simmon (Continental Vending Machine Case)
U.S V Simmon (1969) (or Continental Vending Machine Case)
Facts:
The case involved loans made by Continental Vending to its affiliated company, Valley Commercial Corporation, which subsequently lent the
money to the president of Continental, Harold Roth. Roth pledged collateral, about 80 percent of which was Continental stock. Although the
accounts receivable from Valley was recorded by Continental, it was not collectible because Roth was unable to pay Valley, and the market value
of Roth's collateral was less than the amount owed.
Roth subsequently declared bankruptcy. The government sued the auditors. The action was brought under Section 32 of the Securities Exchange
Act 1934 alleging that a footnote in Continental's financial statements did not adequately disclose the fact that Roth diverted corporate funds
from Continental for private use through its affiliated Valley corporation.
Two audit partners and an audit manager were prosecuted for allegedly participating in the conspiracy to defraud Continental's stockholders. The
auditors argued that they had followed GAAP in the disclosure of the footnote and thus free of criminal liability.

Outcome:
The auditors were found guilty. The court held that "Generally accepted accounting principles instruct an accountant what to do in the usual case
when he has no reason to doubt that the affairs of the corporation are being honestly conducted. Once he has reason to believe that this basic
assumption is false, an entirely different situation confronts him." The auditors were fined $17,000 and their licenses to practice as CPAs were
revoked. However, they were pardoned by President Nixon in 1972.

Lesson:
The AICPA provides guidance on procedures that should be considered by an auditor when s/he is performing an audit involving related party
transactions in AU 550 Related Parties.
The auditors learned that demonstrating compliance with GAAP was not a successful defense in the case of a criminal charge of willfully and
knowingly making a false statement. Therefore, auditors must make sure that the financial statements adequately disclose known and material
management frauds.

Other key cases on an auditors liability for criminal action are presented in Tables 4-19 and 4-20 below.
Table 4-19 U.S V Weiner (Equity Funding Case)
U.S V Weiner (1975) (or Equity Funding Case)
Facts:

Financial and Integrated Audits - Frederick Choo

U.S V Weiner (1975) (or Equity Funding Case)


With the help of a computer, the top management of the Equity Funding Corporation created fictitious insurance policies and overstated its net
income and assets by over $100 million. Moreover, the management misstated the financial statements by recording fictitious commission
income, borrowing funds without recording the corresponding liability, and creating the fictitious insurance policies.
The auditors, an audit partner and two audit managers, were sued for failure to detect that $2.1 billion of the Equity Funding Corporation's $3.2
billion of assets were based on bogus insurance policies generated by the top management with the help of the computer.

Outcome:
The management fraud was so glaring that the court decided that the auditor must have been aware of the fraud and therefore guilty of knowing
complicity. Indeed, a special AICPA committee found that "the fraud was not based on a sophisticated application of data processing
technology." The committee concluded, "that customary audit procedures properly applied would have provided a reasonable degree of assurance
that the existence of fraud at Equity Funding would be detected."

Lesson:
The AICPA re-examines the auditor's assumption about top management honesty and issues AU 240 Consideration of Fraud in a Financial
Statement Audit. The standard states that "An audit of financial statements in accordance with generally accepted auditing standards should be
planned and performed with an attitude of professional skepticism. The auditor neither assumes that management is dishonest nor assumes
unquestioned honesty." In addition, the auditor learned that the best defense to a potential criminal charge is not to risk performing a sloppy
audit.

Table 4-20 U.S V Natelli (National Student Marketing Corporation Case)


U.S V Natelli (1975) (or National Student Marketing Corporation Case)
Facts:
Natelli, an auditor of Peat, Marwick, Mitchell & Co, was in charge of the 1968 audit of the National Student Marketing Corporation. The
company sold marketing programs (advertising contracts) to companies for promotional campaigns on college campuses.
The company uses a percentage-of-completion method to recognize revenues. This resulted in some $1.7 million uncollectible accounts
receivable on the books of the company, representing unconfirmed commitments from customers. Subsequently, approximately $1 million of the
uncollectible accounts receivable were written off. However, the auditor neither disclosed the material effect of the uncollectible accounts
receivables nor acknowledged the prior mistake made in recognizing uncollectible accounts receivable.

Outcome:
The circumstances and actions of the auditor were construed by the court to be a willful violation of the Securities Exchange Act of 1934 and
resulted in criminal liability.

Lesson:
Criminal liability can be imposed under Section 32 of the Securities Exchange Act 1934 when an auditor willfully and knowingly conceals
material prior errors.
The auditors learnt that they couldnt defense successfully by a plea of ignorance when they have shut their eyes to what was plainly to be seen.

Criminal Action under the Racketeer Influenced and Corrupt Organization Act 1970 (RICO)
The Racketeer Influenced and Corrupt Organization Act 1970 (RICO) was originally drafted as part of the 1970
Organized Crime Control Act to curtail the inroads of organized crime into legitimate business. The Act permits a
person victimized by a pattern of racketeering activity to sue for treble damages and attorneys fees. The RICO
states that a pattern of racketeering activity means at least two acts of racketeering activity within a two-year period.
Despite its focus on organized crime, the provisions of the RICO have been extended to losses suffered from
fraudulent securities offerings and failures of legitimate businesses.
Auditors have often been named as codefendants on the basis that their involvement with the issuance of
materially false financial statements for a minimum of two years out of a ten-year period constitutes a pattern of
racketeering activity. A key case, ESM Government Securities V Alexander Grant & Co (1986) that illustrates
criminal action against the auditors under the RICO is summarized in Table 4-21.
Throughout the 80s, the case law applying the RICO to the auditors was mixed. Some courts make it clear
that the RICO applies to an extensive participation by the auditors in the audit clients racketeering activities beyond
an annual audit, while other courts held that the issuance of a materially false audit report would constitute an act of
racketeering activity. Legislation has been considered by Congress to clarify the applicability of the RICO to the
auditors; but there was no action from Congress. Meanwhile, in 1993, The U.S. Supreme Court heard another RICO
case involving auditors, known as Reves V Ernst & Young (1993) that essentially clarified the applicability of the
RICO to the auditors. In this case, which involved investor losses related to a farmers cooperative that went
bankrupt, the Court ruled that requires some participation (of the auditor) in the operation or management of the
enterprise (audit client) itself. It further ruled that the auditors issuance of unqualified audit reports for two
consecutive years on the farmers cooperative did not meet the participation test. In short, the Court ruled that
external auditors who do not help run corrupt business cannot be sued under the provisions of the RICO. Many legal
observers hope this decision will mark an end to a majority of RICO actions against auditors.

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4 The Auditor's Legal Environment

Table 4-21 ESM Government Securities Case


ESM Government Securities V Alexander Grant & Co (1986) (or ESM case)
Facts:
The management of ESM devised a scheme of fictitious transactions to conceal operating losses from 1977 through to 1984. In 1978, the partner
from Alexander Grant & Co (now Grant Thornton & Co) who was in charge of the ESM audit was informed by the management that the
previous 1977 years audited financial statements contained a material misstatement that was not discovered by the auditor. Faced with potential
embarrassment and damage to his auditing career, the partner agreed to not disclose the fraud to give the management one year to work its way
out of the losses. The management failed to make up the losses, but the partner continued to cover up the fraudulent scheme until the company
collapsed in 1985.

Outcome:
The partner was convicted of criminal charges under the RICO for his role covering up the fraud and was sentenced to a 12-year prison term.

Lesson:
Several lessons can be learned from this case:
(1) The auditor can be found criminally guilty in the conduct of an audit even if the auditors background indicates integrity in their personal and
professional life. The criminal liability can extend to partners and staff.
(2) Independence in appearance and fact by all individual auditors on the engagement is essential, especially in a defense involving criminal
actions.
(3) Good documentation may be just as important in the auditors defense of criminal charges as in a civil suit.
(4) The potential consequences of the auditor knowingly committing a wrongful act are so severe that it is unlikely that the potential benefits
could ever justify the actions.

Private Securities Litigation Reform Act of 1995


In 1995, a federal law, the Private Securities Litigation Reform Act, was passed by Congress to curb frivolous
securities-related litigation and to reduce significantly potential damages in securities-related litigation against the
auditor. The key provisions of the Private Securities Litigation Reform Act of 1995 include:
Doctrine of proportionate liability instead of joint and several liability.
Joint and several liability is a doctrine that allows a successful plaintiff to recover the full amount of a
damage award from the defendants who have money or insurance. In reality, when a group of defendants (e.g.,
auditors, management, and an audit client) are found liable for damages, the auditors are the only parties with deep
pockets of money to pay damages. Thus, the auditors usually pay the entire amount even though they may be only
partially at fault. The Reform Act of 1995 seeks to replace joint and several liability with proportionate liability,
unless the violation is willful; that is, the auditors knowingly participated in a fraud, thereby remaining jointly and
severally liable for all the plaintiffs damages. Under proportionate liability, the auditors are only required to pay a
proportionate share of the courts damage award, depending upon the degree of fault determined by a judge and jury
(e.g., 20%, 30%, but not 100%). Specifically, civil lawsuits for damages under the Reform Act of 1995 now are
governed by the following proportionate liability terms:
1. The total responsibility for loss is divided among all parties responsible for the loss.
2. If other defendants are insolvent, a solvent defendants (e.g., auditors) liability is extended to 50% more than the
proportion found at the trial. For example, if an auditor is found 20% responsible for a loss and the audit client and
its managers are insolvent, the auditor will have to pay 30% (20% + of 20%) the loss, but not 100% as before.
3. An exception to compensate smaller investors is that all defendants remain jointly and severally liable to plaintiffs
who have net worth of less than $200,000 and lost 10% or more of the net worth in the case.
Cap on Actual Damages.
The Reform Act of 1995 also caps the actual damages under the securities acts based on an investor purchase
price of a security and the mean trading price during a 90-day period following the date on which information is
released that corrects the misstatement or omission in the financial statements. For example, assume that an investor
purchases a security at $40 per share. On the day of the release of the information that corrects the misstatement, the
closing price for the security falls to $20. During the following 90-day period the security returns to a closing price
of $30 per share with an average for the period of $25 per share. Actual damages would be capped at $15 ($40-$25)
per share.
Responsibility to Report Illegal Act.
The Private Securities Litigation Reform Act of 1995 imposed new reporting requirements on auditors who
detect or otherwise become aware of illegal acts by issuers of securities. If an auditor concludes that an illegal act
has a material effect on the financial statements, senior management has not taken appropriate action, and the illegal
act warrants a departure from a qualified audit report or a withdrawal from an engagement, the auditor should report
these conclusions directly to the board of directors. The board should then notify the SEC within one day. If the

Financial and Integrated Audits - Frederick Choo

board does not file a timely report with the SEC, the auditor should make a report to the SEC. The Reform Act of
1995 explicitly states that the auditor will not be held liable in a civil action for any finding, conclusions, or
statements made in such reports. Chapter 6 further discusses the reporting requirements on illegal acts.
Securities Litigation Uniform Standards Act of 1998
The proportionate liability doctrine in the Private Securities Litigation Reform Act of 1995 applies only to
lawsuits brought in federal courts under federal securities laws. Since the act applies only to lawsuits brought in
federal courts, clever lawyers took their cases to state courts that follow the joint and several liability doctrine.
This loophole was closed by Congress passing the Securities Litigation Uniform Standards Act of 1998. This
Uniform Standard Act of 1998 requires that class action lawsuits with 50 or more parties must be filed in the federal
courts.
Class Action Fairness Act of 2005
The Uniform Standard Act of 1998 requires that class action lawsuits with 50 or more parties must be filed in the
federal courts. Since smaller class actions lawsuits with less than 50 parties can still be pursued in state court, clever
lawyers took their cases to state court by filing multiple class actions lawsuits in state court with each lawsuit filed
on behalf of fewer than 50 parties. For example, in an attempt to circumvent the Uniform Standard Act of 1998,
attorneys brought a number of Enron-related lawsuits in Texas state court with each suit filed on behalf of less than
50 parties in Newby V Enron Corp. (2002). Consequently, Congress passed the Class Action Fairness Act of 2005 in
response to attorneys attempt to circumvent the Uniform Standard Act of 1998 by filing nationwide multiple class
actions lawsuits in various state courts. The Class Action Fairness Act of 2005 expands the federal jurisdiction to
include most multistate class actions lawsuits where there is more than $5 million in dispute. It appears that the
federal judges are more likely to dismiss dubious claims under the Act. Moreover, the Class Action Fairness Act of
2005 imposes increased judicial and regulatory scrutiny over the propriety of class action settlements because in
some past settlements the only parties that actually benefited were the attorneys.
Sarbanes-Oxley Act of 2002
In 2002, prompted by the Enron Corp. and Arthur Andersen case, Congress passed the Sarbanes-Oxley Act of 2002
to restore investor confidence in the securities markets and to deter future corporate frauds. The Act includes
sections that create the PCAOB, stricter independent rules, and increased internal controls reporting responsibilities.
The creation of the PCOAB is the most significant aspect of the Sarbanes-Oxley Act, which ends decades of selfregulation by the accounting profession.
Table 4-22 provides a brief summary of the Enron Corp. and Arthur Andersen case. In this case, Arthur
Andersen became the first major CPA firm ever convicted of a felony one count of obstruction of justice in the
Enron investigation. The indictment, which named only the firm and not any employees or partners, accused Arthur
Andersen of the wholesale destruction of documents relating to the Enron Corp. collapse. Ironically, in 2005, the
U.S. Supreme Court unanimously reversed Arthur Andersens conviction due to vague instructions provided to the
jury for determining whether Arthur Andersen obstructed justice. However, the Supreme Courts decision did little
to resuscitate Arthur Andersen because the 2002 conviction was a fatal blow to the CPA firm.
Table 4-22 Enron Corp. and Arthur Andersen Case
U.S. V. Enron Corp. and Arthur Andersen (2002)
Facts:
In 2001, after showing profit for the previous several years, Enron Corp. reported a third quarter loss of $618 million and a $1.2 billion reduction
in owners equity related to off-balance sheet partnerships. The news resulted in a sharp drop in Enrons stock price and a formal SEC
investigation. On November 8, 2001, Enron Corp. announced that it had overstated profits by $586 million, erasing almost all its profits from the
past five years, collapsing the stock price, and diminishing the confidence of its clients. Within a month of this announcement, Enron Corp. filed
for Chapter 11 bankruptcy.
The Enron collapse involved many players, including company executives, investment bankers, financial analysts, and accountants. Enrons
auditor Arthur Andersen, a Big Five CPA firm at the time, quickly became the source of government scrutiny. In 2002, the Justice Department
accused top Arthur Andersen officials of directing employees to alter and/or shred Enron Corp.- related documents after it knew about the SEC
investigation of Enron Corp. collapse. The accusation was centered on an e-mail message written by an Arthur Andersen attorney. In that e-mail
message the attorney advised an Arthur Andersen partner to revise a memo to omit certain information, including a comment that an Enron Corp.
press release that included an earnings announcement was misleading. Arthur Andersen argued that the firm was merely applying its document

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4 The Auditor's Legal Environment

U.S. V. Enron Corp. and Arthur Andersen (2002)


retention policy in destroying the documents.
The governments investigation of Enron Corp.s accounting practices revealed a number of accounting frauds, including misuse of specialpurpose entities (SPE) to sell off underperforming assets at a profit. Because of undisclosed Enron Corp. guarantees related to the transactions,
most of these sales were really schemes to overstate paper gains and understate liabilities. Meanwhile, the governments investigation of
Arthur Andersens document retention policy revealed a wholesale destruction of documents relating to its audit of Enron Corp.

Outcome:

In 2002 Andrew Fastow, Enrons former CFO and principal player in the companys accounting schemes, pleaded guilty to two counts of
conspiracy, and was sentenced to serve the maximum 10-year sentence.
In 2006 former Enron chairman Kenneth Lay and former president Jeffery Skilling were convicted on numerous federal fraud and conspiracy
charges. Shortly after the conviction, Lay died of a massive heart attack and his conviction was vacated. Skilling was sentenced to 24 years in
prison.
In 2002, Arthur Andersen was found guilty of one count of obstruction of justice in the Enron Corp. investigation. However, in 2005, the U.S.
Supreme Court unanimously overturned the felony conviction handed down against Arthur Andersen in 2002 due to vague instructions provided
to the jury for determining whether Arthur Andersen obstructed justice. The Supreme Courts decision to overturn Arthur Andersens felony
conviction was little consolation to the more than 20,000 partners and employees who lost their jobs when the CPA firm was forced out of
business by the felony conviction.

Lesson:

In the wake of Arthur Andersons felony conviction, the Sarbanes-Oxley Act and the PCAOB Auditing Standard No.3 (AS 3) Audit
Documentation require that all audit documentations that form the basis of the audit or review are required to be retained for seven years from
the date of completion of the engagement, unless a longer period of time is required by law. For example, in cases involving pending or
threatened lawsuit, investigation, or subpoena. Prior to the Act and AS 3, CPA firms typically would not include in their working papers
documentation that was inconsistent with the final conclusion of the audit team, nor would they include all internal correspondence leading up to
a final decision. The Act and AS 3 now require that any document created, sent, or received, including documents that are inconsistent with a
final conclusion, be included in the audit files. This includes any correspondence between engagement teams and national technical accounting or
auditing experts in a CPA firms national office. In addition, this type of correspondence is required to be retained to facilitate any subsequent
investigations, proceedings, and litigation.
Many lessons in creative accounting can be gleaned from this case, including:
(1) More than $8 billion in loans was misclassified as trades of energy futures. The borrowed funds were labeled cash flows from trading
activities; the related liabilities were labeled price risk management liabilities and buried in an enormous derivatives trading budget that ran in the
hundreds of billions of dollars. Readers of the financial statements had no way to know that Enron Corp. was borrowing such large amounts of
money simply for basic operating funds.
(2) Enron Corp. abused mark-to-market (MTM) accounting. MTM is typically used in the financial securities industry to include in income
unrealized gains and losses in security positions. In other words, income is recognized when increases in value occur in a companys securities
assets, and a loss is recognized when decreases in value occur. This does not follow the accounting principle of matching in which gains and
losses are associated with the actual sales of a companys security assets. In any case, SEC gave Enron Corp. permission to use MTM accounting
for its natural gas trading business, but Enron Corp. abused the practice by applying it to business activities other than those relating to natural
gas securities. It immediately recognized as current income the amounts of estimated future income from contracts signed. It also recognized as
income increases in value from investments that were based on complex assumptions. For example, Enron Corp. used MTM to mark up the
value of its investment in Mariner Energy (a private oil and gas exploration company) from $185 million to $367 million, thus creating $182
million in revenue. Enron Corp. later admitted that the markup had been greatly overstated.
(3) Enron Corp. used special-purpose entities (SPEs) to hide enormous MTM losses by creating hedge agreements with the SPEs that were
supposed to cover Enron Corp.s MTM losses. The problem was that the SPEs were funded with revenue from sales of Enrons stock, so they
were unable to cover MTM losses when Enron Corp.s stock price declined. Eventually, Enron Corp.s stock prices dropped, and the SPEs
became insolvent.
(4) Enron Corp. sold future income streams at their present value to generate cash and reported these proceeds as revenue. The problem was that
Enron Corp. guaranteed the future income streams, thus creating accounting sales without real economic substance. Some of the guarantees were
part of secret side agreements.

Future Legal Development


The threat of legal liability serves to prevent or limit inappropriate behavior, such as negligent, on the part of
auditors. However, auditors cannot be expected to absolutely ensure the accuracy of either financial statements or
the financial health of a business entity. Thus, the auditing profession has an interest in minimizing auditors
exposure to legal liability. It is increasingly exploring the possibility of utilizing alternative dispute resolution
procedures (i.e., arbitration and mediation) as a means of reducing litigation costs. Using arbitration and mediation
to settle disputes does not remove legal liability (except perhaps punitive damages), but it may significantly reduce
the administrative and legal support costs of litigation. For example, in 2005, Sun Microsystems Inc. disclosed in its
proxy statement that the companys engagement letter agreement with Ernst & Young LLP was subject to
alternative dispute resolution procedures and an exclusion of punitive damages. A strict reading of this engagement
letter agreement suggests that Sun Microsystems Inc. is barred from bringing suit against Ernst & Young and would
need to seek redress through mediation and arbitration; furthermore, it suggest that Ernst & Young would be liable
only for compensatory (not the often more costly punitive) damages. Although the effectiveness of this engagement
letter agreement in limiting auditors liability has not been legally tested, some negative publicity over these
agreements has resulted in Ernst & Youngs deciding no longer to include language related to exclusion of punitive

Financial and Integrated Audits - Frederick Choo

damages in its engagement letters. However, it continues to include the language related to alternative dispute
resolution.
Audited financial statements are now being provided using XBRL (eXtended Business Reporting
Language). In 2009, the SEC issued rules requiring public companies to provide financial information in a form that
can be easily downloaded directly into interactive spreadsheets to make it easier for investors to analyze and to assist
in automating regulatory filings. The SEC mandated that this form of financial information to be posted to a
companys website. Under the current SEC rules and professional auditing standards, auditors are not required to
perform procedures or provide assurance on XBRL-tagged data in the context of audited financial statements.
Accordingly, the auditors report on the financial statements does not cover the process by which XBRL-tagged data
that results from this process, or any representation of XBRL-tagged data. However, auditors may choose to engage
in XBRL-related assurance engagements (services) such as 1. Agree-upon procedures engagements on XBRLtagged data to assist management in its evaluation of the XBRL-tagged data and the audit committee in its oversight
role. 2. Assurance engagements on the controls related to the XBRL-tagging process and examinations of the
accuracy of the XBRL-tagged data itself. 3. Assurance engagements on financial information as presented in
particular pre-defined instance documents.

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4 The Auditor's Legal Environment

Multiple-Choice Question
4-1

The auditor's failure to exercise minimum care in an audit is the definition of


a. fraud.
b. gross negligence.
c. ordinary negligence.
d. due diligence.

4-2

A major outcome of the 1136 Tenants Corporation Case (1976) was that
a. the auditor had no responsibility in detecting frauds.
b. the auditor owed no contractual obligation to the client because it was not a written contract.
c. the auditor was aware of frauds and failed to follow-up the frauds.
d. the auditor misunderstood the terms of the contract.

4-3

The Ultramares doctrine establishes that the auditor is


a. liable to clients for gross negligence.
b. liable to third parties for ordinary negligence.
c. liable to primary beneficiaries for gross negligence.
d. liable to foreseeable third parties.

4-4

The concept of foreseeable third parties establishes that the auditor is liable to third parties whom
a. the auditor is able to establish a privity of contract.
b. the auditor has foreseen as a group of users who will rely on the audit report.
c. the auditor has committed ordinary negligence.
d. the auditor foresees a group of users who will likely rely on the audit report.

4-5

Which of the following legal cases established the fact that the auditor had conducted the audit with reckless behavior?
a. Howard Sirota V. Solitron Devices, Inc. (1982).
b. Rosenblum V. Adler (1963).
c. Continental Vending Machine case (1969)
d. Ultramares case (1931).

4-6

Under the Securities Act of 1933, the auditor's responsibility for the fairness of the client's financial statements covers up to
a. the date the client's financial statements.
b. the effective date of the client's registration statement.
c. the date of the audit report.
d. the date of the client's director report.

4-7

Under the Securities Exchange Act of 1934, most civil suits against the auditor relate to
a. Section 10 (b) of the Act.
b. Rule 10b-5 of the Act.
c. Section 10(b) and Rule 10b-5 of the Act.
d. Section 10 of the Act.

4-8

A leading case of criminal action against the auditor is


a. the Equity Funding case
b. the National Student Marketing case.
c. the Continental Vending Machine case.
d. the Bar Chris case.

Financial and Integrated Audits - Frederick Choo

4-9

Which of the following legal cases established a general awareness of the auditor's exposure to criminal prosecution?
a. Escott V. Bar Chris (1968).
b. Rosenblum V. Adler (1983).
c. Continental vending machine case (1969).
d. Rusch Factors V. Levin (1968).

4-10

The U.S. Supreme Court ruled in 1976 in Hochfelder V. Ernst & Ernst that before CPAs could be held liable for Rule 10b5 of the Securities Exchange Act of 1934, what would be required to be shown to the court was the auditors
a. Ordinary negligence.
b. gross negligence.
c. knowledge and intent to deceive.
d. recklessness.

4-11

The similarity which exists in both the United States V. Natelli case, aka National Student Marketing case of 1975, and the
ESM Government Securities V. Alexander Grant & Co. case of 1986 is that in each case
a. a partner in a national CPA firm served prison time.
b. the partners were punished for the shoddy work of their subordinates.
c. a presidential pardon kept them from serving time in prison and allowed them to retain their CPA licenses.
d. the auditors were not convicted for failing to discover the problem in year 1, but for failing to disclose the problem when
it was discovered in year 2.

4-12

Which of the following auditors defenses, when used in a third-party lawsuit, usually means non-reliance on the financial
statements by the user?
a. Absence of causal connections.
b. Lack of duty.
c. Non-negligent performance.
d. Contributory negligence.

4-13

Which of the following statements about the Securities Act of 1933 is not true?
a. It concerns only the reporting requirements for companies issuing new securities.
b. The amount of the potential recovery is the original purchases price plus punitive damages.
c. It deals with the information in registration statements and prospectuses.
d. The only parties that can recover from auditors under the 1933 act are original purchasers of securities.

4-14

Which of the following resulted in a federal law passed in 1995 that significantly reduced potential damages in securitiesrelated litigation against the auditor?
a. Public Securities Damages and Settlements Act.
b. Racketeer Influenced and Corrupt Organization Act.
c. U.S. Securities Claims Reform Act.
d. Private Securities Litigation Reform Act.

4-15

Tort actions against CPAs are more common than breach of contract actions because
a. the burden of proof is on the auditor rather than on the person suing.
b. the amounts recoverable are normally larger.
c. the person suing need prove only negligence.
d. there are more torts than contracts

4-16

To be successful in a civil action under Section 11 of the Securities Act of 1933 concerning liability for a misleading registration
statement, the plaintiff must prove
a.
b.
c.
d.

Defendants Intent to Deceive


Yes
Yes
No
No

Plaintiffs Reliance on the Registration Statement


Yes
No
Yes
No

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4-17

The Private Securities Litigation Reform Act 1995 resulted in a number of changes in statutory law that revised the SEC Acts of 1933
and 1934. Which of the following was not one of the major changes that resulted from the Reform Act of 1995?
a. The statute introduced proportionate liability for auditors who were not found to knowingly commit a violation of the
securities laws.
b. The statute imposed a responsibility to report illegal acts to the SEC.
c. The statute provided that auditors would not be held liable for civil actions for statements made in the reporting of illegal
acts to the SEC.
d. The statute created a cap on damages based on the personal net worth of the auditors.

4-18

One of the elements necessary to hold an auditor liable to a client is that the auditor
a. acted with scienter.
b. was a fiduciary of the client.
c. failed to exercise due care.
d. executed an engagement letter.

4-19

Under the provisions of the Securities Exchange Act of 1934, which of the following activities must be proven by a stock purchaser in
a suit against a CPA?
I. Intention by the CPA to manipulate, deceive, or defraud investors.
II. Gross negligence by the CPA.
a. I only.
b. II only.
c. Both I and II.
d. Neither I nor II.

4-20

An auditor lost a civil lawsuit for damages under the Private Securities Litigation Reform Act of 1995. The court found total losses of
$5 million; the auditor was found 30% at fault, and the auditor was the only solvent defendant. The court would order the auditor to
pay
a. $5,000,000.
b. $2,250,000.
c. $1,500,000.
d. $0.

4-21

X Corp. approved a merger plan with Y Corp. One of the determining factors in approving the merger was the financial
statements of Y that were audited by A, a CPA. X has engaged A to audit Ys financial statements. While performing the audit, A
failed to discover certain fraud that later caused X to suffer substantial losses. For A to be liable under common-law negligence, X at a
minimum must prove that A
a. knew of fraud.
b. failed to exercise due care.
c. was grossly negligent.
d. acted with scienter.

4-22

If a CPA recklessly departs from the standards of due care when conducting an audit, the CPA will be liable to third parties
who are unknown to the CPA (i.e., foreseeable 3rd parties) based on
a. privity of contract.
b. gross negligence.
c. strict liability.
d. criminal deceit.

4-23

Under common law, which of the statements is generally correct regarding the liability of a CPA who negligently
expresses an opinion on audit of a clients financial statements? (Hint: Consider the key word negligently)
a. The CPA is liable only to those third parties who are in privity of contract with the CPA.
b. The CPA is liable only to the client.
c. The CPA is liable to anyone in a class of third parties who the CPA knows will rely on the opinion.
d. The CPA is liable to all possible foreseeable users of the CPAs opinion.

Financial and Integrated Audits - Frederick Choo

4-24

Under common law, which of the statements is generally correct regarding the liability of a CPA who fraudulently
expresses an opinion on audit of a clients financial statements? (Hint: Consider the key word fraudulently)
a. The CPA is liable only to third parties in privity of contract with the CPA.
b. The CPA is liable only to known users of the financial statements.
c. The CPA probably is liable to any person who suffered a loss as a result of the fraud.
d. The CPA probably is liable to the client even if the client was aware of the fraud and did not rely on the opinion.

4-25

The best description of whether a CPA has met the required standard of due professional care in conducting an audit of a
clients financial statements is
a. the clients expectations with regard to the accuracy of audited financial statements.
b. the accuracy of the financial statements and whether the statements conform to generally accepted accounting principles.
c. whether the CPA conducted the audit with the same skill and care expected of an ordinarily prudent CPA under the
circumstances.
d. whether the audit was conducted to investigate and discover all acts of fraud.

4-26

When performing an audit, a CPA will most likely be considered negligent when the CPA fails to
a. detect all of a clients fraudulent activities.
b. sign a written audit engagement letter.
c. warn a client of known material internal control weaknesses.
d. warn a clients customers of embezzlement by the clients employees.

4-27

Which of the following facts must be proven for a plaintiff to prevail in a common-law ordinarily negligent action against an auditors
(defendants) misrepresentations?
a. The defendant made the misrepresentations with a reckless disregard for the truth.
b. The plaintiff justifiably relied on the misrepresentations.
c. The misrepresentations were in writing.
d. The misrepresentations concerned opinion.

4-28

A, a CPA, expressed an unqualified opinion on C Corp.s financial statements. Relying on these financial statements, B
Bank lent C $2 million. A was unaware that B would receive a copy of the financial statements or that C would use them to obtain a
loan. C defaulted on the loan. To succeed in a common-law civil action against A, B must prove, in addition to other elements that B
was
a. free from contributory negligence.
b. in privity of contract with A.
c. justified in relying on As financial statements.
d. in privity of contract with C.

4-29

C Corp. orally engaged A, a CPA, to audit its financial statements. Cs management informed A that it suspected the
accounts receivable were materially overstated. Though the financial statements A audited indeed included a materially overstated
accounts receivable, A expressed an unqualified opinion. C used the financial statements to obtain a loan to expand its operations. C
defaulted on the loan and incurred a substantial loss. If C sues A for negligence in failing to discover the overstatement, As best
defense will be that A did not
a. have privity of contract with C (i.e., lack of duty).
b. sign a written engagement letter.
c. cause Cs substantial loss (i.e., absence of causal connection).
d. violate GAAS in performing the audit (i.e., nonnegligent performance)

4-30

Y bought Z Corp. common stock in an offering registered under the Securities Act of 1933. A, a CPA, gave an unqualified
opinion on Zs financial statements that were included in the registration statement filed with the SEC. Y sued A under the provisions
of the 1933 act that deal with a false statement or an omission of fact required to be in the registration statement. Y must prove that
a. there was fraudulent activity by A.
b. there was a material misstatement in the financial statements.
c. Y relied on As opinion.
d. A was negligent.

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4-31

Under Section 11 of the Security Act of 1933, a CPA usually will not be liable to the purchaser of securities
a. if the purchaser is contributory negligent.
b. if the CPA can prove due diligence.
c. unless the purchaser can prove privity with the CPA.
d. unless the purchaser can prove scienter on the part of the CPA.

4-32

C Corp. made a public offering subject to the Securities Act of 1933. In connection with the offering, A, a CPA, rendered
an unqualified opinion on Cs financial statements included in the SEC registration statement. P purchased 1000 of the offered shares.
P has brought a civil action against A under Section 11 of the Securities Act of 1933 for losses resulting from misstatements of facts in
the financial statements included in the registration statements. As weakest defense would be that
a. P knew of the misstatements when P purchased the stock.
b. Ps losses were not caused by the misstatements.
c. A was not in privity of contract with P
d. A conducted the audit in accordance with GAAS.

4-33

C Corp. engaged A, a CPA, to audit the financial statements to be included in a registration statement C was required to
file under the provision of the Securities Act of 1933. A, the CPA, failed to exercise due diligence and did not discover the omission
of a fact material to the statements. P, a purchaser of Cs securities, may recover from A under Section 11 of the Securities Act of
1933 only if the P
a. brings a civil action within 1 year of the discovery of the omission and within 3 years of the offering date.
b. proves that the registration statement was relied on to make the purchase.
c. proves that A was negligent.
d. establishes privity of contract with A.

4-34

Under Section 11 of the Securities Act of 1933, which of the following may a CPA use as a defense?
a.
b.
c.
d.

4-35

None-proximate clause
Yes
No
Yes
No

A, a CPA, audited the financial statements of C Corp. As a result of As negligence in conducting the audit, the financial
statements included material misstatements. A was unaware of this fact. The financial statements and As unqualified opinion were
included in a registration statement and prospectus for an original public offering of stock by C. P, a purchaser, purchased shares in
the offering. P received a copy of the prospectus prior to the purchase but did not read it. The shares declined in value as a result of the
misstatements in Cs financial statements becoming known. Under which of the following acts is P most likely to prevail in a lawsuit
against A? (Hint: Think about the scienter element)
a.
b.
c.
d.

4-36

Non-negligent Performance
Yes
Yes
No
No

Securities Exchange Act of 1934, Section 10(b), Rule 10b-5


Yes
Yes
No
No

Securities Act of 1933, Section 11


Yes
No
Yes
No

In a suit against an auditor under Section 10(b) and Rule 10b-5 of the Securities Act of 1934, an investor (buyer or seller of
securities) must prove all the following except that
a. the investor was an intended user of the financial statements that contained misstatement.
b. the investor relied on the financial statements that contained misstatement.
c. the transaction involved some form of interstate commerce.
d. the auditor committed scienter.

4-37

A, a CPA, issued an unqualified opinion on the financial statements of C Corp. These financial statements were included in
the Cs annual report, and Form 10K were filed with the SEC. As result, of As reckless disregard for GAAS, material misstatements
in the financial statements were not detected. Subsequently, P, an investor, purchased stock in C in the secondary market without ever
seeing Cs annual report or Form 10-K. Shortly thereafter, C became insolvent, and the price of the stock declined drastically. P sued
A for damages based on Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. As best defense is that
a. There has been no subsequent sale for which a loss can be computed.
b. P did not purchase the stock as part of an initial offering.
c. P did not rely on the financial statements or Form 10-K.
d. P was not in privity with A.

Financial and Integrated Audits - Frederick Choo

4-38

Under Section 10(b) of the Securities Exchange Act of 1934, a CPA may be liable if the CPA acted
a. without a written contract.
b. with independence.
c. without due diligence.
d. without good faith (i.e., act with scienter)

4-39

A, a CPA, was engaged to audit C Corp.s financial statements. During the audit, A discovered that Cs inventory
contained stolen goods. C was indicted and A was subpoenaed to testify at the criminal trial. C claimed accountant-client privilege to
prevent A from testifying. Which of the following statements is correct regarding Cs claim? (Hint: Criminal Law rather than
Common Law applies here)
a. C can claim an accountant-client privilege only in states that have enacted a statute creating such a privilege.
b. C can claim an accountant-client privilege only in federal courts.
c. The accountant-client privilege can be claimed only in civil suits.
d. The accountant-client privilege can be claimed only to limit testimony to audit subject matter.

4-40

The Sarbanes-Oxley Act and the PCAOB Auditing Standard 3 (AS 3) require that
I. all audit documentations that form the basis of the audit or review are required to be retained for seven years.
II. all audit documentations that are inconsistent with the final conclusion of the audit team are not to be retained for
seven years.
III. all correspondences between the engagement teams and the CPA firms national office relating to the audit are not to
be retained for seven years.
IV. all correspondences between the engagement teams and the CPA firms national office relating to the audit are to be
retained for seven years.
a. I and II.
b. II and IV.
c. I and III.
d. I and IV.

4-41

The auditing profession is increasingly exploring the possibility of utilizing alternative dispute resolution procedures (i.e.,
arbitration and mediation) as a means of reducing litigation costs. This future legal development does not
a. reduce the administrative and legal support costs of litigation.
b. minimize the auditors exposure to legal liability.
c. remove the auditors legal liability except perhaps punitive damages.
d. exclude the auditor from punitive damages.

4-42

As a result of Enron Corp. case (2002), attorneys can only file class action lawsuits involving more than $5 million in dispute in
federal courts under
a. Sarbanes-Oxley Act of 2002.
b. Private Securities Litigation Reform Act of 1995.
c. Securities Litigation Uniform Standards Act of 1998.
d. Class Action Fairness Act of 2005.

Key to Multiple-Choice Question


4-1 c. 4-2 c. 4-3 c. 4-4 d. 4-5 a. 4-6 b. 4-7 c. 4-8 c. 4-9 c. 4-10 c. 4-11 d.
4-12 a. 4-13 b. 4-14 d. 4-15 b. 4-16 d. 4-17 d. 4-18 c. 4-19c. 4-20 b. 4-21 b.
4-22 b. 4-23 c. 4-24 c. 4-25 c. 4-26 c. 4-27 b. 4-28 c. 4-29 d. 4-30 b. 4-31 b.
4-32 c. 4-33 a. 4-34 a. 4-35 c. 4-36 a. 4-37 c. 4-38 d. 4-39 a. 4-40 d. 4-41 c.
4-42 d.

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4 The Auditor's Legal Environment

Simulation Question 4-1


Simulation Question 4-1 is an adaptation with permission from a case by Reisch, J. T. in the Issues in Accounting Education, a publication of the
American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.

Introduction

BX Buys the Rights to Bolsan

BX Finds the Motherlode

In the spring of 1993, David Winston found himself thinking, What have I got to lose? He was contemplating spending the last
$10,000 of his companys cash to purchase the mineral rights to a piece of land in Indonesia. Winston had just received a call from an old friend,
John Feldman, who indicated that the land probably contained 2 to 3 million ounces of gold. A geologist by trade, Feldman had been exploring
the jungles of Southeast Asia for mineral deposits for the previous two decades and had discovered a large copper and gold deposit in New
Guinea. It was just one of many successful mines he had discovered in the region.
Winston had filed for personal bankruptcy earlier in the year and he was struggling to keep his small company afloat. The company,
Brodnax Minerals Co. (hereafter, BX), a Montana-based exploratory mining company, was founded by Winston in 1988. BX had struggled since
its inception, and at one point the financial lookout for BX looked so bleak that CEO Winston wrote to shareholders in the companys 1991
annual report, Yes, we are still in business!
Much of Winstons personnel financial problems stemmed from nearly $60,000 in credit-card debt he had accumulated and an earlier
court order for Winston to repay over $40,000 to a brokerage firm for a mishandled stock transaction. A broker had mistakenly credited
Winstons account with shares Winston had already sold. When the brokerage firm notified Winston of its mistake, he refused to refund the
money gained when he resold the shares. In a statement about the transaction, Winston later explained, You have to have your priorities. I was
constantly putting out fires running an exploratory mining company and didnt have the time to worry about things like bank statements.
Winston had been a stockbroker himself for over 20 years before he ventured in 1988 into the world of the exploratory mining
industry. However, he had a vision of striking it rich with a big find, and perhaps most importantly, he had the ability to sell his dream to
investors.
Between 1989 and 1992, BXs stock price averaged $0.27 per share and fell to as low as $0.02 per share after the company failed to
find minerals on its most promising claim. But there was a reversal of fortune in 1993 when Winston received the fateful call from John Feldman.
Winston and Feldman met initially in 1987 at a mining convention when Winston first became interested in the exploration business.
Winston was impressed by Feldmans successful finds and his enthusiasm for exploring. In fact, Feldmans enthusiasm earmarked him in the
mining industry as having big arms, meaning he had the tendency to show the upside potential of a project by stretching his arms farther and
farther apart as he described the project.
Feldman persuaded Winston to take a look at the Indonesian property when he called Winston on a spring day in 1993. Using most of
BXs remaining cash, Winston flew to Jakarta to meet Feldman. The pair spent nearly two weeks trekking through the rain forest before Winston
pair flew home, convinced there was a gold mine in the Indonesian jungle.
Prior to Winstons trip, Feldman had explored the area for an Australian company, Queensland Gold. Queensland had hired Feldman
and another geologist, Michael DeAngelo, to assess the region for potential minerals. Feldman and DeAngelo estimated that the areas, known as
Bolsan, contained 2 to 3 million ounces of gold, despite their finding only trace amounts of gold in 19 core drillings. They were convinced there
was gold, based on favorable geological formations in the area, but that the holes were not drilled in the right places. Their report, however,
conflicted with the findings of a dozen other companies who found the remote area, a thick jungle populated by clamorous monkeys and a few
native tribesmen, to be economically unfeasible for mining. Despite the positive report from Feldman and DeAngelo, cash-strapped Queensland,
wanting to pull out of the region, put the mineral rights to Bolsan up for sale at a price of $180,000.
When Winston went back to Montana, he used his brokerage skills to laud the upside potential for striking it rich in Indonesia.
Winston quickly raised over $250,000 through the sale of stock and in the summer of 1993 used the proceeds to purchase the mineral rights to
Bolsan.
Soon after BX obtained the mineral rights to the Bolsan property, Feldman officially joined the company as Vice President of
Operations. Feldman also brought his exploring friend, Michael DeAngelo, abroad as the chief geologist. DeAngelo, who possessed a near-genius
IQ, had previously developed a novel theory about the formation of gold deposits. The theory, rejected by conventional geologists, suggests that
gold deposits are formed at fault line junctions by mineralized fluids transported to the earths surface during volcanic activity. DeAngelo
convinced Feldman that his theory had merit, and the two geologists, using the theory as a basis for their exploratory work, began to assess the
Bolsan region more closely in hopes of finding gold.
The first significant discovery of gold at Bolsan occurred in early 1994 when DeAngelo noted an outcrop of volcanic rocks with a
yellowish tint along a riverbank in the area. With news of the find, Winston enticed Paul Krause, a former executive of mining giant Barrent Gold
Corp., to join BXs board of directors. The addition of the well-respected Krause helped transform the image of BX from a fledging venture
company to a real player in the market. Krauses expertise in the industry gave investors a high comfort level in BXs operations. With Kraus on
board, Winston began to use his contacts in the brokerage business to obtain additional funding for BXs exploration in the Bolsan region. By
March 1994, Winston had arranged a $6 million private placement of preferred stock for BX. The inflow of cash enabled BX to continue its
drilling through 1994, and by years end, BX estimated the property contained just over three million ounces of gold.
It was not until January 1995, however, that BX geologists found what they were looking for a dome-like geological structure,
hidden under the entangled canopy of the rain forest, which lay at the crossroads of fault lines. The area was mapped and the geological
abnormalities were confirmed by satellite imagery. When Feldman reported the findings to BXs Montana headquarters, he told Winston, I think
weve got a monster by the tail.
BX continued to drill in the region and the findings were very promising. In October 1995, BX estimated the Bolsan mine contained
30 million ounces of gold, making it one of the worlds largest gold mines. As drilling in the region increased, so did the estimates of gold. In
February 1996, Feldman announced that 40 million ounces of gold had been estimated by an independent firm, Kearn Labs Ltd. This wellrespected firm processed the core samples, but did not do its own drilling.
In July 1996, BX announced that the estimate had risen to nearly 47 million ounces, planning it slightly behind the worlds largest
gold mine, which contained 51 million ounces. Before the end of that year, the Bolsan mine was thought to have been the worlds largest gold

Financial and Integrated Audits - Frederick Choo

mine at an estimated 57 million ounces. Investors wanted in on the gigantic deposit and BX needed cash to expand its drilling in the area. On
March 4, 1997, the company raised nearly $30 million in an equity offering.
The estimates continued to climb as the drilling continued. On March 17, 1997, BX announced that its estimated gold reserves were
71 million ounces, and the following day, Feldman told investors he was extremely confident in predicting that the mine would eventually
yield over 200 million ounces of gold.
The stock market responded to the announcements, and BXs stock price soared. Prior to the acquisition of the mineral rights in
Indonesia, BX shares traded for pennies. They traded for less than $0.25 in 1991, rose to over $1 in late 1993, and were trading at $3 by the end
of 1994. As word of the gold find spread through the stock market during 1995, the stock reached $15 per share in August and rose to over $50 in
October upon the announcement that Bolsan contained 30 million ounces of gold. By February 1996, shares were trading for over $200. The
following month, BX announced a 10-for 1 stock split. Shares of BX reached their peak in September 1996 at $28.13, the equivalent of over $281
in pew-split terms. Shortly thereafter, and until March 1997, the stock price of BX had settled to around $20. The decrease in price was primarily
attributable to uncertain political risk in Indonesia.

Political Instability in Indonesia

The Golden Glitter is Gone

Its Really a Salt Mine

Nearly every major business deal in Indonesia can be linked to a few politicians who control the central government. The mining
industry is no exception. With billions of dollars at stake in the mine, these politicians wanted to lay claim to some or all of the gold in Bolsan.
As an exploration company, BX had no expertise in actually extracting minerals. The company had to obtain a major mining partner
or sell its claim to the highest bidder since it did not have the capability of operating the worlds largest gold mine The Indonesian government
wanted the mining operations to begin as soon as possible and began to put pressure on BX in the fall of 1996 to find a partner or sell out. In fact,
the government already had a proposal in mind for BX, which it had been working covertly on for months. The Indonesian government was
aggressively pursuing an alliance between Barrent Gold and BX. Barrent, one of the worlds largest mining entities, had been operating mines in
Indonesia for some 20 years; ties between Barrent and the Indonesia government were strong.
In November 1996, the Indonesian government simply declared that Barrent would have a 75 percent interest in Bolsan while BX
would have the remaining 25 percent. The government also indicated that it would appreciate a 10 percent interest in the site, although it did
not indicate from which party that share would come. In addition, the government threatened to revoke mining permits for the Bolsan property
until the ownership dispute was resolved. However, the subtle threats made by the Indonesian government were never enforced because several
key political advisers argued that the arrangement would act as a catalyst to erode foreign investment in Indonesia. Thus, the deal between
Barrent and BX never proceeded.
Barrent was not the only mining company interested in Bolsan. In January 1997, Vancoucer-based Placid Mines Inc. offered to
acquire BX in a stock swap valued at $4.5 billion. While the offer was good, Placid did not have the necessary political ties to the Indonesian
government to consummate the merger; however, a Houston based company, Freemont Copper & Gold Inc., did.
Freemont has operated the largest copper and gold mine in Indonesia since 1972 and employed nearly 17,000 Indonesians. On
March21, 1997, a deal was struck between BX and Freemont that was immediately approved by the Indonesian government. Under terms of the
agreement, Freemont received a 15 percent stake in Bolsan, became sole operator of the mine, and committed to providing $1.6 billion in
financing for the operation, all subject to due diligence testing of the gold reserves. BX maintained a 45 percent stake in Bolsan. The Indonesian
government secured a 10 percent interest, with the remaining 30 percent interest split between Indonesian companies controlled by influential
government officials.
The agreement with Freemont reduced BXs stake in Bolsan to only 45 percent, with BX receiving no tangible compensation for
giving up 55 percent of the mine. However, Winston defended the deal, saying, Brondnax ends up getting 45 percent of a potential 200 million
ounces of gold without spending another dime, and the property will be managed by a first-class operator. Many Indonesian businessmen
indicated the lack of compensation for its reduced claim was the only means by which BX could clear the way to begin mining.
Shortly after agreeing in principle to operate the Bolsan mine, Freemont geologists were sent to Indonesia to begin their due diligence
testing. This included taking independent samples from the site as well as reviewing BXs existing sampling data. The seven test holes drilled by
Freemont indicated an insignificant amount of gold, although the geologists were aware that discrepancies often exist when a limited number of
core samples, only a few inches wide, are drilled. Concerned over their findings, Freemont officials arranged a meeting with DeAngelo and the
other BXs geologists to reconcile the differences in the sample results.
On April 18, 1997, DeAngelo boarded a helicopter at Bolsan that was to take him to Jakarta to meet with Freemont officials. However
en route to the meeting, DeAngelo was killed when he took a mysterious plunge of some 800 feet into the jungle below. Although a suicide note
was found indicating that DeAngelo could no longer bear the anguish of a debilitating liver disease and malaria, his family and friends suspect he
was pushed from the helicopter.
The death of DeAngelo started rumors about the Bolsan site. When many speculated that the amount of gold might have been
overstated, the market began to react. The share price immediately slid some $5, to just below $15. But the slide was halted by remarks made by
Feldman, who angrily dismissed notions that the size of the deposit was misstated and said he was 110 percent confident the gold was there.
Freemonts geologists tried to obtain sample data recorded by BX to continue their due diligence testing, but the BX geologists at
Bolsan could not provide much information about their samples. Freemont learned that a fire had broken out a t the Bolsan mining compound on
January 11, 1997, which destroyed several buildings, as well as thousands of pages of BXs sample logs and other key data. These items were
critical for comparing the assay (analysis of ore) results to scientific descriptions of the cores and the locations from which the samples were
taken. In addition to the fire, Freemont also learned about the unusual manner in which the cleanup took place. Rather than looking for the
remains of records or other salvageable items, DeAngelo ordered a bulldozer to plow the site immediately after the fire was put out.
The dam broke on April 25, 1997, when Freemont announced that its preliminary findings indicated there were only traces of gold in
its samples, and that an independent mining laboratory, Strickland, would issue a final report a few weeks later. Freemonts statement sent BX
shares on a steep downward ride. The value of the stock plunged nearly 84 percent, from about $13 to $2 per share, erasing an equity value of
$2.4 billion in a single day.
The results of Strictlands testing confirmed the doubts about the lack of gold at the Bolsan site. On June 5, 1997, Strickland said it
found only trace amounts of gold at Bolsan and that there was virtually no possibility of an economic gold deposit at the site. In its report,
Strickland noted, the magnitude of the tampering with core samples taken at Bolsan, and the resulting falsification of assay values, is of a scale
that, to our knowledge, is without precedent in the history of mining.

97

98

4 The Auditor's Legal Environment

In laymans terms, the core samples taken from the property had been salted or adulterated; that is, the drilled cores were laced with
particles of gold from other sources. Both Winston and Feldman vehemently denied any involvement in the elaborate scheme to taint the core
samples and placed the blame on DeAngelo. The mystery of how the Bolsan samples were salted and who was responsible is still a puzzle. But
several pieces of the puzzle have come to light.
The standard industry practice to prevent tampering with samples is to have geologists log the samples, place them in numbered
plastic bags, seal the bags, and dispatch the samples immediately to an independent laboratory for assaying. BX, however, did not follow this
practice. The owner of a trucking company that transported BXs samples to Kearn, the independent lab, indicated that samples were warehoused
by BX for a few days to month before being sent to the lab. Before being transported, witnesses said, the samples were opened and mixed with
powders by BX geologists under the supervision of DeAngelo. In addition, no samples were sent to the lab unless they were personally checked
by DeAngelo. This questionable handling of the samples suggests evidence of the salting operation used to inflate the gold claims. Moreover,
Strickland found the gold particles in BX samples to be rounded, a common characteristic of gold found in riverbeds, rather than flaky, a physical
trait of gold embedded deep within the earth.
The day the Strickland report was released, the remaining values of the BX shares plunged another 97 percent, to close at $0.08 per
share. Some 58 million shares were traded that day as skittish investors stampeded for the closest exit. The following day, BX shares were
delisted by NASDAQ because the company no longer met certain listing requirements.

Shedding Light on the Saga

Shareholders File Lawsuits

In the summer of 1996 (when the value of BX shares was skyrocketing), the officers of the company quietly began exercising options
they owned. The exercise of the stock options increased the companys equity by over $18 million, and gains realized by Winston and Feldman
from immediately reselling their new shares were substantial approximately $125 million between the two. DeAngelo also took in nearly $5
million form the exercise of options. Although disclosures of the transactions were made as required by the SEC, the information did not
adversely impact the markets value of BX.
In the eight years since its inception, BX had never earned a dime from operations, although it did earn interest income on its cash
holdings. As of December 31, 1996, BX had approximately $44 million in total assets, comprising mostly cash and fixed assets. You should
access Data File 4-1 in iLearn for Table 1, which shows selected financial information of BX for 1995 and 1996. The gold claims were not
included on the balance sheet because the deposits were not yet considered probable; that is, even though preliminary drillings indicated the
existence of gold, the sampling data were not specific enough to adequately estimate the quantity and grade of the ore. Under GAAP, only proven
and probable reserves that meet certain measurement criteria are recorded as assets (SFAS No.89). The company also had approximately $2
million in payables and $42 million in equity on its balance sheet. As of December 31, 1996, the markets value of the company was nearly $4.5
billion; thus, the stock market clearly valued the large gold deposit, even though it was never included on the balance sheet.
The auditors report, dated January 24, 1997 and included in the 1996 BX annual report issued on February 12, 1997, contained a
standard unqualified opinion for the two-year comparative financial statements. You should access Data File 4-1 in iLearn for Table 2, which
shows the independent auditors (Healy & Wallace LLP) unqualified report. No mention of the gold was explicitly included in the footnote
disclosures, although the accounting treatment for the mining property was described in the following note on the companys operations:
The Company is engaged in the acquisition, exploration and development of mining properties. The mining properties are recorded at
cost. Acquisition, exploration, and related overhead expenditures are deferred and will be amortized over the estimated life of the property. The
estimated life of the property depends on whether the property contains economically recoverable reserves that can be brought into production.
The total amount recorded for mineral properties and deferred exploration expenditures represents costs incurred to date and does not reflect
present or future values. If properties are determined to be commercially unfeasible, related costs will be expensed in the year that determination
is made.
In addition to audited financial statements, BX included a managements discussion and analysis (MD&A) section in its 1996 annual
report. You should access Data File 4-1 in iLearn for Table 3, which shows excerpts from the MD & A section.
BX filed for bankruptcy on June 9, 1997, shortly after the Strickland report was issued. Although the company had net assets of over
$70 million (including the $30 million raised in March by the equity issuance) at the time of the bankruptcy filing, it sought protection from an
onslaught of legal suits that were launched as a result of purported fraud. In addition to class-action lawsuits against BX and its officers and
directors, shareholders of BX also filed suits against Kearn Labs, the independent assaying firm, various investment advisors, and BXs external
auditor, Healy & Wallace LLP.
Healy & Wallace LLP (hereafter, H&W) was included as a defendant in the lawsuits because shareholders believed the firm breached
its duty to exercise due professional care and failed to uncover the fraud. Shareholders allege that H&W should have noticed that information
contained in the MD&A section of the 1996 annual report was misleading, given the fact that H&W had copies of private quarterly reports issued
by Kearn Labs to BX. Those reports explicitly stated that the core samples the lab tested were provided to it by BX and that the labs estimates
were not conclusive enough to consider the deposit to be a probable mineral reserve. In addition, shareholders contend that if H&W had a
sufficient understanding of BXs internal controls, the fraud would have been detected much earlier.
In response to the suits alleging negligence, H&W announced it would vigorously defend itself and claimed that it followed generally
accepted auditing standards (GAAS) while conducting its audit. In addition, the accounting firm maintained that the financial statements
contained no material misstatements and were fairly presented in conformity with generally accepted accounting principles (GAAP).
H&W is a large, well-respected regional firm with several audit clients in the mining industry, including the sixteenth largest
American mining company. That particular audit client also has mines located in foreign countries; thus dealing with the international operations
of a company is not new to the firm. Like many public accounting firms, H&W has, on occasion, been named as a defendant in litigation against
clients and third parties. The firm has never had a judgment against it for negligence. Although during the last decade they have settled out of
court two times.
The firm was familiar with BXs operations since H&W had audited the company each year since 1993, and a standard unqualified
opinion had been expressed in each of those years. The engagement partner indicated that the control risk had always been assessed at the
maximum because it was more economical to expand the scope of substantive tests given the nature of the accounts contained on BX financial
statements than to rely on the companys internal controls. There also had never been any unresolved disputes between the auditors and
management, and by all accounts the substantive audit procedures performed by H&W on the 1996 BX engagement were carried out with a high
level of quality.
You should access Data File 4-1 in iLearn for Table 4, which shows a timeline of significant developments involving BX,
including events that transpired in 1996 and 1997.

Financial and Integrated Audits - Frederick Choo

Required
Assume you are part of the legal teams involved in the class-action lawsuit brought by BX shareholders against H&W, the external auditor. Using
the format below, answer the following questions from both the shareholders (the plaintiffs) and the auditors (the defendants) point of view.
Some viewpoints from both sides are provided to help you complete the rest.
1. Is H&W liable to BXs shareholders for issuing an inappropriate audit report?
The Plaintiff (Shareholders)
1. Some information included in the MD&A section was presented not
in conformity with GAAS because the gold was probable and should
be noted as an explanatory paragraph to the audit report.
2.
3.
4.

The Defendant (Auditors)


1. Information in BXs annual report was presented in conformity with
GAAP because the gold was properly excluded from the balance sheet
since it was not probable.
2.
3.
4.

2. Is H&W liable to BXs shareholders for improperly accepting the BX client?


The Plaintiff (Shareholders)
1. If the defendant had performed thorough background checks on
management, it would have discovered that management lacked
integrity, for example, Winstons mishandling of a stock transaction.
2.
3.
4.

The Defendant (Auditors)


1. Just because Winston filed for personal bankruptcy does not mean
he lacked integrity.
2.
3.
4.

3. Is H&W liable to BXs shareholders for not detecting the BXs fraud?
The Plaintiff (Shareholders)
1. The defendant overlooked obvious red flags such as the mysterious
fire in January 1997 that destroyed sample records.
2.
3.
4.

The Defendant (Auditors)


1. The red flag concerning the fire that destroyed the 1997 sample
records did not have a material impact on the financial statements
because the gold was excluded from the financials.
2.
3.
4.

Simulation Question 4-2


This simulation question is based upon a true set of facts; however, the names and places have been changed. The simulation Question is
developed by F. Choo in Financial and Integrated Audits, a publication of CSU AcademicPub, California.
In 2008, San Francisco Chronicle reported that a San Mateo Court was in the process of ruling on whether the public accounting firm
of Rod Ferria & Associate, CPAs, LLP (hereafter, RFA), should be required to pay all or part of $20 million in damages relating to Jazer Co. for
failing to detect a scheme to defraud the company. Jazer Co., an SEC registrant, charged that RFA was negligent in failing to discover fraud
committed by the companys controller and wanted RFA to foot the bill for all $20 million in claims by and against the company. The company
claimed that if it had known about the fraud, it could have stopped it and recovered financially. Bank of American, the bank involved in the case
claimed that it granted a loan of $5 million based on misstated financial statements. The stockholders claimed that they purchased $5 million
Jazer Co.s stock on the American Stock Exchange at an inflated price due to the misstated financial statements. They acknowledged that while
stock had been outstanding and traded for many years prior to the fraud, they made their investment decisions relying upon the misstated
financial statements.
RFAs general counsel said, We anxiously await a decision that will show that CPAs are not guarantors for everything that goes on in
the company. Jazer Co.s lawyer said that she anxiously awaited a decision because it will clearly show that CPAs are liable for finding fraud.
The $20 million lawsuit was as follows:
Jazer Co.
Bank of America .
Stockholders

Required

Claim Against Auditor


$10 million
$ 5 million
$ 5 million

Claim Against Auditor and Jazer Co.


None
$ 5 million
$ 5 million

99

100

4 The Auditor's Legal Environment

1. Assume that the case is brought under common law; that the San Mateo court follows the foreseeable concept but may move back to the
Ultramares concept in a third-party lawsuit, and that RFA can be charged under different types of negligence in performing the audit, answer
the following questions:
a. Should RFA be found liable to Jazer Co.? Explain and cite prior legal case(s) to support your arguments.
b. Should RFA be found liable to Bank of America? Explain and cite prior legal case(s) to support your arguments.
c. Should RFA be found liable to the stockholders of Jazer Co.? Explain and cite prior legal case(s) to support your arguments.
2. Assume that the case is brought under the Securities Exchange Act of 1934, and that FRA can be charged under different types of negligence
in performing the audit, answer the following questions:
a. Should RFA be found liable to Jazer Co.? Explain and cite prior legal case(s) to support your arguments.
b. Should RFA be found liable to Bank of America? Explain and cite prior legal case(s) to support your arguments.
c. Should RFA be found liable to the stockholders of Jazer Co.? Explain and cite prior legal case(s) to support your arguments.
3. Assume that the case is brought under the Securities Act of 1933; that the stock involved are new stock issued to the public for the first time,
and that the financial statements involved had been included in a registration statement for the securities, answer the following questions:
a. Should RFA be found liable to Jazer Co.? Explain and cite prior legal case(s) to support your arguments.
b. Should RFA be found liable to Bank of America? Explain and cite prior legal case(s) to support your arguments.
c. Should RFA be found liable to the stockholders of Jazer Co.? Explain and cite prior legal case(s) to support your arguments.
4. Assume that the case is brought under the Private Securities Litigation Reform Act of 1995, and that according to the Joint and Several
Liability doctrine, Jazer Co. is liable for 50% and RFA is liable for 50% of a $10 million damage awarded to the Bank of America and the
stockholders, answer the following questions:
a. If the co-defendant, Jazer Co., were insolvent, how much the remaining co-defendant, RFA, has to pay for the $10 million damage awarded to
the Bank of America and the Stockholders?
b. If the stockholders initially purchased Jazer Co.s $5 million stock at $100 per share and that the average closing price of the stock was $20 per
share during the 90-day period following the date of a press release about the misstated financial statements, how much damage per share could
the stockholders claim against the auditor, RFA?

Simulation Question 4-3


Simulation Question 4-3 is an adaptation with permission from a case by McKnight, C. A., T. S. Manly, and P. S. Carr in the Issues in
Accounting Education, a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true
set of facts; however, the names and places have been changed.

Li and Associates, CPAs, LLP

Two Clients of Li and Associates, CPAs, LLP

Jeanne Thomsons Employment and Education History

In 1979, Jet Li graduated from college with an accounting degree. After seven years at an international accounting firm, Jet decided to
start his own CPA firm, Li and Associates, CPAs, LLP (hereafter, L & A). This firm, located in San Francisco, caters to local clients; specifically,
Jet and his staff of four professionals specialize in non-public companies. The majority of the services provided by L & A are tax planning and
preparation; however, the firm also performs bookkeeping services, audits (mainly for client debt compliance purposes), and other attestation
services. L & A has been a profitable and successful business for Jet. Tax returns are rarely questioned by the IRS, and banks and other lenders
trust the attestation services provided by L & A. Clients have come to expect quality work from L & A, and they receive this quality.
Ali Automotive
Ali Automotive is the most profitable car dealership in San Francisco. The company, which sells approximately 100 new cars each
month, has been a business leader in the city for 30 years. Ali Automotive sells about 20 percent more used cars than new ones each month. In
addition to the margins made on car sales, Ali Automotive earns additional revenues through its finance and service departments. These revenues
for service and parts average $200,000 each month. The dealership has a strong financial history and expects moderate growth in the future.
Mohammad Ali leads this family-run automotive dealership. Outgoing and personable, he brings strong sales and customer service to
this business, which he took over when his father retired ten years ago. Ali family members are responsible for all aspects of the business except
the accounting department. Ali knew accounting was difficult and wanted a CPA firm to perform bookkeeping services and tax preparation. L &
A has been Ali Automotives accountant for ten years. Ali has been very pleased with the CPA firms work. He was especially impressed with
Karen Green, an L & A employee in charge of the bookkeeping services provided to Ali over the past two years. He trusted her completely and,
although he did not understand accounting, felt she did an excellent job.
Kim Jewelers
Kim Jewelers is another important client of L & A. Founded and operated by renowned artist and silversmith Jung Kim, Kim
Jewelers sells Jung Kims unique and highly demanded creations. As Kims reputation grew, he knew he needed a good partner to run the
business side of the company. Therefore, he enlisted an M.B.A. to manage the production and finance departments, so he could concentrate on
Kim Jewelers creative development. Based on his education and experience with manufacturing companies, the new partner quickly identified
the need for internal controls at Kim Jewelers. Since the raw materials and finished goods inventory consisted of small but valuable pieces, he
implemented a number of physical controls such as locks on the cases and security cameras. He also added other extensive controls, including
policy and procedures manuals and training for the employees, formal accounting and finance documents, and an extensive computer system with
limited access. Although a total separation of duties is not present at Kim Jewelers due to its small staff, both Jung Kim and his partner actively
monitor the companys daily activities. Each year, L & A reviews Kim Jewelers annual and quarterly results and prepares its taxes. The L & A
employees assigned to Kim Jewelers consider it an easy engagement, because Kim Jewelers presents impeccable, nearly error-free records.
After working as a retail sales associate for ten years, Jeanne Thomson returned to college to complete her accounting degree. She put
in many hours at her sales job, but had not received the compensation or respect she believed she deserved. She rarely missed work, was

Financial and Integrated Audits - Frederick Choo

punctual, and often exceeded her sales quota; however, she was never promoted or given a substantial raise. Therefore, Anna decided a college
degree was the key to her financial success.
Jeanne worked hard in college while continuing her sales job, looking after her two children, and supporting her husband who was
injured at his job. Jeanne was determined to make life better for herself and her family. During college, she was willing to get the job done in
her courses. Faculty members knew that Jeanne was bright, but her performance was often marginal. She often skipped class, but when she was
there, she was an active participant in discussions and seemed to grasp concepts well. She often missed daily assignments, but she would
compensate by earning higher scores on exams. Group assignments were particularly difficult for Jeanne, because they forced her to arrange
meeting times outside of class. Luckily for Jeanne, her classmates always covered her responsibilities when she could not do the work. Most of
them understood she could not work and complete all her homework assignments while watching her kids. They also enjoyed the baked goods
she brought to meetings. Every once in a while, some fellow students would give her a poor peer evaluation because she did not complete her
portion of the assignment; however, the good grades on the assignments outweighed the evaluations. She felt that most college students could not
comprehend her position because they did not have the same real-life responsibilities.
Jeanne completed her degree with 150 hours and a 3.00 GPA. She was thrilled; her family was very proud. Jeannes father-in-law, a
prominent attorney, was especially overjoyed. Despite his help, Jeannie and his son had struggled with their finances. He was so proud they had
started taking responsibility for themselves. After graduation, Jeanne began her job search immediately. She had many bills to pay, including
payments on a new convertible, a present she gave herself after graduation. She was glad to quit her sales position and hoped she would receive
the respect she felt she rightfully deserved as an accountant.

Jeanne Thomson Joins Li and Associates, CPAs, LLP

Jeanne Thomsons Performance at Li and Associates, CPAs, LLP

Busy season was about to begin, and one of L & As best employees, Karen Green, gave her two-week notice. Karen was a smart,
successful CPA who enjoyed the challenge and the camaraderie of working in an office. Although she did not need to work due to a large
inheritance, Kate often worked 50-plus hours a week during her five years with the firm. Jet Li was sad to see such a valuable employee leave the
firm.
Jeannes resume could not have come to Jet Li at a better time. Although Annas grades were not outstanding, Jet was impressed that
Jeannie did have a 3.00 GPA while working full-time and maintaining a family. Jeannie appeared able to multi-task, a skill demanded of Jet Lis
staff. Jet Li was also pleased that Jeanne came from a distinguished family in San Francisco; he didnt feel the need to check her references,
because the Thomson family was well known and respected. Therefore, he hired Jeanne immediately.
When Jeanne started working, she was immediately assigned to Ali Automotive to take Karen Greens place. This client was small
and required only one staff accountant. Jet Li not only introduced Jeanne to Mohammad Ali and the other Ali Automotive employees, but also
spent the first day with Jeanne on the job. Previously, he had spent three days training Karen Green at Ali Automotive, but since it was busy
season, he had to focus his attention on tax returns. He was thankful that Jeanne was a fast learner. Jeanne could not believe all of the information
needed just to perform bookkeeping services. Although she felt she learned a lot in her accounting courses, they were nothing like actual on-thejob experience. While Mohammad Ali did not expect a new graduate to take over Karen Greens job, he trusted Jet Lis judgment. After all,
Jeanne had worked hard for years before obtaining her degree, appeared eager to learn, and was eager to pass the CPA examination.
Jeanne worked for three years for L & A with Ali Automotive as one of her main responsibilities. She performed bookkeeping
services for Ali Automotive, visiting the automotive dealership once a week. She was fortunate that a lot of the work could be done from L & As
office. After the initial learning curve, Jeanne excelled in the eyes of Mohammad Ali. She always got her job done on time and in spotless order.
Her weekly job responsibilities included recording journal entries, preparing checks for bills to be paid by Ali, and making trips to the bank and
post office. Monthly, Anna prepared bank reconciliations and compiled financial statements for review by Ali. After approval, Jeanne forwarded
the financial statements to the bank, which were a requirement to keep Ali Automotives line of credit open. Within a few months, Mohammad
Ali completely trusted Jeanne, just as he had trusted Karen Green. He didnt need to review the financial statements, journal entries, or the
supporting documents for payments. He did not understand accounting, and he believed in Jeanne. In fact, he was about to approach Jeanne about
working for Ali Automotive full-time. She really seemed to be a part of the Ali family and dedicated to the job. When Ali employees put in extra
hours, Jeanne followed suit. Even during her vacations, Jeanne took time to help at the dealership. Jet Li was pleased with the high praise from
Mohammad Ali. He was relieved that he did not have to frequently review her work. Since the client was happy, he worked on other projects and
stayed out of Jeannes way.
Jeanne was also assigned to Kim Jewelers. This client required the work of two staff accountants and a senior. At first, Jeanne was
glad to have colleagues available to answer questions, share the work, and help her get started. She learned a lot from the senior accountant
during the first year, although it was odd to be supervised by someone younger than she was. Jeanne was impressed with the internal controls at
Kim Jewelers and often commented on the impressive hands-on management style in every aspect of the business. Jeanne liked working at Kim
Jewelers, but often suggested to her colleagues there that it was Ali Automotive where she was the most needed. To the detriment of her Kim
Jewelers audit team, Jeanne often delayed working on the engagement whenever Ali Automotive needed her. She was the only staff accountant
on the Ali Automotive job; it was her top priority.
After three years, Jet Li began to receive mixed reviews from clients for Jeanne Thomson. He was content with her praise from Ali
Automotive, but other clients, including Kim Jewelers, were less impressed. Jeanne seemed to perform at or below expectations for a third-year
staff on her other jobs. Her intelligence and confidence were evident, but her work and effort did not convey her abilities. In addition, she often
complained that her friends at large international accounting firms were making quite a bit more money than she was. On the positive side,
Jeanne recently passed the CPA examination. She was professional at work and in the community; her expansive wardrobe always reflected the
role of a professional, and her demeanor was a positive reflection on L & A. Jeanne also was making some new business contacts for L & A
through her membership at the country club and the gated neighborhood where she lived. In fact, she had brought in two new clients for the firm,
a feat that was unheard of for a staff accountant. Jeanne was well liked by her coworkers at L & A. She often had them over to her new home to
socialize after working hours. They enjoyed her company and were impressed that she was juggling her career and family. Since her husband was
still collecting disability, they assumed Jeannes father-in-law was footing the bill for some of their luxuries.
Unfortunately, Jeanne had a car wreck during busy season of her fourth year. Although she did not have any permanent injuries,
Jeanne had to stay in the hospital for three weeks. During that time, Jet Li covered her work responsibilities. During the second week of Jeannes
absence, Jet collected Alis mail from the post office and began preparing checks for payment. Jet was surprised to see a very large credit card
bill. Upon examination of the bill, Jet noticed large charges at a home improvement store. Was Ali Automotive expanding its business? Jet was
curious, and when he brought flowers to the hospital for Jeanne, he asked her about the charges. Jeanne could not answer Jets questions and
seemed rattled by the discussion. Jet contacted the credit card company to determine if the charges were valid. He discovered that the charges

101

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4 The Auditor's Legal Environment

were authorized by Jeanne Thomson. Further investigation revealed that the charges were for personal items for Jeanne. In response to these
charges, Jet meticulously examined the dealerships accounting records and found that Jeanne had been making personal charges and cash
withdrawals on Alis credit card for two and a half years. Jet swiftly contacted Alis credit card company to terminate a pending payment of
$200,000 that was fraudulently charged by Jeanne Thomson to Home Upgrade, a home improvement store. Consequently, Home Upgrade suited
L & A for professional negligence under a third party liability law suit. Lastly, Jet also investigated Jeannes work with her other clients,
including Kim Jewelers. He was relieved that he did not find any additional irregularities; nevertheless, he was overwhelmed and distraught over
Jeannes fraud at Ali Automotive.

Required
1. List and discuss three personal or situational factors that might have triggered Jeanne Thomson to commit fraud at Ali Automotive.
2. List and discuss three personal or situational factors that might not have triggered Jeanne Thomson to commit fraud at Kim Jewelers.
3. Assume that Ali Automobile files a civil common lawsuit against Li and Associates, CPAs, LLP for breach of contract and Jeanne Thomson
for fraud, answer the following questions:
a. Should L & A be found liable to Ali Automobile? Explain and cite prior legal case(s) to support your arguments.
b. Should Jeanne Thomson be found liable to Ali Automobile? Explain and cite prior legal case(s) to support your arguments.
4. Assume that Home Upgrade files a third-party joint liability common lawsuit against Li and Associates, CPAs, LLP and Ali Automobile; that
the San Francisco court follows the foreseeable concept but may move back to the Ultramares concept in a third-party lawsuit, and that L &
A can be charged under different types of negligence in performing professional services, answer the following questions:
a. Should L & A be found liable to Home Upgrade? Explain and cite prior legal case(s) to support your arguments.
b. Should Ali Automobile be found jointly liable to Home Upgrade? Explain and cite prior legal case(s) to support your arguments.

Financial and Integrated Audits - Frederick Choo

Chapter 5
Audit Plan Preplan and Documentation
Chapter Learning Outcomes (LOs) Checklist
After reading this chapter, you should be able to:
LO5-1 Describe the four main considerations of preplan in a financial audit.
LO5-2 Describe the six main considerations of preplan in an integrated audit.
LO5-3 Explain the external auditors consideration of the internal auditors involvement
in preplanning an audit.
LO5-4 Compare and contrast the general documentation requirements between the
SECs SOX 2002 and AICPAs AU 230.
LO5-5 Compare and contrast the specific documentation requirements between
PCAOBs AS No.3 and AICPAs AU 240.
LO5-6 Identify the content of the auditors permanent and current files.

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5 Audit Plan - Preplan and Documentation

Chapter 5 Audit Plan Preplan and Documentation


Preplan in a Financial Audit
Preplan in a financial audit involves four main considerations as shown in Figure 5-1.
Figure 5-1 Main Considerations of Preplan in Financial and Integrated Audits
The Audit Process

Audit Plan

Preplan and
Documentation CH 5

Tests of Controls

Tests of Balances

Completing the Audit

Financial Audit

Audit Report

Integrated Audit

Objectives CH 6
1. Investigate the Client

Evidence CH 7
2. Understand the Clients
Business
Internal Control CH 8
3. Assign Staff to the
Engagement
Materiality and Risk CH 9
4. Sign the Engagement
Letter
Program and
Technology CH 10
5. Considers Matters Specific to
An Integrated Audit

6. Consider the Risk of Fraud


and Management Override
of Controls

Financial and Integrated Audits - Frederick Choo

Table 5-1 provides some comments on the four main considerations of preplan in a financial audit.
Table 5-1 Four Main Considerations of Preplan in a Financial Audit
Consideration
(1) Investigate the client

(2) Understand the clients business

(3) Assign staff to the engagement

Comments
For new client:
Prior to accepting a new client, AU 210 Terms of Engagement requires the successor auditor to
communicate, either orally or in writing, with the predecessor auditor. The initiative in
communication rests with the successor auditor. The inquiry of the predecessor auditor is important
because the predecessor auditor may be able to provide the successor auditor with information that
assists him/her in determining whether to accept the engagement.
The successor auditor should also request the client to authorize the predecessor auditor to allow a
review of the predecessor's working papers, including documentation of planning, internal control,
audit results, and other matters of continuing accounting and auditing significance, such as the
working paper analysis of balance sheet accounts, and those relating to contingencies. In addition, the
client's consent to the review is needed in accordance with Rule 301 of the Code of Professional
Conduct on confidential client information.
The auditor may hire a professional investigator to obtain information about the reputation and
background of the potential new clients management.
The auditor may also use the internet to search and learn more about the potential new client. Table
5-2 describes some useful sites for the electronic search.
The auditor should assess the legal and financial stability of the potential new clients and reject it if it
poses a high risk of litigation.
For old client:
The incumbent auditor should review prior experience with the existing client and decide whether to
continue auditing the client.
KPMG LLP has developed and implemented an innovative technology-enabled auditor decision aid,
known as KRisksm, for making acceptance and continuance risk assessments of both new and old
clients.
The auditor should obtain a knowledge of the nature of the client's business, its code of ethics,
organization, and its operating characteristics, such as the type of business, types of products and
services, capital structure, related parties, locations, and production, distribution and compensation
method. Some procedures to accomplish these are:
(a) A tour of the client's plant and offices.
(b) A review the client's legal documents, policies and the auditor's working papers from prior years.
Legal documents that the auditor should examine include corporate charter and bylaws, minutes of
corporate meetings, and contracts.
(c) Consult the AICPA Industry Audit Guide, industry publications, periodicals and financial
statements of other business entities in the industry to obtain knowledge of the business environment
in which the client operates, such as economic conditions, government regulations, and changes in
technology.
(d) Gain knowledge of the clients values and ethical standards through policy statements and code of
ethics. In response to the Sarbanes-Oxley Act of 2002, the SEC now requires each public company to
disclose whether it has adopted a code of ethics that applies to senior management, including the
CEO, CFO, and principal accounting officer or controller. A company that has not adopted such a
code must disclose this fact and explain why it has not done so. Accordingly, as a part of the
understanding of the clients business, the auditor should gain knowledge of the companys code of
ethics.
(e) Identify related parties of the client through inquiry of management, review of SEC filings, and
contacting the stock registrar to identify principal stockholders. A related party transaction is any
transaction between the client and a related party (Discussed in Chapter 20). Related party
transactions increase inherent risk of a client because they are not at arms length and may not be
valued at the same amount as they would have been if the transactions had been with an independent
third party. Accordingly, Sarbanes-Oxley Act of 2002 specifically prohibits related party transactions
that involve personal loans to executives. It is now unlawful for any public company to extend or
maintain credit, to arrange for the extension of credit, or to renew the extension of credit in the form
of personal loan to any director or executive officers. These restrictions do not apply to any loan,
such as a home loan or credit card agreement, made by a bank or other insured financial institution
under normal banking operation using market terms offered to the general public. In light of these
prohibitions, the auditor should now be alert of any such loans to directors or executives that are
illegal acts.
(f) Perform analytical procedures (Discussion in Chapter 7)
Considerations for assigning staff to the engagement are:
(a) In the case of a new client, the key members of the audit team are identified; this will allow the
prospective client to assess the credentials of the proposed audit team whose resumes are usually
enclosed with the pre-engagement proposal.
(b) In the case of an old client, ensure the continuity of the assigned audit staff to the client and
maintain the familiarity of the assigned audit staff with the client.

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5 Audit Plan - Preplan and Documentation

Consideration

(4) Sign the engagement letter

Comments
(c) In the case of a client with computerized accounting systems, and if specialized computer skills
are needed, the auditor should seek a professional possessing such skills, who may be an individual
with the audit firm or an outside professional.
(d) When outside expert help is needed, AU 620 Using the Work of a n Auditors Specialist requires
the auditor to satisfy himself/herself concerning the professional qualification and reputation of the
specialist, such as computer analysts, lawyer, and appraiser, by inquiry or other procedures, as
appropriate. There are more discussions on using the work of a specialist in Chapter 20.
(e) Recall in Chapter 2 that the partner-in-charge of an audit should be rotated at least every seven
years as per the Firms Division of the AICPA and every five years as per the Sarbanes-Oxley Act
2002.
Recall Table 2-10 in Chapter 2 that under Section 301 of the Sarbanes-Oxley Act, audit committees
(or those charged with governance) are now directly responsible for the appointment, compensation,
and oversight of the external auditor. Moreover, Section 202 of the Sarbanes-Oxley Act amends
Section 10A of the Securities Exchange Act of 1934 to require that the audit committee must also
pre-approve all audit and non-audit services provided by the external auditor. This means that the
auditor should now establish an understanding with the audit committee (or those charged with
governance) regarding services to be performed in the audit engagement. Since that understanding is
usually established through an engagement letter, the auditor should obtain signed engagement letters
directly from the audit committee (or those charged with governance).
An understanding with the client regarding an audit of the financial statements generally includes the
following matters:
(a) The objective of the audit is the expression of an opinion on the financial statements.
(b) Management is responsible for the entitys financial statements and the selection and application
of the accounting policies.
(c) Management is responsible for establishing and maintaining effective internal control over
financial reporting.
(d) Management is responsible for designing and implementing programs and controls to prevent and
detect fraud.
(e) Management is responsible for identifying and ensuring that the entity complies with the laws and
regulations applicable to its activities.
(f) Management is responsible for making all financial records and related information available to
the auditor.
(g) At the conclusion of the engagement, management will provide the auditor with a letter
(management representation letter) that confirms certain representations made during the audit.
(h) Management is responsible for adjusting the financial statements to correct material
misstatements and for affirming to the auditor in the management representation letter that the effects
of any uncorrected misstatements aggregated by the auditor during the current engagement and
pertaining to the latest period presented are immaterial, both individually and in the aggregate, to the
financial statements taken as a whole.
(i) The auditor is responsible for conducting the audit in accordance with generally accepted auditing
standards. Those standards require that the auditor obtain reasonable rather than absolute assurance
about whether the financial statements are free of material misstatement, whether caused by error or
fraud. Accordingly, a material misstatement may remain undetected. Also, an audit is not designed to
detect error or fraud that is immaterial to the financial statements. If, for any reason, the auditor is
unable to complete the audit or is unable to form or has not formed an opinion, s/he may decline to
express an opinion or decline to issue a report as a result of the engagement.
(j) An audit includes obtaining an understanding of the entity and its environment, including its
internal control, sufficient to assess the risks of material misstatement of the financial statements and
to design the nature, timing, and extent of further audit procedures. An audit is not designed to
provide assurance on internal control or to identify significant deficiencies. However, the auditor is
responsible for ensuring that those charged with governance are aware of any significant deficiencies
that come to his/her attention. An understanding with the client also may include other matters, such
as the overall audit strategy; involvement of the internal auditor, if applicable (a more detailed
discussion of the internal auditors involvement is provided in a separate section below);
involvement of a predecessor auditor; fees and billing; any limitation of or other arrangements
regarding the liability of the auditor or the client, such as indemnification to the auditor for liability
arising from knowing misrepresentations to the auditor by management; condition under which
access to audit documentation may be granted to others; additional services to be provided relating to
regulatory requirements, and other services to be provided in connection with the engagement, for
example, non-attestation services, such as accounting assistance and preparation of tax returns subject
to the limitations CPC Rule 101.
After a decision is made to accept or continue an engagement, an engagement letter is drafted by the
auditor for the audit committees signature. Such an engagement letter is not required by the
professional standards. However, the AICPA recommends the preparation of an engagement letter for
every audit engagement in light of the potential risk of misunderstanding between the parties. Recall
1136 Tenant's Corp case in Chapter 4. An example of an engagement letter is shown in Figure 5-2.
After accepting the engagement, the senior auditor responsible for coordinating the field work usually
schedules a pre-audit conference with the audit team primarily to give guidance to the staff regarding

Financial and Integrated Audits - Frederick Choo

Consideration

Comments
both technical and personnel aspects of the audit.

Table 5-2 Auditors Electronic Search for Information about a Prospective Client
Electronic Search
Accounting and auditing standards
relevant to a prospective client.

Resources

This information may be searched and retrieved from :


FASB
FASB provides its standards on its web site, www.fasb.org. Also, FASBs Financial Accounting
Research System provides a CD ROM that contains Statements on Financial Accounting Standards,
Emerging Issues Task Force Abstracts, and FASB Implementation Guides.

AICPA
AICPAs reSOURCE ONLINE Accounting and Auditing Literature provides access to all AICPA
professional standards, audit and accounting guides, and technical practice aids over the Internet.
Financial information about companies
in a prospective clients industry.

This information may be searched and retrieved from:


Compustat and Disclosure SEC Database (Disclosure)
Subscribers to Compustat and Disclosure may search and retrieve financial data that have been
extracted from SEC filings and annual reports of public companies.

EDGAR (Electronic Data Gathering and Retrieval System)


Auditors may access EDGAR via the Internet to obtain the SEC filings of certain public companies,
including their financial statements.
Current development relevant to a
prospective client.

The Internet provides online access to newspaper and journal articles. Also, many companies and
industry associations have WWW home pages that describe current developments and statistics.
Some useful Internet resources are as follows:

Public Company Accounting Oversight Board (PCAOB), www.pcaobus.org

Securities and Exchange Commissions


Home page, www.sec.gov/
EDGAR page, www.sec.gov/edgarhp.htm
Securities Act of 1933, www. law.uc.edu/CCL/33Act/Index.html
Securities Exchange Act of 1934, www. law.uc.edu/CCL/34Act/Index.html

Accounting and Auditing Web Sites


American Institute of CPAs (AICPA), www.aicpa.org
Association of Certified Fraud Examiners (CFE), www.acfe.com
The Institute of Internal Auditors (IIA), www.theiia.org
Tax and Accounting, http://taxsites.com

Large Accounting Firms


PricewaterhouseCoopers, LLP, www.pwcglobal.com
Ernst & Young, LLP, www.ey.com
Deloitte & Touche, LLP, www.deloitte.com
KPMG, LLP, www.us.kpmg.com
Grant Thornton, LLP, www.gt.com
BDO Seidman, www.bdo.com
McGladrey & Pullen, LLP, www.rsmmcgladrey.com

107

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5 Audit Plan - Preplan and Documentation

Figure 5-2 Example of an Engagement Letter


M & M, CPAs, LLP
San Francisco, CA 94321

Jan 4, 20xx

Mr. A, Chair of Audit Committee


XYZ Company
San Francisco, CA 94321
Dear Mr. A, Chair of Audit Committee
This letter is to confirm our arrangement for our audit of XYZ Company for the year ended December 31, 20xx.
We will audit the consolidated balance sheet of XYZ Company and its subsidiaries, YZ Company and XY Company, as of December 31,
20xx, and the related consolidated statements of earnings, retained earnings, and cash flows for the year then ended. Our audit will be made
in accordance with the standards of the Public Company Accounting Oversight Board and in compliance with the Sarbanes-Oxley Act of
2002. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation.
We direct your attention to the fact that management is responsible for the fair presentation of financial statements and the establishment and
maintenance of adequate internal control in compliance with the Sarbanes-Oxley Act of 2002. The standards of the Public Company
Accounting Oversight Board require us to obtain reasonable assurance, but not absolute, assurance that the financial statements are free of
material misstatement. Accordingly, we cannot guaranty that our audit will detect all errors, fraud, and illegal acts that might be present. Our
findings regarding your internal control, including information regarding material weaknesses, will be reported to the audit committee in a
separate letter.
We will also perform a review, but not an audit, of the Company's financial statements for each of the first three quarters of the financial year
ended December 31, 20xx. Our review will be in accordance with standards established by the American Institute of Certified Public
Accountants as set forth in Statement on Auditing Standards AU 930, titled "Interim Financial Information".
Assistance to be provided by your accounting department personnel, including the preparation of the detailed trial balance and supporting
schedules, is described in a separate attachment.
Our examination is scheduled for performance and completion as follows:
Begin field work
Completion of field work
Delivery of audit report

May
31, 20xx
February 15, 20xx
March
1, 20xx

Our fee will be based on the time spent by various members of our staff at our regular rates, plus travel and other out-of-pocket costs
(photocopying, telephone, etc.). Invoices will be rendered every two weeks and are payable on presentation. We will notify you immediately
of any circumstances we encounter which could significantly affect our initial fee estimate of $160,000.
If the above arrangement is in accordance with your understanding, please sign and return to us the duplicate copy of this letter.
We are pleased to have this opportunity to serve you.
Very truly yours,
____________________
M & M, CPAs, LLP
Arrangement Accepted:
___________________________
Mr. A, Chair of Audit Committee

______________
Date

External Auditor Consideration of the Internal Auditors Involvement


AU 610 Using the Work of Internal Auditors requires the external auditor to consider the involvement of the internal
auditor at the preplan phase of an audit. The decision process the auditor follows is outlined in Figure 5-3. The

Financial and Integrated Audits - Frederick Choo

major issue for the external auditor is considering the competence and objectivity of the internal auditors and the
effect of their work on the audit. Factors that the auditor should consider include:
Competence
1. Educational level and professional experience.
2. Professional certification and continuing education.
3. Audit policies, procedures, and checklists.
4. Practices regarding their assignments.
5. The supervision and review of their audit activities.
6. The quality of their working paper documentation, reports, and recommendations.
7. Evaluation of their performance.
Objectivity
1. The organizational status of the internal auditors responsible for the internal audit function. For example, the
internal auditor reports to an officer of sufficient status to ensure that the audit coverage is broad and the
internal auditor has access to the board of directors or the audit committee.
2. Policies to maintain internal auditors objectivity about the areas audited. For example, internal auditors are
prohibited from auditing areas to which they have recently been assigned or are to work upon completion of
responsibilities in the internal audit function.
The internal auditors work may affect the nature, timing, and extent of the audit procedures performed by
the independent auditor. For example, as part of their regular work, internal auditors may review, assess, and
monitor controls of the clients the accounting system. Similarly, part of their work may include confirming
receivables or observing certain physical inventories. If the internal auditors are competent and objective, the
external auditor may use the internal auditors work in these areas to reduce the scope of audit work. The materiality
of the account balance or class of transactions and its related audit risk may also determine how much the external
auditor can rely on the internal auditors work. When internal auditors provide direct assistance, the external auditor
should supervise, review, evaluate, and test their work.
Preplan in an Integrated Audit
Preplan in an integrated audit is coordinated with the preplan in a financial audit. For both audits, the auditor
considers matters related to the clients industry, business, and regulatory environment and so on (see Figure 5-1 and
Table 5-1). In addition, the auditor considers preplan matters specific to an integrated audit that includes 1.
Knowledge of the entitys internal control over financial reporting (ICFR) obtained during other engagements. 2.
Matters affecting the industry in which the client operates, such as financial reporting practices, economic
conditions, laws and regulations, and technological changes. 3. Matters relating to the clients business, including its
organization, operating characteristics, and capital structure. 4. The extent of recent changes in the client, its
operations, or its ICFR. 5. Preliminary judgments about materiality, risk, and other factors relating the determination
of material weaknesses. 6. Control deficiencies previously communicated to the audit committee or management. 7.
Legal or regulatory matters of which the client is aware. 8. The type and extent of available evidence related to the
effectiveness of the clients ICFR. 9. Preliminary judgments about the effectiveness of ICFR. 10. Public information
about the client relevant to the evaluation of other likelihood of material financial statement misstatements and the
effectiveness of the clients ICFR. 11. Knowledge about risks related to the clients evaluated as part of the audits
client acceptance and retention evaluation. 12. The relative complexity of the clients operations.
The auditor also considers preplan matters specific to the risk of fraud and the risk of management override
of controls in an integrated audit such as: 1. Controls over significant, unusual transactions, particularly those that
result in late or unusual journal entries. 2. Controls over journal entries and adjustments made in the period-end
financial reporting process. 3. Controls over related-party transactions. 4. Controls related to significant management
estimates. 5. Controls that mitigate incentives for, and pressures on, management to falsify or inappropriately
manage financial results.
Lastly, to effectively plan an integrated audit, PCAOBs AS 5 recommends 1. Scaling the audit which
means the auditor takes into consideration the size and complexity of the client, its business processes, and business
units that affect the way in which the client achieves effective internal control objectives. 2. Using the work of
others which means the auditor uses the work performed by, or receives direct assistance from, internal auditors
(consistent with AU 610), company personnel, and third parties working for management (e.g. valuation specialist
discussed in Chapter 19) or the audit committee.

109

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5 Audit Plan - Preplan and Documentation

Figure 5-3 The External Auditors Consideration of the Internal Auditors Work
1. Obtain an understanding of the internal audit function:
a. Gather information about its activities
b. Consider the relevance of the internal audit activities to the audit of the financial statements

No

Are internal audit


activities relevant
to the external audit?
Yes

No

Is it efficient to
consider the work of
internal auditors?
Yes

2. Assess the competence and objectivity of the internal auditors.


Yes
Are internal auditors
competent and objective?

No

Yes
3. Consider the effect of the internal auditors work on the audit:
a. Understanding internal control.
b. Risk assessment.
c. Test of controls and test of balances procedures.
4. Consider the extent of the effect of the internal auditors work.
5. Coordinate external audit work with internal auditors.
6. Evaluate and test the effectiveness of the internal auditors work

Does the auditor plan


to request direct assistance
from internal auditors?
Yes
7. Apply the procedures outlined in AU 610
Using the Work of Internal Auditors

END

No

Financial and Integrated Audits - Frederick Choo

Documentation in Financial and Integrated Audits


The audit preplan, the audit program, the tests performed, the collection and evaluation of evidence, and the
conclusions reached by the auditors are documented in the audit working papers in compliance with AICPAs AU
230 Audit Documentation in a financial audit and PCOABs Auditing Standard No.3 (AS 3) Audit Documentation in
an integrated audit. At the completion of audit, auditors at the supervisory level review these working papers
prepared by the audit staff.
The primary function of the working papers is to provide the principle support for the auditor's opinion and
to aid the auditor in the conduct and supervision of the audit. Moreover, the information contained in the working
papers is the auditor's primary means for proving due diligence under Section 11 of the Securities Act of 1933 and
Section 18 of the Securities Exchange Act of 1934.
Working papers are the property of the auditor. However, the auditor's right of ownership is subject to the
limitations of AICPA Rule of Conduct 301 on confidential client information. In a financial audit, completed
working papers are typically retained in the auditor's office for at least two years following an engagement, after
which the papers are moved to a remote location for storage, sometimes on microfilm form and sometimes on
computer disk. The retention period thereafter should be sufficient to meet the audit firm's needs and consistent with
applicable federal and state statutes of limitations. In an integrated audit, an applicable federal status is the Corporate
and Criminal Fraud Accountability Act of 2002 which requires the auditor to maintain working papers for seven
years. Moreover, under this Act, it is a felony for the auditor to knowingly destroy or create working papers to
impede, obstruct or influence any existing or contemplated federal investigation; an offense subject to financial fines
and imprisonment up to 10 years.
In February 2003, the SEC, under the Sarbanes-Oxley Act of 2002, issued a set of rules on the retention of
records for audits and reviews. The rules require the auditor to maintain the following documentation: 1. Working
papers or other documents that form the basis for the audit of the companys annual financial statements or review
of the companys quarterly financial statements. 2. Memos, correspondence, communications, other documents, and
records, including electronic record, that meet the following criteria: a. the materials are created, sent, or received in
connection with the audit or review, and b. the materials contain conclusions, opinions, analyses, or financial data
related to the audit or review. Accordingly, The SECs rule significantly increases the audit documentation that must
be retained. For example, auditors will now be required to retain email correspondence that contains information
meeting the above criteria. In addition, the SECs rule acknowledges that administrative records and other
documents not containing relevant financial data or the auditors conclusions, opinions, or analysis, do not meet the
retention criteria. For example, superseded drafts of memos, duplicates, previous copies of working papers that have
been corrected for typographical errors or errors due to training of new employees, or voice-mail messages do not
need to be retained.
Audit Documentation under AICPAs AU 230 in a Financial Audit
AICPAs AU 230 Audit Documentation states that the auditor should maintain working papers, the form and
content of which should be designed to meet the circumstances of a particular engagement. In addition, the
standard states that the quantity, type, and content of working papers will depend on: 1. The anticipated nature of the
auditors report. 2. The nature of the engagement. 3. The nature of the financial statements, schedules, or other
information reported. 4. The nature and condition of the clients records. 5. The assessed control risk. 6. The needs
for supervision and review of the audit work. Concerning the quantity of working papers, the standard further
stipulates that the working papers should be sufficient to show that the accounting records agree or reconcile with
the financial statements or other information reported on and that the applicable standards of field work have been
observed. Finally, concerning the content of working papers, the standard further stipulates that certain of the
auditors working papers may sometimes serve as a useful reference source for the client, but the working papers
should not be regarded as a part of, or a substitute for, the clients accounting records. Although the form and
content of working papers vary with the circumstances, they are typically divided into two categories of files:
permanent and current. Figure 5-4 shows the two categories of working papers files: permanent and current files.
Table 5-3 describes the content of the permanent and current files.

111

112

5 Audit Plan - Preplan and Documentation

Figure 5-4 Two Categories of Working Papers

Working papers

Permanent files
Include:
Corresponding file
Tax file

Current files

Contain

Contain

1. Copies of articles of incorporation, bylaws,


bond indentures and contracts.
2. Analyses of previous years accounts.
3. Organization charts, flowcharts, and
internal control questionnaires.
4. Analytical procedure results of previous
years audit

Audit Program

Copy of financial statements

Working trial balance

Lead Schedule

Detailed supporting schedule

Table 5-3 Permanent and Current Files


File
Permanent Files

Description
Permanent files contain information that is of continuing interest and relevance to the auditor in performing in
performing recurring engagement on an audit client. The permanent files are typically separated into three bundles:
(1) Corresponding file:
It is also known as the administrative file. It contains all correspondence to, from, or on behalf of a client. For
example, the auditor's client advisory comments letter on insignificant control deficiencies. Information contained in
this file is useful for planning the following year's audit.
(2) Permanent file:
This file contains information of continuing interest and relevance to an audit engagement. For example, the file may
include a client's articles and bylaws of incorporation, terms of capital stock and bond issues, chart of accounts,
organization charts, flow charts of internal control structure, schedule of amortization of long-term debt and
depreciation of assets, lease agreements, labor-management agreements, pension plan, copies of contracts, excerpts
from minutes, and analysis of business industry and economy. The permanent file should be updated during each
engagement.
(3) Tax file:
The tax file contains information relevant to a client's past, current, and future income tax obligations. For example,
the file may include a client's prior year state and federal income tax returns and schedule of significant temporary
differences between pretax accounting income and taxable income. This file serves as a basis for preparing current

Financial and Integrated Audits - Frederick Choo

File
Current Files

Description
year returns or for performing other tax-related services, such as representing the client in an IRS audit.
Current files are also known as the analysis files and they contain information relevant to a given audit client for a
particular year's audit. Working papers in the current files typically include the:
(1) Audit program. A detailed listing of all audit procedures to be performed during the engagement.
(2) Copy of financial statements. A draft copy of the current years financial statements.
(3) Working trial balance. A list of all the account balances from the general ledgers. It includes columns for
adjustment and reclassification. The working trial balance may be prepared by the client or the auditor. If the client
prepared a working trial balance, the auditor should verify the trial balance by footing the columns and tracing the
account balances to the general ledgers.
(4) Lead schedules. A lead schedule details each individual account balance within a major account category on the
financial statements, e.g., petty cash and cash at bank under cash account. The lead schedule also summarizes the audit
adjustments affecting the accounts.
(5) Detailed supporting schedules. A detailed supporting schedule documents specific audit procedures and tests
performed on individual account balances. The tests, the results, and the conclusions constitute the body of "sufficient
appropriate evidential matter" supporting the auditor's opinion on the financial statements. The detailed supporting
schedules typically include:
(a) An analysis schedule (e.g. allowance for doubtful debts)
(b) A reconciliation schedule (e.g. bank reconciliation)
(c) A reasonableness test schedule (e.g. provision for depreciation)
(d) Internal documents (e.g. memorandum)
(e) External documents (e.g. SEC Form 10-K)
(6) Audit adjustment and reclassification entries. Audit adjustments are journal entries proposed by the auditor to the
client. The purpose of the entries is to correct for material errors discovered during the audit (e.g. to write off obsolete
inventories that are not written off by the client). The "adjustments" column of the working trial balance lists the
journal entries. Audit reclassifications are items requested by the auditor to be reclassified to ensure proper
presentation of the financial statements. The "reclassifications" column of the working trial balance lists the audit
reclassifications (e.g. reclassification of material current installments of long-term liabilities as current liabilities).
Figure 5-5 shows an example of working paper organization. Figure 5-6 shows an example of working paper content.

Expanded Audit Documentation under AICPAs AU 240 in a Financial Audit


In 2002, the Auditing Standard Board issued AU 240 Consideration of Fraud in a Financial Statement Audit that
expands the auditors documentation requirements. AU 240 requires the auditor to discuss and identify fraud risk
factors at the planning phase of the financial statement audit. It also requires the auditor to perform additional testing
procedures on suspected fraud. Finally the auditor is required to discuss fraud with the management and audit
committee. All this work relating to the auditors consideration of fraud in a financial statement audit must be
documented in the working papers. Table 5-4 provides some brief comments of the expanded audit documentation
relating to the consideration of fraud in a financial statement audit.
Table 5-4 Expanded Documentation in Relation to the Consideration of Fraud

Expanded Documentation

Discussions among engagement


team members in planning the audit
regarding the susceptibility of the
clients financial statements to fraud.
Documentation should include (1) how
and when the discussion occurred, (2)
description of audit team members who
participated, and (3) subject matter
discussed.

Procedures performed to obtain


information necessary to identity and
assess
the
risks
of
material
misstatements due to fraud.

Specific
risks
of
material
misstatements due to fraud that were
identified, and a description of the

Brief Comments
The discussion should include:
(1) An exchange of ideas or brainstorming among the audit team members.
(2) A consideration of the known external and internal conditions that might (a) create
incentives/pressures for management and others to commit fraud, (b) provide the opportunity for
fraud to be penetrated, and (c) indicate a culture or environment that enables managements
attitude/rationalization to commit fraud.
(3) An emphasis on the need to maintain a questioning mind and to exercise professional
skepticism in gathering and evaluating evidence throughout the audit.
(4) Inputs from key team members from different locations and specialists assigned to the team.
These procedures include:
(1) Make inquiries of management and others about the risk of fraud. These inquiries include: (a)
Managements knowledge about suspected fraud. (b) Audit committees view about the risk of
fraud. (c) Internal auditors about their views about the risk of fraud. (d) Other employees
perspective regarding the risk of fraud.
(2) Consider the results of procedures relating to the acceptance and continuance of the audit
engagement (Discussion in Chapter 5).
(3) Consider the results of the analytical procedures performed in planning the audit (Discussion in
Chapter 7).
(4) Reviews of interim financial statements.
The identification of a risk of material misstatement due to fraud involves professional judgment
and includes the consideration of:
(1) The type of risk that may exist, i.e., whether it involves fraudulent financial reporting or

113

114

5 Audit Plan - Preplan and Documentation

Expanded Documentation

auditors response to those risks.

The
results
of
additional
procedures performed to address the risk
of improper revenue recognition.

The
results
of
additional
procedures performed to address the risk
of improper inventory quantities.

The
results
of
additional
procedures performed to address the risk
of biased management estimates.

The
results
of
additional
procedures performed to address the risk
of management override internal
controls.

The nature of the communication


about fraud made to management, the
audit committee, and those charged with
governance.

Brief Comments
misappropriation of assets.
(2) The significance of the risk, i.e., whether it is of a magnitude that could lead to material
misstatements.
(3) The likelihood of the risk, i.e., the likelihood that it will result in material misstatements.
(4) The pervasiveness of the risk, i.e., whether it affects the financial statements as a whole or is
restricted to certain accounts or class of transactions.
The auditors response to the risks of material misstatement involves professional skepticism in
gathering and evaluating audit evidence and involves the consideration of: (1) The overall effect
on how the audit is conducted, i.e., general considerations such as assignment of personnel and
supervision, managements selection and application of accounting principles, and predictability of
auditing procedures.
(2) Changing the nature, timing, and extent of auditing procedures (Discussion in Chapter 10).
These procedures include:
(1) Perform substantive analytical procedures relating to revenue using disaggregated data, e.g.,
comparing revenue reported by mouth and by product line.
(2) Confirm with customers certain relevant contract terms and agreements, e.g., acceptance
criteria, delivery and payment terms, cancellation or refund provisions.
(3) Inquiry of the sales and marketing personnel or legal counsel regarding sales or shipments for
unusual terms associated with the transactions.
(4) Be present at one or more locations to observe goods being shipped at period end.
(5) Test controls on revenue transactions that are processed electronically for existence and
occurrence.
These procedures include:
(1) Review inventory record to identify specific locations for inventory count observation on an
announced basis.
(2) Apply more rigorous procedures during the inventory count observation, e.g., examine the
purity, grade, or concentration of inventory in liquid form.
(3) Comparison of quantities for the current period with prior periods by class or category of
inventory to test the reasonableness of the quantities counted.
These procedures include:
(1) Engage a specialist/expert or develop independent estimates for comparison to management
estimates, e.g., comparing the fair value of a derivative.
(2) Retrospective review of similar management estimates in prior periods for the reasonableness
of judgments and assumptions supporting management estimates.
The auditor should use professional judgment to determine additional procedures to examine
journal entries and other adjustments for evidence of management override of internal controls.
These procedures include:
(1) Assess the risk of material misstatement associated with a specific class of journal entries.
(2) Assess the effectiveness of specific internal controls associated with a specific class of journal
entries.
(3) Gather both manual and electronic evidence for a specific class of journal entries.
(4) Identify unique characteristics of fraud associated with a specific class of journal entries such
as entries (a) made to seldom used accounts, (b) made by individuals who typically do not make
journal entries, (c) made pre- or post-period with little or no explanation, (d) made pre- or postperiod with no account number, and (e) made containing round numbers or a consistent ending
number.
(5) Examine other accounts affected by a specific class of journal entries at different locations.
(6) Examine journal entries or other adjustments processed outside the normal course of business,
e.g., entries used to record nonrecurring transactions, such as business combinations and
nonrecurring estimates, such as asset impairment.
The communication process includes:
(1) Fraud involving senior management should be reported directly to the audit committee.
(2) Fraud resulting from significant deficiencies in the design and operation of internal controls
should be reported to those charged with governance as material weakness AU 265
Communicating Internal Control Related Matters Identified in an Audit (Discussion in Chapter 8).
(3) Ordinarily, the auditor is not responsible to disclose fraud to outside parties except in the
following situations: (a) To comply with legal and regulatory requirements. (b) To a successor
auditor when the successor makes inquiries in accordance with AU 210 Terms of Engagement. (c)
In response to a subpoena. (d) To a funding agency or other specified agency in accordance with
requirements for the audits of entities that receive governmental financial assistance.

Specific Documentation Requirements under PCAOBs AS 3 in an Integrated Audit


PCOABs Auditing Standard No.3 (AS 3) Audit Documentation contains specific documentation requirements for
audits of public companies for significant findings or issues, actions taken to address them (including additional
evidence obtained), the basis for the conclusions reached. Examples of significant findings or issues that required
documentation under PCAOBs As 3 include:

Financial and Integrated Audits - Frederick Choo

1. Significant matters involving the selection, application, and consistency of accounting principles, including
related disclosures. For example, accounting for complex or unusual transactions, accounting estimates and
uncertainties related to management assumptions.
2. Results of auditing procedures that indicate a need for significant modification of planned auditing procedures or
the existence of material misstatements or omissions in the financial statements or the existence of significant
deficiencies in internal control over financial reporting.
3. Audit adjustments and the ultimate resolution of these items.
4. Disagreement among members of the engagement team or with others consulted on the engagement about
conclusions reached on significant accounting or auditing matters.
5. Significant findings or issues identified during the review of quarterly financial information.
6. Circumstances that cause significant difficulty in applying auditing procedures.
7. Significant changes in the assessed level of audit risk for particular audit areas and the auditors response to those
changes.
8. Any other matters that could result in modification of the audit report.
In addition, the auditor must identify all significant findings or issues in an engagement completion memorandum.
This memo should be specific enough for a reviewer to gain a thorough understanding of the significant findings or
issues.

115

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5 Audit Plan - Preplan and Documentation

Figure 5-5 An Example of Working Paper Organization

Balance Sheet
12/31/0x
Cash
$15,000
Accounts Receivable 35,000
X
X
X

Working
Trial
Balance

Lead Schedule

ABC Company Ref: TB


DR
|
CR
Working Trial Balance |Adjust |Reclass | Adjusted Trial Balance
Cash
$15,000
X
X
X
ABC Company
Ref: A-lead
Cash Lead Schedule
Account No. W/P Ref
Adjusted Balance
101
A-1 Petty cash
$ 500
102
A-2 Cash-General 12,000
103
A-3 Cash-Payroll
2,500
$ 15,000 To: TB
======
ABC Company
Ref: A-2
Bank Reconciliation W/P Ref
Balance per bank
$ 14,000 A-2.1
Add: Deposits in transit
2,000
Less: Outstanding checks
4,000 A-2.2
Balance per book
$ 12,000 To:A-lead
======
Bank Confirmation

Detailed Supporting Schedules

Cash balance at bank

Ref: A-2.1

$ 14,000 To: A-2


======

Listing of Outstanding Checks


Check No.
688
689
X
X
X

Ref: A-2.2

Amount
$ 168
863
x
x
x
______
$ 4,000 To: A-2
======

Financial and Integrated Audits - Frederick Choo

Figure 5-6 An Example of Working Paper Content


ABC Company
Bank Reconciliation
12/31/20xx

Schedule: A-2
Client Date: 1/10/20xx
Reviewed by: FC
Date: 1/18/20xx

Prepared by:

Acct. 101 General account, Bank of America


$ 109,713 T

Balance per Bank


Add:
Deposit in transit
12/30

$ 10,017

12/31

11,100

#
#

A-2.1

21,117

Deduct:
Outstanding checks
# 8008 12/16

3,068

8013 12/16

9,763

8016 12/23

11,916

8028 12/23

14,717

8033 12/28

37,998

8036 12/30

10,000

^
^
^
^
^
^

(87,462)

Other reconciling items:


Bank error
Deposit for another bank customer credited
to General account by bank, in error

(15,200)

Balance per bank, adjusted

28,168
=====

A-3
TB

F
Balance per books before adjustments

32,584

A-1

(4,416)

C 3.1
A-1

Adjustments:

Unrecorded bank service charge


NSF check returned by bank, not collectible from customer
Balance per books, adjusted

216
4,200

A-1
28,168
=====

F
T = Traced and agreed to bank confirmation
# = Traced deposit to the December 200x cash receipts and to the
January 200x bank cutoff statement.
^ = Traced check to the December 200x cash disbursements and to the
January 200x bank cutoff statement.
X = Cross-footed
TB = Traced to 12/31 adjusted trial balance.
C = Cross-index to working paper 3.1
F = Footed

117

118

5 Audit Plan - Preplan and Documentation

Multiple-Choice Questions
5-1

Which of the following procedures does not belong to the preplan phase of an audit engagement?
a. Establishing the management's assertion.
b. Establishing the client's reason for audit.
c. Establishing contact with the preceding auditor.
d. Establishing contract with the client.

5-2

What is the responsibility of a successor auditor with respect to communicating with the predecessor auditor in connection with a
prospective new audit client?
a. The successor auditor has no responsibility to contact the predecessor auditor.
b. The successor auditor should obtain permission form the prospective client to contact the predecessor auditor.
c. The successor auditor should contact the predecessor auditor regardless of whether the prospective client authorizes
contact.
d. The successor auditor need not contact the predecessor if the successor is aware of all available relevant facts.

5-3

The current file of the auditor's working papers should include


a. copies of client's contracts.
b. client's organization charts.
c. client's chart of accounts.
d. client's SEC Form 10-k.

5-4

The primary purpose of the auditor's working papers is to


a. support a client's financial statements.
b. support the adjustment and reclassification entries recommended by the auditor.
c. support the auditor's tests of controls and tests of balances.
d. support the auditor's opinion about the client's financial statements.

5-5

An audit working paper that shows the auditor's reasonableness test on a client's provision for depreciation is known as a(an)
a. adjustment and reclassification entries.
b. detailed supporting schedule.
c. lead schedule.
d. working trial balance.

5-6

Which of the following eliminates voluminous details from the auditors working trial balance by classifying and
summarizing similar or related items?
a. Account analyses.
b. Lead schedules.
c. Control accounts.
d. Supporting schedules.

5-7

An auditor who accepts an audit engagement and does not possess the industry expertise of the audit client should
a. engage financial experts familiar with the nature of the business entity.
b. refer a substantial portion of the audit to another CPA who will act as the principal auditor.
c. inform the clients management that an unqualified opinion cannot be issued.
d. obtain knowledge of matters that relate to the nature of the clients business.

5-8

The engagement letter


a. affects the CPA firms responsibility to external users of audited financial statements.
b. can be used to alter the auditors responsibility under generally accepted auditing standards.
c. can affect legal responsibilities to the client.
d. affects only an audit engagement, but does not affect review or compilation services.

5-9

After audit preplan, an engagement letter should be sent to the client. The letter usually would not include
a. a statement that management advisory services would be made available upon request.
b. a reference to the auditors responsibility for the detection of errors or frauds.
c. an estimation of the time to be spent on the audit work by audit staff and management.
d. a reference to managements responsibility for adequate internal controls.

Financial and Integrated Audits - Frederick Choo

5-10

Ordinarily, the working papers can be provided to someone else only with the express consent of the client. This is the case
even if
a. the papers are subpoenaed by a court.
b. the papers are used as a part of an AICPA quality review program.
c. the papers are requested as evidence in an AICPA Joint Trial Board hearing.
d. the papers are transferred as a result of a CPA selling his/her practice to another CPA firm.

5-11

Which of the following is the most likely first step an auditor would perform at the preplan phase of the audit process?
a. Provide the audit teams credentials to a potential new client.
b. Evaluate the internal controls of a potential new client.
c. Tour a potential new clients plants and facilities.
d. Consult and review the work of the predecessor auditor.

5-12

Which of the following would not be included in the auditors working papers?
a. The accounting manual.
b. The results of the preceding years audit.
c. Descriptions of the internal controls.
d. A time budget for the various audit areas.

5-13

Which of the following would not be a consideration of a CPA firm in deciding whether to accept a new client?
a. Clients standing in the business community.
b. Clients probability of achieving an unqualified opinion.
c. Clients relation with its previous CPA firm.
d. Clients financial stability.

5-14

Which of the following statement would least likely appear in an auditors engagement letter?
a. Fees for our services are based on our regular per diem rates, plus travel and other out-of-pocket expenses.
b. During the course of our audit we may observe opportunities for economy in, or improved controls over, your
operations.
c. Our engagement is subjected to the risk of that material errors or irregularities, including fraud and defalcations, if they
exist, will not be detected.
d. After performing our analytical procedures we will discuss with you the other audit procedures we consider necessary to
complete the engagement.

5-15

At the preplan phase, an auditor obtains knowledge about a new clients business to
a. provide constructive suggestions concerning improvements to the clients internal control.
b. develop an attitude of professional skepticism concerning managements financial statement assertions.
c. understand the nature of the clients business organization and its operating characteristics.
d. evaluate whether the aggregation of known misstatements causes the financial statements to be materially misstated.

5-16

At the preplan phase, an auditor most likely would


a. identify specific internal control activities that are likely to prevent fraud.
b. evaluate the reasonableness of the clients accounting estimates.
c. discuss the scheduled time for the performance and completion of the audit.
d. inquire of the clients attorney for unrecorded pending litigation.

5-17

At the preplan phase, a successor auditor should request the new client to authorize the predecessor to allow a review of the
predecessors
a.
b.
c.
d.

Engagement letter
Yes
Yes
No
No

Working papers
Yes
No
Yes
No

119

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5 Audit Plan - Preplan and Documentation

5-18

At the preplan phase, would the following factors ordinarily be considered in assigning staff for a new engagement?
a.
b.
c.
d.

5-19

Credential of the staff in the audit team


Yes
Yes
No
No

Continuity and periodic rotation of personnel


Yes
No
Yes
No

Which of the following factors most likely would cause an auditor not to accept a new audit engagement?
a. The auditor is not able to review the predecessor auditors working papers.
b. The prospective client does not permit the auditor to enquire its legal counsel concerning the risk of any pending
litigation.
c. The auditor does not fully understand the prospective clients operations and industry.
d. The prospective client does not assess the credentials of the proposed audit team.

5-20

In creating lead schedules for an audit engagement, a auditor often uses automated working paper software. What client
information is needed to begin this process?
a. Interim financial information such as third quarter sales, net income, and inventory and receivables balances.
b. Specialized journal information such as the invoice and purchase order numbers of the last few sales and purchases of
the year.
c. General ledger information such as account numbers, prior-year account balances, and current-year unadjusted
information.
d. Adjusting entry information such deferrals and accruals, and reclassification journal entries.

5-21

An auditor ordinarily uses a working trial balance resembling the financial statements without footnotes, but containing
columns for
a. cash flow increases and decreases.
b. audit objectives and assertions.
c. reconciliations and tick-marks.
d. reclassifications and adjustments.

5-22

At the preplan phase, a matter most likely to be agreed upon between the auditor and the client before implementation of
testing procedures is the determination of
a. evidence to be gathered to provide a sufficient basis for the auditors opinion.
b. procedures to be undertaken to discover litigation, claims, and assessments.
c. pending legal matters to be included in the inquiry of the clients attorney.
d. timing of the auditors physical inventory observation.

5-23

Which of the following documentation is required for an audit in accordance with generally accepted auditing standards?
a. A flowchart of an internal control questionnaire that evaluates the effectiveness of the clients internal controls.
b. A client engagement letter that summarizes the timing and details of the auditors planned field work.
c. An indication in the working papers that the accounting records agree or reconcile with the financial statements.
d. The basis for the auditors conclusions when the assessed level of control risk is at the maximum level for all financial
statement assertions.

5-24

Which of the following statements concerning audit working papers is false?


a. An auditor may support an opinion by other means in addition to working papers.
b. The form of working papers should be designed to meet the circumstances of a particular engagement.
c. An auditors working papers may not serve as a reference source for the client.
d. Working papers should show that the auditor has obtained an understanding of internal control.

5-25

In planning a new audit engagement, which of the following is not a factor that affects the auditors judgment as to the
quantity, type, and content of working papers?
a. The type of report to be issued by the auditor.
b. The content of the clients representations letter.
c. The nature and condition of the clients records.
d. The auditors preliminary evaluation of control risk based on discussions with the client.

Financial and Integrated Audits - Frederick Choo

5-26

Although the quantity and content of audit working papers vary with each particular engagement, an auditors permanent
file most likely includes
a. schedules that support the current years adjusting entries.
b. prior years accounts receivable confirmations that were classified as exceptions.
c. documentation indicating that the audit work was adequately planned and supervised.
d. analyses of capital stock and other owners equity accounts.

5-27

The audit working paper that reflects the major components of an amount reported in the financial statements is the
a. interbank transfer schedule.
b. carryforward schedule
c. supporting schedule.
d. lead schedule.

5-28

Which of the following factors would least likely affect the content of an auditors working papers?
a. The condition of the clients records.
b. The assessed level of control risk.
c. The nature of the auditors report.
d. The medium used to record and maintain the working papers.

5-29

The permanent file of an auditors working papers most likely would include copies of the
a. lead schedules.
b. attorneys letter.
c. bank statements.
d. debt agreements.

5-30

The current file of an auditors working papers ordinarily should include


a. a flowchart of the internal control procedures.
b. organization charts.
c. a copy of the financial statements.
d. copies of bond and note indentures.

5-31

The current file of an auditors working papers most likely would include a copy of the
a. Bank reconciliation.
b. pension plan contract.
c. articles of incorporation.
d. flowchart of the internal control activities.

5-32

Which of the following statements ordinarily is true concerning the content of working papers? (Hint: Think of the
standards requirement about quantity)
a. Whenever possible, the auditors staff should prepare schedules and analyses rather than the entitys employees.
b. It is preferable to have negative figures indicated in red figures instead of parentheses to emphasize amounts being
subtracted.
c. It is appropriate to use calculator tapes with names or explanations on the tapes rather than writing separate lists onto
working papers.
d. The analysis of asset accounts and their related expense or income accounts should not appear on the same working
paper.

5-33

Before accepting an audit engagement, a successor auditor should make specific inquiries of the predecessor auditor
regarding the predecessors
a. opinion of any subsequent events occurring since the predecessors audit report was issued.
b. understanding as to the reasons for the change of auditors.
c. awareness of the consistency in the application of GAAP between periods.
d. evaluation of all matters of continuing accounting significance.

121

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5 Audit Plan - Preplan and Documentation

5-34

A, CPA, has been retained to audit the financial statements of C Company. Cs predecessor auditor was B, CPA, who has
been notified by C that Bs services have been terminated. Under these circumstances, which party should initiate the communications
between A and B?
a. A, the successor auditor.
b. B, the predecessor auditor.
c. Cs controller or CFO.
d. The chairman of Cs board of directors.

5-35

Ordinarily, the predecessor auditor permits the successor auditor to review the predecessors working paper analyses
relating to
a.
b.
c.
d.

5-36

Contingencies
Yes
Yes
No
No

Balance Sheet Accounts


Yes
No
Yes
No

Which of the following factors most likely would cause an auditor not to accept a new audit engagement?
a. The prospective client has no formal written code of conduct.
b. The integrity and reputation of the prospective clients management are very bad.
c. Procedures requiring segregation of duties are subject to management override.
d. Management fails to modify prescribed controls for changes in conditions.

5-37

The scope and nature of an auditors contractual obligation to a client is ordinarily set forth in the
a. management representation letter.
b. scope paragraph of the auditors report.
c. engagement letter.
d. introductory paragraph of the auditors report.

5-38

Which of the following documentation is not required for an audit in accordance with generally accepted auditing
standards (GAAS)?
a. A client engagement letter that summarizes the timing and details of the auditors planned field work.
b. The basis for the auditors conclusions when the assessed level of control risk is below the maximum level.
c. A written audit program setting forth procedures necessary to accomplish the audits objectives.
d. An indication that the accounting records agree or reconcile with the financial statements.

5-39

At the preplan phase of an audit, which of the following procedures would an auditor least likely perform?
a. Coordinating the assistance of the prospective clients in gathering evidence.
b. Tour the prospective clients plant and facilities.
c. Selecting a sample of vendors invoices for comparison with receiving reports.
d. Reading the current years interim financial statements.

5-40

At the preplan phase of an audit, a auditor most likely would


a. identify specific internal control activities that are likely to prevent fraud.
b. evaluate the reasonableness of the clients accounting estimates.
c. discuss the timing of the audit procedures with the clients management.
d. inquiry of the clients lawyer as to whether any unrecorded claims are probable of assertion.

5-41

The senior auditor responsible for coordinating the field work usually schedules a pre-audit conference with the audit team
primarily to
a. give guidance to the staff regarding both technical and personnel aspects of the audit.
b. discuss staff suggestions concerning the establishment and maintenance of time budget.
c. establish the need for using the work of specialists and internal auditors.
d. provide an opportunity to document staff disagreements regarding technical issues.

Financial and Integrated Audits - Frederick Choo

5-42

To obtain an understanding of a continuing clients business at the preplan phase of an audit, an auditor most likely would
a. perform tests of details of transactions and balances.
b. review prior-year working papers and the permanent file for the client.
c. read specialized industry journals.
d. re-evaluate the clients internal control.

5-43

Which of the following audit documents would not have to be retained in the audit working paper files?
a. Working papers used to form the basis for the audit opinion.
b. Memos exchanged between audit team members that contain analyses of client financial data.
c. Emails summarizing conclusions about client business risks.
d. Superseded drafts of documents corrected for errors made by audit staff.

5-44

Which of the following is not a criteria that the SEC would use to determine the retention of audit documents?
a. Documents that are created, sent, or received in connection with the audit or review services.
b. Documents contain conclusions, opinions, analyses, or financial data related to the audit or review services.
c. Documents that are created, sent, or received in connection with the AICPAs peer review program.
d. Documents that are electronic, such as email and voice mail, which contain conclusions, opinions, analyses, or financial
data related to the audit or review services.

5-45

The Sarbanes-Oxley Act of 2002 changed several elements of the audit preplan phase. Which of the following is not a
correct statement regarding these changes?
a. The auditor should now establish an understanding with the management regarding services to be performed in the audit
engagement.
b. The auditor-in-charge of an audit engagement should now be rotated at least every five years.
c. The auditor should now alert to any personal loans to directors or executives of the company that are illegal acts.
d. The auditor should now gain knowledge of the companys code of ethics.

5-46

Auditing standards on consideration of fraud in a financial statement audit expanded the requirements of documentation in
working papers. Which of the following is not one the expanded requirements?
a. The results of additional procedures performed to address the risk of improper revenue recognition.
b. The results of additional procedures performed to address the risk of improper inventory pricing.
c. The results of additional procedures performed to address the risk of biased management estimates.
d. The results of additional procedures performed to address the risk of management override internal controls.

5-47

With regard to assigning staff to an engagement in the preplan phase of an audit, which of the following
is unlikely to be considered by the audit firm?
a. Rotation of the partner-in-charge of the audit of a privately held company every seven years.
b. Rotation of the partner-in-charge of the audit of a publicly held company every five years.
c. Rotation of the partner-in-charge of the audit of all companies every seven years or five years
depending on the size of the companies.
d. Rotation of the partner-in-charge of the audit of a company as per the Sarbanes-Oxley Act of 2002.

5-48

Which of the following statements concerning audit working papers is false?


a. Working papers are the property of the audit client.
b. Working papers contain adjustment and reclassification entries recommended by the auditor.
c. Working papers of a predecessor auditor should be made available to the successor auditor.
d. Working papers support the auditors opinion about the clients financial statements.

5-49

If the external auditor considers the internal auditors to be competence and objective, the external auditor will not proceed
to
a. consider the extent of the effect of the internal auditors work.
b. coordinate external audit work with internal auditors.
c. evaluate and test the effectiveness of the internal auditors work.
d. appoint the internal auditors as team members of the external auditor.

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5-50

PCOABs Auditing Standard No.3 (AS 3) Audit Documentation requires the auditor to document significant findings or
issues in an audit. Which of the following is not an example of a significant finding or issue that required documentation?
a. Results of auditing procedures that indicate a need for significant modification of planned auditing procedures.
b. Disagreement among members of the engagement team about conclusions reached on insignificant accounting
transactions.
c. Unusual and significant accounting estimates identified during the review of quarterly financial information .
d. Significant changes in the assessed level of audit risk for particular audit areas.

5-51

Which of the following is not a characteristic of preplan in an integrated audit?


a. Preplan in an integrated audit is coordinated with the preplan in a financial audit.
b. The auditor considers preplan matters specific to an integrated audit that includes knowledge of the entitys internal control over
financial reporting (ICFR) obtained during other engagements.
c. To effectively plan an integrated audit, the auditor should not consider using the work of others.
d. The auditor considers preplan matters specific to the risk of fraud and the risk of management override of controls in an integrated
audit

Key to Multiple-Choice Questions


5-1 a. 5-2 b. 5-3 d. 5-4 d. 5-5 b. 5-6 b. 5-7 d. 5-8 c. 5-9 a. 5-10 d. 5-11 d.
5-12 a. 5-13 b. 5-14 d. 5-15 c. 5-16 c. 5-17 c. 5-18 a. 5-19 b. 5-20 c. 5-21 d
5-22. d. 5-23 c. 5-24 c. 5-25 b. 5-26 d. 5-27 d. 5-28 d. 5-29 d. 5-30 c. 5-31 a.
5-32 c. 5-33 b. 5-34 a. 5-35 a. 5-36 b. 5-37 c. 5-38 a. 5-39 c. 5-40 c. 5-41 a.
5-42 b. 5-43 d. 5-44 c. 5-45 a. 5-46 b. 5-47 c. 5-48 a. 5-49 d. 5-50 b. 5-51 c.

Financial and Integrated Audits - Frederick Choo

Simulation Question 5-1


Simulation Question 5-1 is an adaptation with permission from a case by Jenne, S. E. in the Issues in Accounting Education , a publication of the
American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the names and places
have been changed.
An opening for partnership had just been announced in the local office of Novogardac & Co, a regional CPA firm. The new
partnership position, justified by increased revenues, was cause for celebration among the managers aspiring to become partners in the firm.
Competition mounted for the new position once the announcement was made. Bill Siegel, one of the senior audit managers, was the current
favorite for admission to the partnership. Bill has consistently received favorable performance evaluations from his superiors and had been
viewed as being technically competent throughout his career. In his last annual performance review as a senior manager, he was told that the only
obstacle he had to overcome in order to be admitted to the partnership was to demonstrate an ability to attract new clients. Bill had been making
himself very visible in the business community by joining local business and not-for-profit organizations and he was becoming a local leader in a
respected civic organization. This activity had helped Bill identify prospective clients and, in fact, had resulted in the addition of several new
clients to the firm. At this point he needed just one or two new clients to ensure his admission as a partner.

Part 1

During a round of golf with the controller of a local automobile dealership, Bill asked his golf partner, Tom, for possible new business
leads. Tom thoughtfully considered the question and finally came up with a name. The automobile dealership frequently sold purchase contracts
to local financial institutions. Recently, Sabrina Phil, the president of Provident Credit Union (hereafter, PCU) had mentioned to Tom that she
was unhappy with her current auditor and was considering a change. She complained about high audit fees and noted some difficulties working
with her current auditor. Tom suggested that Bill contact Sabrina to determine whether she was serious about switching auditors, but he warned
that Sabrina was a tough businesswoman with a reputation for being shrewd. Bill was so delighted with the new lead that he happily picked up
the tab for golf and lunch.
Bill wasted no time arranging a meeting with Sabrina. Just as Tom said, Sabrina was unhappy with her current auditor and very
willing to consider a change. Bill noted that a reputable firm had audited PCU the previous year and, as far as he could tell, the accounting
records appeared to be in reasonable order. Based on his experience with similar clients, Bill developed a tentative proposal to perform the audit
of PCU for a fee slightly less than the previous years fee. Sabrina quickly consented and agreed to notify her prior auditor. Permission was
granted for the prior auditor talk freely with Bill regarding PCU. According to Bills best estimates of time required and personnel to be assigned,
Novogradac & Co would be able to recover its normal billing rates for services performed at the proposed fee amount. Bill told Sabrina that the
engagement, including the proposed audit fee, could not be finalized until he performed a more thorough background investigation of PCU and
had obtained approval of the Novogradac partners. This investigation, required by Novogradac prior to acceptance of all new clients, was to
include a more in-depth financial review of the past five years, a credit check, and an evaluation of the general reputation of PCU and Sabrina.
Novogradac required Bill to inform the partner-in-charge of audit, Lucy Ball, and to obtain a favorable vote of the local office partners prior to
acceptance of the new client.

Required
1 a. Given Bills technical competence, why is he being required to demonstrate an ability to bring new clients into the firm in order to be
admitted to the partnership?
1 b. What information and procedures does Novogradac require prior to acceptance of a new audit client?

Part 2

The background review produced the following information:


1. PCU is a small, closely held, and well-established financial institution. It has operated successfully for 20 years under Sabrinas leadership.
Sabrina currently serves as Chairman of the Board of Directors and CEO of PCU. PCU weathered a recent business recession and still maintained
net income comfortably above the average for peer financial institutions.
2. Sabrina has a reputation as an aggressive businesswoman who always lands on her feet. She has used sales of short-term certificates of
deposit (CDs) to raise cash quickly to take advantage of new business opportunities. Similarly, she has sold large portfolios of loans to avoid
reissuing CDs when interest rates were favorable. She personally supervises collection activities on difficult loans and one collection agency
owner familiar with PCU commented that there was not much opportunity left for collection after Sabrina got through.
3. As of the previous audit, total assets of PUC were approximately $10 million. Within the past five years, the total assets had fluctuated from a
low of $8 million to a high of nearly $20 million. Stockholders equity was slightly larger than average when compared to similar financial
institutions. Virtually all the debt of PCU was related to depositor accounts, primarily CDs.
4. Bill visited the predecessor auditor and was allowed to examine and copy some of the working papers from the prior year audit. He noted that
there had been a few more adjusting journal entries proposed than he normally would have expected. In discussing the adjustments with the
predecessor auditor, Bill noted that it had been difficult for the predecessor auditor to convince Sabrina that the adjustments were necessary.
However, Sabrina eventually agreed to make a sufficient number of the proposed adjustments to receive an unqualified audit opinion. As Bill
reached the end of his meeting, the predecessor auditor said, Of course, you hate to lose any client, but if we had to choose one to give up it
would be PCU.
5. Most of the loans held by PCU came from used car dealers, small home repair and remodeling contractors, and door-to-door sales people in the
area. These types of loans were often difficult to collect. Sabrina discounted the loans heavily, paying only a fraction of their face value, and
usually bought them with recourse. Because Sabrina had demonstrated an ability to collect a high percentage of these loans, she always has an
ample supply of sales people and small businesses willing to sell her their loans receivable.
6. Talks with the controller of PCU went reasonably well. The controller was very friendly and tried to be helpful. Overall, the accounting records
appeared to be in reasonably good order. However, Bill was not impressed with the knowledge and abilities of the controller. The controller had
completed a few accounting courses, but did not have a degree in accounting and had not completed any professional certification program in
accounting (e.g., CPA, CMA, CIA, CFE).

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7. Bills business contacts were willing to freely discuss their experience with Sabrina and with PCU. They consistently depicted Sabrina as
disciplined, aggressive, and shrewd. Within PCU she was viewed as direct, overbearing, and intolerant of error.
8. PCU generally had a reputation for paying obligations on time or shortly after the due date. However, it was common for Sabrina to take
exception to the charges billed and it was common for her to attempt to renegotiate the charges prior to making payment. The prior auditor had
been paid within a reasonable time after completion for the engagement.
Bill summarized his background review for Lucy, noting the above points. All things considered, he concluded that PCU would be an
acceptable audit client and recommended to Lucy that Novogradac accept the engagement. Bill fully understood the importance of increased firm
revenues to justify the new partnership position. Annual employee reviews were scheduled the following week and this would be Bills last
opportunity to add another client prior to his evaluation for a partnership position. If Bill were not admitted to the partnership soon, he would
likely be asked to leave the firm to make room for other promising candidates.

Required
2 a. Prepare a list of specific factors/reasons to accept the PCU audit engagement. One factor/reason is provided to help you complete the rest of
about eleven factors/reasons.
i. Successful operation of the business for 20 years. Continuing businesses usually present less audit risk than startup companies with no record of
success.
ii.
iii
2 b. Prepare a list of specific factors/reasons to reject the PCU audit engagement. One factor/reason is provided to help you complete the rest of
about seven factors/reasons.
i. Management control is centered in one person, Sabrina. This situation makes it easier for Sabrina to commit fraud without being detected,
thereby increasing audit risk.
ii.
iii

Part 3

Based on the recommendations of Bill and Lucy, the vote of the local office partners, the PCU audit engagement was accepted. With
the acceptance of PCU, Bills goal to become a partner was realized. Bill acquired a loan (not from PCU) and bought into the partnership. This
was a crowning achievement in Bills career and he was justifiably proud of his promotion.
Unfortunately, all did not go well with the audit of PCU. The controller quit shortly after the clients year-end and the new controller
was less qualified for the position than his predecessor. He apparently overstated his abilities and experience to obtain the position. The new
controller often struggled to understand the unique accounting practices within the financial institution industry. This was an obvious frustration
to Sabrina. Since her own knowledge of detailed accounting procedures was limited, she was unable to resolve technical accounting issues
herself. Sabrina appeared to be looking to the auditors to resolve technical accounting issues as part of the audit. It became apparent that neither
the controller nor Sabrina would be of great help in answering the more difficult accountingrelated questions that were likely to arise during the
audit.
Reconciliation of the beginning balances in the general ledger with the prior year audited financial statements for PCU turned out to
be a major challenge. While Bill was fortunate enough to get copies of the audited trial balance numbers and proposed adjusting entries from the
prior auditor, there was neither a record of which entries had been posted and which had not, nor was there a reconciliation between the audited
trial balance numbers and the resulting financial statements. Either there was a deficiency in the predecessors working papers, or they purposely
withheld critical information.
Attempts to obtain additional information from the predecessor auditor were futile. In some cases it was discovered that an adjustment
was made to the books for a different amount from that proposed by the predecessor auditor. In other cases, incorrect adjustments were made or
no entries were made at all. Account balances were combined under headings on the financial statements different from those used on the trial
balance and there was no documentation detailing the combination of accounts. It took many hours of searching the clients journals and ledgers
to finally track all the entries and to reconcile the clients beginning account balances with the prior year audited financial statements. For most of
their audit clients, this reconciliation was unnecessary because the account balances in the ledger closely matched the amounts reported on the
financial statements and numbers from the trial balance were typically traced to the financial statements in the working papers.
The audit of fixed assets exceeded the budget by a significant amount of time due to the lack of records. The prior controller of PCU
had calculated depreciation expense for depreciable assets for the year under audit before leaving PCU. Unfortunately, he did not leave a copy of
his calculations to support depreciation expense. All efforts to contact the previous controller for an explanation failed. The new controller was
unable to explain how depreciation expense was derived and, due to lack of confidence in his accounting abilities, he was afraid to make any
changes to the amounts calculated by the prior controller. The disclosure of depreciation methods on the prior year financial statements was too
vague to determine which methods were used for each asset or asset group.
The professional staff assigned to audit fixed assets obtained original purchase documentation for each of the fixed assets and by trial
and error attempted to determine the method of depreciation employed. Straight line, sum-of-the-years digits, double declining balance, declining
balance at 1.5 times the straight-line rate, and MACRS (Modified Accelerated Cost Recovery System, a depreciation method used for tax purpose
and defined in the Tax Reform Act of 1986), were all attempted using various estimates of useful lives and salvage values.
Unfortunately, the audit team was unsuccessful in determining the depreciation methods used for any of the assets. It noted that the
amounts recorded for depreciation expense and for accumulated depreciation were consistently between straight-line and double declining
balance amounts. Footnote disclosures were somewhat vague, noting the use of an accelerated method of depreciation for most fixed assets.
The depreciable assets were about 10 percent of total assets on the balance sheet. Most of the assets consisted of the various receivables held by
the financial institution. Thus, it was determined that, in spite of the problems described above, no material error existed in depreciation expense
or accumulated depreciation. A recommendation was made to the client to select a generally accepted method of calculating depreciation and to
document the calculation in the future.

Financial and Integrated Audits - Frederick Choo

Evidence suggesting the existence of a related party surfaced early in the audit. The building owned and occupied by PCU also housed
a travel agency by the name of East & West Travel (hereafter, EWT). The travel agency operated in the main lobby of the financial institution
with no signs or dividers between the space occupied by PCU and the space occupied by EWT. In fact, it was necessary for employees of both
organizations to pass through the working areas of the other business to enter and exit the building and to access the shared break room and
restrooms. On one occasion, Sabrina was observed correcting the manager of the travel agency and appeared to be threatening his employment
with the agency. Employees of the travel agency would not reveal anything to the auditors.
Discussions with employees of PCU indicated that Sabrina had regular conversations with the manager of the travel agency similar to
the one observed by the audit staff. However, the employees of PCU were unable to verify any direct relationship between the two entities other
than the shared building space. Sabrina denied any ownership, managerial responsibility, or other relationship with EWT. A thorough search was
made for transactions between the two entities. The only transactions noted were the rental payments made by EWT to PCU at an amount
considered by the auditors to approximately fair market value for the space used.
Stockholders equity presented another problem during the audit. When asked whether she had an ownership interest in PCU, Sabrina
flatly denied any ownership whatsoever. When the stock book was examined, however, the audit team found that Sabrina owned approximately
2.5 percent of the outstanding stock in PCU. Due to the obvious misrepresentation by Sabrina to the concern regarding related-party transactions,
Bill made an appointment to talk to Sabrina to review the ownership of PCU. Armed with the stock records, Bill questioned Sabrina regarding
each owner of PCU. At this point, Sabrina acknowledged the ownership noted in the stock records, but quickly countered that it was really
insignificant. Further questioning revealed that Sabrinas aged mother owned approximately 57.5 percent of the outstanding shares of stock.
Sabrina was frequently leaving work at PCU to care for her mother. Discussions with the PCU employees revealed that Sabrinas mother was
very old, in poor health, and dependent on Sabrina for transportation and daily care, including assistance with doctor appointments, grocery
shopping, and meal preparation. There was no evidence that Sabrinas mother had been actively involved in the management oversight of PCU,
participation with the board of directors, or communication with the auditor. No reason was ever discovered for Sabrinas evasive and obviously
incorrect answers.

Required
3 a. When Bill was admitted as a new partner, he acquired a loan to make a substantial financial investment in Novogardac & Co. Why are new
partners required to make a substantial financial investment in the firm as specified in the partnership agreement?
3 b. Audit evidence indicates that EWT may be related to PCU. Why is the possible existence of a related party of concern to the auditors?
3 c. Audit evidence indicates that Sabrina was evasive about her ownership interests in PCU and that her mother owned a majority interest in
PCU. What are the implications of these findings to the audit of PCU?

Part 4

As a result of the issues that arose, the required audit hours greatly exceeded the time budget originally prepared by Bill. Even though
there was not a promised completion date, Sabrina began to be eager to receive the audit opinion and get the auditors out of the building. At one
point she called Lucy Ball and complained that the audit was taking too long. She said that she had made numerous calls to Bill during the past
week and that none of her calls had been returned. But the office receptionist verified that Sabrina had not called the office during the past week
at all. In fact, Bill had been in the PCU building talking to Sabrina the previous day during which time Sabrina had not expressed any concerns
related to the audit or Bills work.
Finally, sufficient appropriate evidence had been gathered to conclude the audit. A number of adjusting journal entries were proposed
and Sabrina fought nearly all of them. Neither she nor her controller demonstrated a sufficient understanding of accounting to challenge the
merits of the entries proposed. When it became clear that Sabrinas challenges had no basis, she finally agreed to a sufficient number of adjusting
entries to allow the financial statements, in the opinion of the auditors, to be fairly stated in all material respects.
The audit was concluded and an unqualified opinion issued. Sabrina waited until she received a 30-day-past-due notice before she
contacted the Novogradac & Co office. She argued over the amount of the bill and again complained about the excessive time that the auditors
took to complete their work. The partners in Novogradac & Co ultimately discounted the bill by 15 percent and Sabrina paid the discounted
amount when the bill was approximately 90 days past due.
Partners in Novogradac & Co each received a salary based on the number of hours they worked and a partnership distribution based
on the size of their partnership investment. The level of salary received was determined by an annual review conducted by the senior partners in
the firm. In order to receive a higher salary, Bill and other partners needed to maintain and increase their client base and charge a higher
proportion of their hours worked to their clients. Note that hours worked for the firm in administrative functions or other activities that could not
billed to a client engagement did not contribute to the revenue of the firm. An increased client base and a higher proportion of hours billed to
clients both resulted in more revenue to Novogradac & Co, and thus justified an increase in salary.
In spite of his increased income as a partner, Bill often found himself a little short of cash. His increase in income as a new partner
was more than offset by the large payments he was required to make on his loan to buy an ownership interest in the firm. It would soon be time to
begin the second audit of PCU and Bill was eager to renew the engagement for another year in order to justify a much-needed increase in salary.

Required
4 a. What factors/reasons might Novogardac & Co have for rejecting to provide future audit services to PCU?
4 b. What factors/reasons might Novogardac & Co have for continuing to provide future audit services to PCU?
Note: You must answer all 4 Parts to earn the extra credit point.

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Simulation Question 5-2


Simulation Question 5-2 is an adaptation with permission from a case by Jones, A. and C. S. Norman in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the
names and places have been changed.

Part 1

The CPA Firm


As of March 2005, Johnson Keith Niemeyer LLP (hereafter, JKN), a large, regional public accounting firm, had offices in 45 U.S. cities in the
West and Midwest, as well as several international affiliations. Firm headquarters are located in the Midwest, and the professional staff at the
headquarters provides outstanding support to the local offices. JKN has a total of 225 partners and approximately 2,000 supporting professionals
and administrative staff. U.S. offices of the firm generally are staffed with 3-10 partners and 20-100 supporting professional accountants and
administrative personnel. The firm provides a full array of audit, tax, and consulting services for its clients; these are mostly privately held,
owner-managed companies with revenues ranging from $1 million to $50 million, although JKN also serves approximately 80 public companies.
JKN has a reputation for being very conservative in its audit practice. Management has been very careful in its client acceptance and
continuance policies. Before submitting proposals to perform audit services, prospective engagement partners must obtain extensive information
about the potential client to make an informed decision about whether to accept or reject the engagement. If the prospective engagement partners
decision were to accept the client; then, at least one additional audit partner must agree with the decision to accept the client. In the course of
evaluating prospective clients, JKN personnel assess their potential exposure from being associated with a particular client or engagement
(engagement risk).1 JKNs acceptance procedures allow the acceptance of high-risk clients only if the risk can be controlled. That is, the
engagement team must have relevant expertise and experience to manage the risk, as well as adequate compensation for the risk assumed.
Potential clients are evaluated for integrity, industry competence, management experience, and financial condition.
If the prospective client is a public company, then additional due diligence procedures are required. These procedures include
evaluating underwriters and legal counsel, performing background checks on members of management and the board of directors, and evaluating
the financial viability of proposed transactions and investor returns. In these situations, JKNs firm policy requires the approval of the partner
responsible for firm-wide audit and accounting policy, as well as the approval of a concurring partner.
Engagement partners re-evaluate existing audit clients on an annual basis to determine whether any events since completion of the last
audit might cause the firm to discontinue its relationship with the client. If an existing client is planning a public offering of its securities, then
additional due diligence procedures are necessary. In addition, the re-evaluation of existing clients requires concurrence by another audit partner
when certain events or circumstances occur. These events include: a change in majority ownership or management, managements refusal to sign
a representation letter, discovery of fraud or other misrepresentations, a clients unwillingness to pay fees, and regulatory investigations.
Traditionally, audit and tax services have been the core business of the firm. However, for the past five years, JKN management has
not been satisfied with the firms financial results, and its new strategy focuses on non-audit services, primarily management consulting and
personal financial services. Therefore, JKN now promotes itself as a business services firm and as a one-stop shop for its clients business
needs. Recently, the firm formed alliances with other financial services providers around the country and is aggressively promoting its ability to
help with retirement plan administration, insurance, wealth management, and information systems needs for small- and medium-size, closely held
business and their owners.
The Briarwood City Office
The Briarwood City office of JKN is located in the Pacific Northwest and is one of the oldest offices in the firm. Three partners, 30 professional
staff (mostly CPAs), and five administrative staff make up the Briarwood City team. The partners all graduated from highly rated accounting
programs in the U.S. Their areas of specialization/responsibility are as follows:
Andrew (Andy) Stevens: office administration and attest services, including small audits, reviews, and compilations. Andy is very much in tune
with the current JKN strategy and is actively involved in promoting non-audit services and establishing alliances with other professional service
providers. Andy joined the firm 20 years ago and has been a partner for ten years.
Frank Clement: Attest services consisting of large and small audits, reviews, and litigation supporting. Frank also serves as a regional quality
control resource, conducting concurring reviews for other offices and serving four publicly listed clients from Briarwood City. Frank moved to
Briarwood City 18 years ago, after eight years with a national firm in its Chicago office.
Bernard (Bernie) Richards: Tax services. Bernie is known as one of the firms best tax partners. He has excellent corporate and individual client
relationships and is one of the most sought-after instructors at firm-wide training sessions. Bernie has been with the firm for 27 years.
Frank and Bernie are very proud of their long careers as audit and tax partners and the firms rich history providing these services.
However, both men have a number of concerns about the future of the firm. They are not very pleased with the firms new strategy to be a
business services firm. In addition, they are very concerned about living up to the firms responsibilities under the Sarbanes-Oxley Act of 2002.
On the other hand, Andy is trying his best to follow the firm strategy of being a one-stop financial service provider, despite the high chargeable
hour goals and pressure to grow the practice in his respective area. Mark Grumbles, the regional managing partner for JKN, is very supportive of
the firms strategy and frequently reminds everyone about the need to grow the firm and to sell nontraditional services.
Luckily, the Briarwood City office has several very competent audit and tax managers to assist in the administration of client
engagements and to train junior staff members. Stuart Harrison, Paula White, Tom Fitch, and Sue Tracey are very experienced and
knowledgeable managers and have great relationships with the partners and the staff. Stuart is a tax manager and Paula, Tom, and Sue handle the
audit, review, and compilation work. The partners are currently looking to hire at least two more capable managers since everyone is stretched
thin. Grumbles would really like to find someone who is experienced at selling non-audit financial services. An organization chart depicting the
hierarchy for the firm is shown in Figure 1. You should access Data File 5-2 in iLearn for Figure 1, which shows JKNs organization chart.
The Client
Riverside Communications Company (hereafter, RCC) commenced business operations in 1925 as a local exchange telephone service provider in
the southwestern part of the state. In 1958, RCC conducted its initial public offering (IPO), and many local residents in its service area became
shareholders. Later, in 1980, a second public offering was conducted, and subsequently the RCC common stock was listed on NASDAQ. The
primary business of RCC still consists of local exchange (or wireline services) to customers in the southwestern part of the state. However, over
1
Engagement risk is the risk that the audit firm will suffer harm because of a client relationship, even though the audit report issued to the client
was correct.

Financial and Integrated Audits - Frederick Choo

the past ten years, RCC has significantly expanded its local territory. Furthermore, passage of the Telecommunications Act of 1996 (targeted at
increasing competition in the industry) encouraged RCC to increase its coverage area and the services offered to its customers.
Through its various wholly owned subsidiaries and nonconsolidated equity investees, RCC provides the following services: local
telephone service (wireline), cellular and paging communications services (wireless), cable television services, telecommunications equipment
sales, leasing of a fiber-optic cable network and tower space, financing services, and directory assistance services. RCC has a history of
successful operations and has a long history of paying dividends. Financial information for the past five years is presented in Table 1. You
should access Data File 5-2 in iLearn for Table 1, which shows recent financial results for Riverside Communications Company. During
that period, revenues have increased due to RCCs continued growth into new lines of business; at the same time, net income has declined mainly
because of investments required for the startup of these new lines of business.
Key personnel of RCC are as follows:
Warren England, Chief Executive Officer (CEO): Warren is a CPA and has been with RCC for 20 years. He started working at RCC as the Chief
Financial Officer (CFO) after spending 13 years in a national public accounting firm, the last three as a partner.
Larry Cashman, CFO: Larry has an M.B.A. and was hired as the CFO ten years ago. At the time he was hired at RCC, he has over 20 years of
experience as either a controller or a CFO for public companies in other industries.
Greg Lowman , Controller: Greg is a CPA and was hired five years ago from JKN after serving as the audit senior on the account for four years.
Additional information and firm characteristics of RCC may be found in Table 2. You should access Data File 5-2 in iLearn for Table 2, which
shows firm characteristics and selected data for Riverside Communications Company.
History of the Audit-Client Relationship
JKN has been serving the audit and tax needs of RCC since the 1950s when the firm assisted the Company with its IPO. The relationship between
JKN and RCC has been very good over the years. Because of its good reputation in the community and because of the prestige of performing
audit and tax services for this client, JKN has been able to attract other sizable clients, including three other small public companies. One of these
public clients is also a telecommunications company with lines of business similar to RCC. There are no other significant telecommunications
company clients in any office of the firm. Frank Clement has been handling the audit partner responsibilities on RCC for each of the three years,
ending December 31, 2004. Tom Fitch has just completed his second year as the engagement manager.
Total fees from RCC have averaged approximately $250,000 per year for the past three years under a fixedfee arrangement for the
annual and quarterly audit and tax services, exclusive of services required in connection with the attestation reporting on internal controls
beginning in 2004, as required by Section 404 of the Sarbanes-Oxley Act and for which an additional $75,000 was billed. The total RCC fees
represent approximately 4 percent of total fees for the Briarwood City office of JKN, placing RCC in the top five of all clients based on total fees
billed and collected.
Occasionally, Larry Cashman will call with questions about how to handle the accounting entries and reporting for non-routine or
unusual transactions. In these special situations, Frank Clement often consults with Michael Bryan from the headquarters office, who has
performed the concurring review of the RCC audit for the past three years. When Frank submits a bill to the audit committee for these extra
services, a minor argument or negotiation often takes place between Frank and Larry regarding the size of the bill. Larry argues that these
consultations should be covered in the fixed-fee audit as defined in their engagement letter with JKN.
Since RCC has a calendar year, the audit takes place during JKNs busy season (January and February). Although the firm prefers not
to accept work for less than standard rates during this period, an exception is made for this client, whose fees average only 80 percent of standard
rates. One of the main reasons for this exception is that the senior members of the RCC management team are very crafty negotiators. Warren
England and Larry Cashman both realize that RCC is an important client to JKN. Warren, having been a partner in a public accounting firm,
knows how to play the game. Therefore, because of the significant fee and the prestige of having this client, JKN makes an exception to its usual
policy of demanding full rates for busy season work. Staff members enjoy working on this audit even though the timetable for fieldwork is tight
and the hours are long. Working on this engagement presents a great opportunity to learn and the audit is clean because of good internal controls
and the competent management and accounting staff of RCC.
The audit is always on time with no material audit adjustments ever required. Client personnel prepare the annual report to
stockholders and the Form 10-K for filing with the SEC; the JKN staff has no problems with the adequacy or format of disclosures, or referencing
the financial information in their workpapers. A management letter (i.e., a clients advisory comments letter) is prepared each year with
suggestions for improvements in internal controls or for more efficient methods of handling operations. However, no material weakness on
internal controls has ever been reported to management or to the audit committee of the board of directors pursuant to Statement on Auditing
Standards No. 112 (AU 325) Communication of Internal Control Related Matters Identified in an Audit . In addition, the attestation report on
managements assessment of internal controls in 2004, as required by Section 404 of the Sarbanes-Oxley Act, was unqualified.
Frank Clement and Tom Fitch meet with the audit committee twice each year, once before the audit to obtain their input and to discuss
the audit plan, and once after completion of the fieldwork to discuss the audit findings and the clients advisory comments letter. Larry Cashman
and Warren England are especially sensitive to the matters mentioned in the clients advisory comments letter and always insist that they see the
letter before the audit committee meeting. Frank and Tom have no problem with that procedure because they want to be sure that the facts are
correct and that their staff has reported everything correctly. However, sometimes these discussions are difficult. Larry and Warren sometimes
object to certain information in the letter, claiming that the information is not significant enough to be communicated to the audit committee of
the board of directors.

Required
1. JKN has a risk assessment policy on a clients acceptance/continuance decision. This policy requires the assessment of three types of risk:
a. Engagement risk the risk that JKN will suffer harm because of a client relationship, even though the audit report issued to the client was
correct.
b. Business risk the risk that JKN will suffer economic loss due to inappropriate business strategy or other business decisions.
c. Audit risk the risk that JKN may fail to appropriately modify the opinion issued to the client, even though the financial statements are
materially misstated.
Assume you are following JKNs risk assessment policy in making RCCs continuance decision, identify and explain each type of risk involved
based on the information regarding the Briarwood City office and the history of the audit client relationship with RCC. Use the following format
to answer:

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5 Audit Plan - Preplan and Documentation

Type of Risk
a. JKNs engagement risk
b. JKNs business risk
c. JKNs audit risk

1.
2.

1.
2.

1.
2.

Risk Factors Identified

Explain the Risk involved

2. Based on your risk assessment, should JKN continue with this client? Explain why or why not?
In your response, you should consider Section 301 and 407 of the Sarbanes-Oxley Act, NASDAQ rules, and any AICPA guidance that you
believe is relevant. Search the internet for relevant information, for example, websites that offer information on the Sarbanes-Oxley Act of 2002
include:
http://cpcaf.aicpa.org/Resources/Sarbanes+Oxley/
http://www.sarbanes-oxley.com
http://www.theiia.org/iia/guidance/issues/sarbanes-oxley.pdf
http://www.sec.gov/spotlight/sarbanes-oxley.htm

Part 2

Growth Strategy for RCC


It is now Spring 2005, and Frank Clement is presented with a series of transactions contemplated by Larry and Warren. RCCs management is
eager to grow the company into one of the leading providers of wireless communications and Internet services in the North-west. The overall
economy and the stock market have been performing well for the past three years, and RCC stock has been trading at all-time highs, ranging from
$75-$80 per share. Senior management and the board of directors have already met with officials from the investment banking division of Morton
Stosch (hereafter, MS), a very large Wall Street securities firm, and with Whipple Killjoy (hereafter, WK), a large private equity firm from San
Francisco, both of which appear to be excited to be part of an arrangement to grow RCC. The transactions contemplated involve, among other
things, a series of mergers and acquisitions to be financed by various public and private debt and equity offerings. Briefly summarized, these
transactions include:
1. Issue high-yield debt of $550 million. $275 million will be loaned by WK, and the remaining $275 million will be underwritten by MS in a
public offering.
2. Issue $250 million convertible preferred stock. All of this stock will be issued to MS and to WK. In three years, the preferred stock will be
convertible into common stock, and a secondary public offering will likely take place at that time so that the current financiers will be able to
liquidate their investment.
3. Dispose of the directory assistance business for $68 million. Although this business is profitable, it does not fit into the strategic plan as a core
service. RCC has a company that is interested in buying the directory assistance business.
4. Acquire FirstCo, a wireless digital communications company, for $650 million. Since the service area is only about 150 miles from RCC, it
seems to fit with the strategy of expanding the companys wireless footprint. This acquisition will also add 300 employees.
5. Acquire the remaining minority interests in two wireless unconsolidated subsidiaries for $75 million. Currently, RCC is a 25 percent
shareholder in each company and carries these as equity investments. Seven other telecommunications companies own the remaining 75 percent,
with no one company owning more than 15 percent. The plan is to buy out the other seven shareholders.
6. Merge with A&D Telecommunications Company, A&D is a company that is very similar to RCC, but is only about 30 percent of the size of
RCC, based on total revenues. A&D is privately owned by approximately 100 shareholders, mostly members of the Manley family, with Christ
Manley as its CEO. The merger plan is to exchange 40 shares of RCC for each share of A&D. As added inducement for pushing this merger to
the A&D shareholders, RCC is promising to make Chris Manley the Chief Operating Officer (COO) of RCC and to grant him a cash bonus of
$1.2 million if the transaction is approved.
7. Buildout the wireless system. This process requires the purchase of licenses and equipment, as well as the construction of towers.
Warren and Larry explain that RCC is especially ready to take advantage of these ripe times in the telecommunications industry.
The accounting department has assembled projections covering the next five years and, although large losses (as much as $90 million in one year)
are projected in the years 2006-2010, the company expects a profit and positive cash flows in 2010. Borrowings will be sufficient to create cash
reserves in the early periods to meet debt requirements.
Frank Clement sees this project as a tremendous opportunity for the Briarwood office, although it will involve some very difficult
accounting and reporting issues that will include filing several registration statements with the SEC. He will surely need the assistance of Michael
Bryan from the headquarters office. Luckily, most of the immediate work will take place in the summer, which is usually slow; however, this
work might also require individuals to postpone planned vacations. The fees from this type of high-risk work will be billed at premium rates, and
they will provide an opportunity to make up for all those years at 80 percent of standard rates. Therefore, this work for RCC should contribute to
great financial results in 2005 for the Briarwood City office.
The other two partners in the Briarwood office, Andy Stevens and Bernie Richards, are also excited about the opportunity. Mark
Grumbles is delighted. He has been pressuring Frank to sell some of JKNs value-added services, such as wealth management, to the RCC
executives and board members. Grumbles comments that after these transactions take place RCC should be a prime candidate for the firm to
provide other non-audit services. This situation should also help the Briarwood office attract more audit clients.

Required
3. The growth strategy for RCC is very ambitious and aggressive. Identify and explain risk factors associated with RCCs growth strategy in
addition to those that you have identified in Part 1. Use the following format to answer:

Financial and Integrated Audits - Frederick Choo

Risk Factors Associated with RCCs Growth


Strategy
1. RCCs increasing complexity.
2. Relationship with Morton Stosch.
3. Relationship with Whipple Killjoy.
4. The telecommunication industry.
5. The size of RCC with respect to the other clients
in the Briarwood office.
6. The expertise required of the Briarwood office
with respect to RCC merger and acquisitions.
7. Other risk factors

Explain the Risk Involved

4. Based on your risk assessment of RCCs growth strategy and your risk assessment on RCCs acceptance/continuance decision in Part 1, should
JKN continue with this client? Explain why or why not?
In your response, refer to Chapter 3 for a discussion on relevant professional ethics, for example, Rule 101 on independence of the AICPAs
Code of Professional Conduct and the PCOABs Auditor Independence Rules.
Note: You must answer both Parts 1 and 2 to earn the extra credit point.

Simulation Question 5-3


Simulation Question 5-3 is an adaptation with permission from a case by Jones, A. and C. S. Norman in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the
names and places have been changed.

Introduction

The CPA Firm


As of March 2005, Johnson Keith Niemeyer LLP (hereafter, JKN), a large, regional public accounting firm, had offices in 45 U.S. cities in the
West and Midwest, as well as several international affiliations. Firm headquarters are located in the Midwest, and the professional staff at the
headquarters provides outstanding support to the local offices. JKN has a total of 225 partners and approximately 2,000 supporting professionals
and administrative staff. U.S. offices of the firm generally are staffed with 3-10 partners and 20-100 supporting professional accountants and
administrative personnel. The firm provides a full array of audit, tax, and consulting services for its clients; these are mostly privately held,
owner-managed companies with revenues ranging from $1 million to $50 million, although JKN also serves approximately 80 public companies.
JKN has a reputation for being very conservative in its audit practice. Management has been very careful in its client acceptance and
continuance policies. Before submitting proposals to perform audit services, prospective engagement partners must obtain extensive information
about the potential client to make an informed decision about whether to accept or reject the engagement. If the prospective engagement partners
decision were to accept the client; then, at least one additional audit partner must agree with the decision to accept the client. In the course of
evaluating prospective clients, JKN personnel assess their potential exposure from being associated with a particular client or engagement
(engagement risk).2 JKNs acceptance procedures allow the acceptance of high-risk clients only if the risk can be controlled. That is, the
engagement team must have relevant expertise and experience to manage the risk, as well as adequate compensation for the risk assumed.
Potential clients are evaluated for integrity, industry competence, management experience, and financial condition.
If the prospective client is a public company, then additional due diligence procedures are required. These procedures include
evaluating underwriters and legal counsel, performing background checks on members of management and the board of directors, and evaluating
the financial viability of proposed transactions and investor returns. In these situations, JKNs firm policy requires the approval of the partner
responsible for firm-wide audit and accounting policy, as well as the approval of a concurring partner.
Engagement partners re-evaluate existing audit clients on an annual basis to determine whether any events since completion of the last
audit might cause the firm to discontinue its relationship with the client. If an existing client is planning a public offering of its securities, then
additional due diligence procedures are necessary. In addition, the re-evaluation of existing clients requires concurrence by another audit partner
when certain events or circumstances occur. These events include: a change in majority ownership or management, managements refusal to sign
a representation letter, discovery of fraud or other misrepresentations, a clients unwillingness to pay fees, and regulatory investigations.
Traditionally, audit and tax services have been the core business of the firm. However, for the past five years, JKN management has
not been satisfied with the firms financial results, and its new strategy focuses on non-audit services, primarily management consulting and
personal financial services. Therefore, JKN now promotes itself as a business services firm and as a one-stop shop for its clients business
needs. Recently, the firm formed alliances with other financial services providers around the country and is aggressively promoting its ability to
help with retirement plan administration, insurance, wealth management, and information systems needs for small- and medium-size, closely held
business and their owners.
The Briarwood City Office
The Briarwood City office of JKN is located in the Pacific Northwest and is one of the oldest offices in the firm. Three partners, 30 professional
staff (mostly CPAs), and five administrative staff make up the Briarwood City team. The partners all graduated from highly rated accounting
programs in the U.S. Their areas of specialization/responsibility are as follows:
Andrew (Andy) Stevens: office administration and attest services, including small audits, reviews, and compilations. Andy is very much in tune
with the current JKN strategy and is actively involved in promoting non-audit services and establishing alliances with other professional service
providers. Andy joined the firm 20 years ago and has been a partner for ten years.

2
Engagement risk is the risk that the audit firm will suffer harm because of a client relationship, even though the audit report issued to the client
was correct.

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Frank Clement: Attest services consisting of large and small audits, reviews, and litigation supporting. Frank also serves as a regional quality
control resource, conducting concurring reviews for other offices and serving four publicly listed clients from Briarwood City. Frank moved to
Briarwood City 18 years ago, after eight years with a national firm in its Chicago office.
Bernard (Bernie) Richards: Tax services. Bernie is known as one of the firms best tax partners. He has excellent corporate and individual client
relationships and is one of the most sought-after instructors at firm-wide training sessions. Bernie has been with the firm for 27 years.
Frank and Bernie are very proud of their long careers as audit and tax partners and the firms rich history providing these services.
However, both men have a number of concerns about the future of the firm. They are not very pleased with the firms new strategy to be a
business services firm. In addition, they are very concerned about living up to the firms responsibilities under the Sarbanes-Oxley Act of 2002.
On the other hand, Andy is trying his best to follow the firm strategy of being a one-stop financial service provider, despite the high chargeable
hour goals and pressure to grow the practice in his respective area. Mark Grumbles, the regional managing partner for JKN, is very supportive of
the firms strategy and frequently reminds everyone about the need to grow the firm and to sell nontraditional services.
Luckily, the Briarwood City office has several very competent audit and tax managers to assist in the administration of client
engagements and to train junior staff members. Stuart Harrison, Paula White, Tom Fitch, and Sue Tracey are very experienced and
knowledgeable managers and have great relationships with the partners and the staff. Stuart is a tax manager and Paula, Tom, and Sue handle the
audit, review, and compilation work. The partners are currently looking to hire at least two more capable managers since everyone is stretched
thin. Grumbles would really like to find someone who is experienced at selling non-audit financial services. An organization chart depicting the
hierarchy for the firm is shown in Figure 1. You should access Data File 5-2 in iLearn for Figure 1, which shows JKNs organization chart.
The Client
Riverside Communications Company (hereafter, RCC) commenced business operations in 1925 as a local exchange telephone service provider in
the southwestern part of the state. In 1958, RCC conducted its initial public offering (IPO), and many local residents in its service area became
shareholders. Later, in 1980, a second public offering was conducted, and subsequently the RCC common stock was listed on NASDAQ. The
primary business of RCC still consists of local exchange (or wireline services) to customers in the southwestern part of the state. However, over
the past ten years, RCC has significantly expanded its local territory. Furthermore, passage of the Telecommunications Act of 1996 (targeted at
increasing competition in the industry) encouraged RCC to increase its coverage area and the services offered to its customers.
Through its various wholly owned subsidiaries and nonconsolidated equity investees, RCC provides the following services: local
telephone service (wireline), cellular and paging communications services (wireless), cable television services, telecommunications equipment
sales, leasing of a fiber-optic cable network and tower space, financing services, and directory assistance services. RCC has a history of
successful operations and has a long history of paying dividends. Financial information for the past five years is presented in Table 1. You
should access Data File 5-2 in iLearn for Table 1, which shows recent financial results for Riverside Communications Company. During
that period, revenues have increased due to RCCs continued growth into new lines of business; at the same time, net income has declined mainly
because of investments required for the startup of these new lines of business.
Key personnel of RCC are as follows:
Warren England, Chief Executive Officer (CEO): Warren is a CPA and has been with RCC for 20 years. He started working at RCC as the Chief
Financial Officer (CFO) after spending 13 years in a national public accounting firm, the last three as a partner.
Larry Cashman, CFO: Larry has an M.B.A. and was hired as the CFO ten years ago. At the time he was hired at RCC, he has over 20 years of
experience as either a controller or a CFO for public companies in other industries.
Greg Lowman , Controller: Greg is a CPA and was hired five years ago from JKN after serving as the audit senior on the account for four years.
Additional information and firm characteristics of RCC may be found in Table 2. You should access Data File 5-2 in iLearn for Table 2, which
shows firm characteristics and selected data for Riverside Communications Company.
History of the Audit-Client Relationship
JKN has been serving the audit and tax needs of RCC since the 1950s when the firm assisted the Company with its IPO. The relationship between
JKN and RCC has been very good over the years. Because of its good reputation in the community and because of the prestige of performing
audit and tax services for this client, JKN has been able to attract other sizable clients, including three other small public companies. One of these
public clients is also a telecommunications company with lines of business similar to RCC. There are no other significant telecommunications
company clients in any office of the firm. Frank Clement has been handling the audit partner responsibilities on RCC for each of the three years,
ending December 31, 2004. Tom Fitch has just completed his second year as the engagement manager.
Total fees from RCC have averaged approximately $250,000 per year for the past three years under a fixedfee arrangement for the
annual and quarterly audit and tax services, exclusive of services required in connection with the attestation reporting on internal controls
beginning in 2004, as required by Section 404 of the Sarbanes-Oxley Act and for which an additional $75,000 was billed. The total RCC fees
represent approximately 4 percent of total fees for the Briarwood City office of JKN, placing RCC in the top five of all clients based on total fees
billed and collected.
Occasionally, Larry Cashman will call with questions about how to handle the accounting entries and reporting for non-routine or
unusual transactions. In these special situations, Frank Clement often consults with Michael Bryan from the headquarters office, who has
performed the concurring review of the RCC audit for the past three years. When Frank submits a bill to the audit committee for these extra
services, a minor argument or negotiation often takes place between Frank and Larry regarding the size of the bill. Larry argues that these
consultations should be covered in the fixed-fee audit as defined in their engagement letter with JKN.
Since RCC has a calendar year, the audit takes place during JKNs busy season (January and February). Although the firm prefers not
to accept work for less than standard rates during this period, an exception is made for this client, whose fees average only 80 percent of standard
rates. One of the main reasons for this exception is that the senior members of the RCC management team are very crafty negotiators. Warren
England and Larry Cashman both realize that RCC is an important client to JKN. Warren, having been a partner in a public accounting firm,
knows how to play the game. Therefore, because of the significant fee and the prestige of having this client, JKN makes an exception to its usual
policy of demanding full rates for busy season work. Staff members enjoy working on this audit even though the timetable for fieldwork is tight
and the hours are long. Working on this engagement presents a great opportunity to learn and the audit is clean because of good internal controls
and the competent management and accounting staff of RCC.
The audit is always on time with no material audit adjustments ever required. Client personnel prepare the annual report to
stockholders and the Form 10-K for filing with the SEC; the JKN staff has no problems with the adequacy or format of disclosures, or referencing
the financial information in their workpapers. A management letter (i.e., a clients advisory comments letter) is prepared each year with
suggestions for improvements in internal controls or for more efficient methods of handling operations. However, no material weakness on
internal controls has ever been reported to management or to the audit committee of the board of directors pursuant to Statement on Auditing

Financial and Integrated Audits - Frederick Choo

Standards No. 112 (AU 325) Communication of Internal Control Related Matters Identified in an Audit . In addition, the attestation report on
managements assessment of internal controls in 2004, as required by Section 404 of the Sarbanes-Oxley Act, was unqualified.
Frank Clement and Tom Fitch meet with the audit committee twice each year, once before the audit to obtain their input and to discuss
the audit plan, and once after completion of the fieldwork to discuss the audit findings and the clients advisory comments letter. Larry Cashman
and Warren England are especially sensitive to the matters mentioned in the clients advisory comments letter and always insist that they see the
letter before the audit committee meeting. Frank and Tom have no problem with that procedure because they want to be sure that the facts are
correct and that their staff has reported everything correctly. However, sometimes these discussions are difficult. Larry and Warren sometimes
object to certain information in the letter, claiming that the information is not significant enough to be communicated to the audit committee of
the board of directors.
Growth Strategy for RCC
It is now Spring 2005, and Frank Clement is presented with a series of transactions contemplated by Larry and Warren. RCCs management is
eager to grow the company into one of the leading providers of wireless communications and Internet services in the North-west. The overall
economy and the stock market have been performing well for the past three years, and RCC stock has been trading at all-time highs, ranging from
$75-$80 per share. Senior management and the board of directors have already met with officials from the investment banking division of Morton
Stosch (hereafter, MS), a very large Wall Street securities firm, and with Whipple Killjoy (hereafter, WK), a large private equity firm from San
Francisco, both of which appear to be excited to be part of an arrangement to grow RCC. The transactions contemplated involve, among other
things, a series of mergers and acquisitions to be financed by various public and private debt and equity offerings. Briefly summarized, these
transactions include:
1. Issue high-yield debt of $550 million. $275 million will be loaned by WK, and the remaining $275 million will be underwritten by MS in a
public offering.
2. Issue $250 million convertible preferred stock. All of this stock will be issued to MS and to WK. In three years, the preferred stock will be
convertible into common stock, and a secondary public offering will likely take place at that time so that the current financiers will be able to
liquidate their investment.
3. Dispose of the directory assistance business for $68 million. Although this business is profitable, it does not fit into the strategic plan as a core
service. RCC has a company that is interested in buying the directory assistance business.
4. Acquire FirstCo, a wireless digital communications company, for $650 million. Since the service area is only about 150 miles from RCC, it
seems to fit with the strategy of expanding the companys wireless footprint. This acquisition will also add 300 employees.
5. Acquire the remaining minority interests in two wireless unconsolidated subsidiaries for $75 million. Currently, RCC is a 25 percent
shareholder in each company and carries these as equity investments. Seven other telecommunications companies own the remaining 75 percent,
with no one company owning more than 15 percent. The plan is to buy out the other seven shareholders.
6. Merge with A&D Telecommunications Company, A&D is a company that is very similar to RCC, but is only about 30 percent of the size of
RCC, based on total revenues. A&D is privately owned by approximately 100 shareholders, mostly members of the Manley family, with Christ
Manley as its CEO. The merger plan is to exchange 40 shares of RCC for each share of A&D. As added inducement for pushing this merger to
the A&D shareholders, RCC is promising to make Chris Manley the Chief Operating Officer (COO) of RCC and to grant him a cash bonus of
$1.2 million if the transaction is approved.
7. Buildout the wireless system. This process requires the purchase of licenses and equipment, as well as the construction of towers.
Warren and Larry explain that RCC is especially ready to take advantage of these ripe times in the telecommunications industry.
The accounting department has assembled projections covering the next five years and, although large losses (as much as $90 million in one year)
are projected in the years 2006-2010, the company expects a profit and positive cash flows in 2010. Borrowings will be sufficient to create cash
reserves in the early periods to meet debt requirements.
Frank Clement sees this project as a tremendous opportunity for the Briarwood office, although it will involve some very difficult
accounting and reporting issues that will include filing several registration statements with the SEC. He will surely need the assistance of Michael
Bryan from the headquarters office. Luckily, most of the immediate work will take place in the summer, which is usually slow; however, this
work might also require individuals to postpone planned vacations. The fees from this type of high-risk work will be billed at premium rates, and
they will provide an opportunity to make up for all those years at 80 percent of standard rates. Therefore, this work for RCC should contribute to
great financial results in 2005 for the Briarwood City office.
The other two partners in the Briarwood office, Andy Stevens and Bernie Richards, are also excited about the opportunity. Mark
Grumbles is delighted. He has been pressuring Frank to sell some of JKNs value-added services, such as wealth management, to the RCC
executives and board members. Grumbles comments that after these transactions take place RCC should be a prime candidate for the firm to
provide other non-audit services. This situation should also help the Briarwood office attract more audit clients.

Part 1

The Project
The next few months are very busy for Frank, Tom, and several JKN staff people assigned to the project. Feelings in the office are mixed about
the impact of RCC. Everyone wants to be in a successful environment, but not everyone is willing to be challenged by such a large project that
involves overtime hours and postponing vacations. Frank and Tom work very well together and are very keen about the success of this project. In
fact, they want to exceed RCCs expectations.
The project involves many meetings with the executive team from RCC and the underwriters from MS and WK, along with the
professional who represent their interests. Several meetings are held at the MS offices in San Francisco. Since MS is accustomed to working with
very large national accounting firms, they are somewhat skeptical of JKN. However, since JKN has been the independent auditor for RCC during
the years to be reported in the offering statements, no changes are feasible. Nevertheless, MS hires specialists from the mergers and acquisitions
group of a national firm to monitor JKNs work. These specialists are expected to be heavily involved in the preparation of the pro forma
financial information that will be included in the registration statements to be filed with the SEC as part of the planned transactions.
Frank and Tom are challenged like they never have been before. Not only are they involved with the RCC project, but they are also
maintaining other client responsibilities, including a fraud investigation concerning another client with international operations that will require
several trips to Asia in the coming months. Frank and Tom find themselves working weekends and nights and are frequently out of town at
meetings.
Some tricky audit and accounting issues come up for the RCC project, such as business combinations, accounting for intangible assets,
asset impairments, early debt extinguishment, revenue recognition, accounting for derivatives, and issuance of comfort letters to underwriters.
Additionally, Frank and Tom discover that the financial statements of A&D must be restated because of errors in previous years that were not

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detected by the local CPA firm. Nevertheless, they receive help from Michael Bryan when needed, and they get through the project. During the
period from May to November of 2005, RCC files ten Form 8-Ks, a Form S-3, a Form S-4, and two Form 10-Qs with the SEC. All of these steps
require the involvement of JKN. Total billings for the project were approximately $1.2 million, an average of 110 percent of standard rates
because firm policy is to bill high-risk SEC work at a premium.
Tom comments that he got more public company experience during this six-month period than he had in the entire eight years of his
career prior to that time. Frank told the other partners in Briarwood City how lucky he was to have Tom on the project, because Tom really
demonstrated his technical talent while gaining the respect of the other outside professionals on the project. Apparently, Larry Cashman and Greg
Lowman felt the same way. On one occasion during a meeting at RCC, they hinted very strongly to Tom that they would certainly enjoy having
someone with his skills on their team.

Required
1. As the project unfolds, you can see that the client relationship between RCC and JKN is changing in a number of ways. Identify these changes
in the auditor-client relationship and explain what might be Frank Clements concerns for JKN in the next 12-18 months with respect to the RCC
audit? Use the following format to answer:
JKN (Auditor) Client (RCC) Relationship
1. The outside specialists hired by MS on behalf of
RCC.
2. Restatement of the A&Ds financial statements.
3. Billing of the project at 110 percent of standard
rates.
4. Impact of Section 206 of the Sarbanes-Oxley
Act if Tom decided to pursue the invitation to
take a position on the RCC management team.

Frank Clements Concerns in the Next 12-18 months

Part 2

Year-End Audit
In November 2005, when it came time to plan the year-end audit, Larry Cashman asked Frank and Tom to prepare a fee estimate, knowing that
the audit would take on a new dimension because of the recent transactions. Larry also told Frank that RCC would seek proposals from several
national accounting firms.
Frank had already given RCCs expansion some thought, and realized that JKN would probably have to compete with the national
firms for continued business with RCC. However, Frank also had other business concerns. For example, there was the impact of the client on
office attitude and morale. Now, RCC would be the largest and most complex client for the Briarwood City office. No longer would fees
averaging 80 percent of standard rates. Some staff would rather not be involved in such a complex pressure situation. On the other hand, more
ambitious staff would be disappointed if they could not participate in such an important assignment.
Finally, after discussions with Mark Grumbles, Stevens, and Richards, Frank quotes a fee of $750,000 for the 2005 audit and tax
work, including $200,000 applicable to the attestation report on internal controls as required by Section 404 of the Sarbanes-Oxley Act of 2002.
Frank and Tom estimate that this fee will result in 100 percent of standard rates, but they cannot be as sure of themselves as in the past because of
the uncertainty about how the new RCC will function. The proposal is sent to the RCC audit committee; very soon thereafter, Larry calls Frank
and tells him to reduce the quote. Frank agrees to reduce the quote to $700,000, but no more. He believes that 93 percent of standard rates will
still be acceptable, assuming an accurate estimate.
After all the fee quotes are in, which includes JKN and two of the national firms, Frank receives a call from Warren England, the CEO
at RCC, who mentions that he would really like to see JKN continue as auditors, but explains the pressure from the new investors, who have a
representative on the audit committee. Warren also says the JKN quote is substantially higher than the competitors quotes and wants to know if
this quote really reflects bottom-line pricing. Frank is sure that the larger firms are attempting to buy the business, but he also realizes that they
have substantially greater resources and are in a better position to negotiate. Nevertheless, he agrees to reduce the estimate once more, this time to
$650,000.

Required
2 a. Identify some JKNs engagement risks based on the information regarding the Briarwood City office and the history of the audit client
relationship with RCC. Engagement risk is the risk that JKN will suffer harm because of a client relationship, even though the audit report issued
to the client was correct.
2 b. Identify some risk factors associated with RCCs growth strategy
2 c. With respect to the identified JKNs engagement risks in 2 a. and the identified risk factors associated with RCCs growth strategy in 2 b.,
explain any concerns you have regarding the following issues:
1. JKNs willingness to negotiate its fee estimate to RCC.
2. JKNs ability to successfully complete the year-end audit for RCC.
3. JKNs ability to continue with this client.
Use the following format to answer:
Issues
1. JKNs willingness to negotiate its fee estimate to
RCC.
2. JKNs ability to successfully complete the yearend audit for RCC.
3. JKNs ability to continue with this client.

Explain any Concern You Have

Financial and Integrated Audits - Frederick Choo

In your response, refer to Chapter 3 for a discussion on relevant professional ethics, for example, Rule 101 on independence of the AICPAs
Code of Professional Conduct and the PCOABs Auditor Independence Rules.
Note: You must answer both Parts 1 and 2 to earn the extra credit point.

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Financial and Integrated Audits - Frederick Choo

Chapter 6
Audit Plan - Objectives
Chapter Learning Outcomes (LOs) Checklist
After reading this chapter, you should be able to:
LO6-1 Distinguish between overall audit objective and specific audit objectives.
LO6-2 Explain the auditors responsibility to detect and report errors and fraud.
LO6-3 Identify the fraud risk factors (the Fraud Triangle) relating to fraudulent
financial reporting and misappropriation of assets.
LO6-4 Explain the auditors responsibility to detect and report illegal acts.
LO6-5 Discuss specific audit objectives.
LO6-6 Understand the relationships among the five basic categories of management
assertions, the eight categories of specific audit objectives, and the three aspects
of information reflected in the financial statements.

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6 Audit Plan - Objectives

Chapter 6 Audit Plan Objectives


In conducting either a financial audit or an integrated audit, the auditor accomplishes two categories of audit
objectives: an overall audit objective and specific audit objectives. The overall audit objective relates to the auditors
responsibilities for detecting material misstatements, whereas the specific audit objectives relate to the audit
procedures that the auditor uses to detect material misstatements. Figure 6-1 shows the two categories of audit
objectives
Figure 6-1 Two Categories of Audit Objectives
The Audit Process

Audit Plan

Tests of Controls

Tests of Balance

Completing the Audit

Audit Report

Preplan and
Documentation CH 5

Objectives CH 6

Financial Audit

Integrated Audit

Evidence CH 7
a. Form an Audit Opinion
1. Overall Audit Objective
b. Detect and Report Errors and
Fraud

Internal Control CH 8

c. Detect and Report Illegal Act

Materiality and Risk CH 9


2. Specific Audit Objectives

Audit Program CH 10

a. Divide the Financial


Statements into 5 Major
Transaction Cycles
b. Identify 5 Basic Categories of
Management Assertions
within each Transaction Cycle
c. Map the 5 Basic Categories
of Management Assertions
into 8 Types of Specific
Audit Objectives
d. Group the 5 Basic Categories
of Management Assertions
and the 8 Types of Specific
Audit Objectives into 3
Aspects of Information
Reflected in the Financial
Statements

Financial and Integrated Audits - Frederick Choo

Overall Audit Objective


Form an Audit Opinion
AU 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally
Accepted Auditing Standards states:
The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which
they present fairly, in all material respects, financial position, results of operations, and its cash flows in conformity with generally accepted
accounting principles.

In order to accomplish this overall objective, the auditor is responsible for detecting material misstatements
in the financial statements as AU 200 further states
The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial sta tements are free of
material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is
able to obtain reasonable, but not absolute, assurance that material misstatements are detected.

Detecting Errors and Fraud


AU 240 Consideration of Fraud in a Financial Statement Audit defines misstatements into error and fraud, and
provides expanded guidance on the auditors responsibility for fraud detection (also known as fraud audit). Errors
are unintentional misstatements (e.g., mistakes in journal entries) or omissions in financial statements. Fraud, in
contrast, is intentional fraudulent financial misstatement (e.g., falsification of accounts) or omission in financial
statements, and misappropriation of assets (e.g., theft of inventory). As indicated by the definitions, intent is the
primary difference between an error and a fraud. AU 240 requires the auditor to:
Consider the risk of errors and frauds (also known as fraud risks) in an audit plan.
An auditor should consider the risk that errors or frauds may occur while planning an audit engagement. The auditor
should consider the risk factors at both the financial statement level and at the individual account balance or class of
transactions level. The fraud risk factors relating to fraudulent financial reporting is presented in Table 6-1. The
fraud risk factors relating to misappropriation of assets is presented in Table 6-2. For each of these two types of
fraud, the fraud risk factors are further classified based on three characteristics generally present for fraud to occur:
1. Incentives/Pressures Management or other employees have incentives or pressures to commit fraud.
2. Opportunities Circumstances provide opportunities for management or employees to commit fraud.
3. Attitudes/Rationalization An attitude, character, or set of ethical values exist that allow management or
employees to commit a dishonest act or they are in an environment that causes them to rationalize committing a
dishonest act. These three conditions are often referred to as the Fraud Triangle.
The auditor should also consider the risks of material misstatement due to three common fraud conditions
throughout the audit. These common fraud conditions may be identified during fieldwork that change or support a
judgment regarding the assessment of the fraud risks. Table 6-3 presents examples of the three common fraud
conditions that the auditor should consider throughout the audit.
Increase emphasis on professional skepticism.
Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence.
Putting aside any prior beliefs as to management's honesty, members of the audit team must exchange ideas or
brainstorm how frauds could occur. These discussions are intended to identify fraud risks and should be conducted
while keeping in mind the characteristics that are present when frauds occur: incentives, opportunities, and ability to
rationalize. Throughout the audit, the engagement team should think about and explore the question, "If someone
wanted to perpetrate a fraud, how would it be done?" From these discussions, the engagement team should be in a
better position to design audit tests responsive to the risks of fraud.
Discuss fraud with management.
The engagement team is expected to inquire of management and others in the organization as to the risk of fraud and
whether they are aware of any frauds. The auditors should make a point of talking to employees in and outside
management. Giving employees and others the opportunity to "blow the whistle" may encourage someone to step
forward. It might also help deter others from committing fraud if they are concerned that a co-worker will turn them
in.
Perform unpredictable audit test.

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During an audit, the engagement team should test areas, locations and accounts that otherwise might not be tested.
The team should design tests that would be unpredictable and unexpected by the client.
Respond to management override of controls.
Because management is often in a position to override controls in order to commit financial-statement fraud, the
standard includes procedures to test for management override of controls on every audit. Three fraud testing
procedures that the auditor must perform in every audit are briefly described in Table 6-4.
AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate
fraud audit into the audit of financial statements. Typically, this 10-step fraud audit is to be integrated as an ongoing
audit process throughout the audit of financial statements as follows:
1. Understand the nature of fraud and the manner in which fraud may be committed at the audit preplan.
2. Develop and maintain professional skepticism throughout the audit process.
3. Brainstorm and share knowledge of fraud with other audit team members at the audit preplan and throughout the
audit process.
4. Obtain information useful in identifying and assessing fraud risks at the audit plan.
5. Identify specific fraud risk factors at the audit plan (see Table 6-1 and Table 6-2).
6. Evaluate the effectiveness of clients internal control against the specific fraud risk factors at the audit plan and
tests of controls (TOC).
7. Perform and adjust audit procedures relating to the specific fraud risk factors at the tests of controls (TOC) and
tests of balances (TOB) (see Table 6-4).
8. Evaluate evidence and consider common fraud conditions and determine whether fraud specialists are needed to
complete the fraud audit at the completing the audit (CTA) (see Table 6-3).
9. Communicate and report fraud to management, audit committee, and the board of directors at the audit report (see
Table 6-5).
10. Document Step 1 through to Step 10 above throughout the audit process.
Finally, it should be noted that AU 240 states that even a properly planned and performed audit may not
detect a material misstatement resulting from fraud because of 1. The concealment aspect of fraudulent activity such
as fraud often involves collusion or falsified documents and 2. The need to apply professional judgment in the
identification of evaluation of fraud risk factors and other conditions.
Table 6-1 Fraud Risk Factors Relating to Misstatement Arising from Fraudulent Financial Reporting
Fraud Risk Factors for Fraudulent Financial Reporting
Incentives/Pressures

(1) Financial stability or profitability is threatened by economic, industry, or client operating conditions, such as:
High degree of competition or market saturation, accompanied by declining margins.
High vulnerability to rapid changes, such as changes in technology, product obsolescence, or interest rates.
Significant decline in customer demand and increasing business failures in either the industry or overall economy.
Operating losses making the treat of bankruptcy, foreclosure, or hostile takeover imminent.

Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and
earnings growth.

Rapid growth or unusual profitability especially compared to that of other companies in the same industry.
New accounting, statutory, or regulatory requirements.

(2) Excessive pressure exists for management to meet the requirements or expectations of third parties due to the following:
Profitability or trend level expectations of investment analysts, institutional investors, significant creditors, or other external parties,
including expectations created by management in, for example, overly optimistic press releases or annual report messages.

Need to obtain additional debt or equity financing to stay competitive including financing of major research and development or capital
expenditures.

Marginal ability to meet exchange listing requirements or debt repayment or other debt covenant requirements.

Perceived or real adverse effects of reporting poor financial results on significant pending transactions, such as business combinations or
contract awards.

(3) Information available indicates that management or the board of directors personal financial situation is threatened by the entitys financial
performance arising from the following:

Financial and Integrated Audits - Frederick Choo

Fraud Risk Factors for Fraudulent Financial Reporting


Significant financial interests in the entity.

Significant portions of their compensation (e.g., bonuses, stock options, and earn-out arrangements) being contingent upon achieving
aggressive targets for stock price, operating results, financial position, or cash flow.

Personal guarantees of debts of the entity.

(4) There is excessive pressure on management or operating personnel to meet financial targets set up by the board of directors or management,
including sales or profitability incentive goals.

Opportunities
(1) The nature of the industry or the clients operations provides opportunities to engage in fraudulent financial reporting that can arise from the
following:

Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm.

A strong financial presence or ability to dominate a certain industry sector that allows the entity to dictate terms or conditions to suppliers
or customers that may result in inappropriate or non-arms length transactions.

Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult
to corroborate.

Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult substance over form
questions.

Significant operations located or conducted across international borders in jurisdictions where differing business environments and
cultures exist.

Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for which there appears to be no clear business
justification.

(2) There is ineffective monitoring of management as a result of the following:

Domination of management by a single person or small group without compensating controls.


Ineffective board of directors or audit committee oversight over the financial reporting process and internal control.

(3) There is a complex or unstable organizational structure, as evidenced by the following:

Difficulty in determining the organization or individuals who have controlling interest in the entity.
Overly complex organizational structure involving unusual legal entities or managerial lines of authority.
High turnover of senior management, counsel, or board members.

(4) Internal control components are deficient as a result of the following:


Inadequate monitoring of controls, including automated controls and controls over interim financial reporting.
High turnover rates or employment of ineffective accounting, internal audit, or information technology staff.
Ineffective accounting and information systems, including situations involving material weaknesses.

Attitudes/Rationalizations
Risk factors reflective of attitudes/rationalizations by board members, management, or employees that allow them to engage in and/or justify
fraudulent financial reporting may not be susceptible to observation by the auditor. Nevertheless, the auditor who becomes aware of the existence
of such information should consider it in identifying the risks of material misstatement arising from fraudulent financial reporting. For example,
auditors may become aware of the following information that may indicate a risk factor:

Ineffective communication, implementation, support, or enforcement of the clients values or ethical standards by management or the
communication of inappropriate values or ethical standards.

Nonfinancial managements excessive participation in or preoccupation with the selection of accounting principles or the determination
of significant estimates.

Known history of violations of securities laws or other laws and regulations, or claims against the client, its senior management, or board
members alleging fraud or violations of laws and regulations.

Excessive interest by management in maintaining or increasing the entitys stock price or earnings trend.
A practice by management of committing to analysts, creditors, and other third parties to achieve aggressive or unrealistic forecasts.
Management failing to correct known material weaknesses on a timely basis.
An interest by management in employing inappropriate means to minimize reported earnings for tax-motivated reasons.
Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality.

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Fraud Risk Factors for Fraudulent Financial Reporting


The relationship between management and the current or predecessor auditor is strained, as exhibited by the following:
(1) Frequent disputes with the current or predecessor auditor on accounting, auditing, or reporting matters.
(2) Unreasonable demands on the auditor, such as unreasonable time constraints regarding the completion of the audit or the issuance of
the auditors report.
(3) Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate
effectively with the board of directors or audit committee.
(4) Domineering management behavior in dealing with the auditor, especially involving attempts to influence the scope of the auditors
work or the selection or continuance of personnel assigned to or consulted on the audit engagement.

Source: AU 240

Table 6-2 Fraud Risk Factors Relating to Misstatements Arising from Misappropriation of Assets
Fraud Risk Factors for Misappropriation of Assets
Incentives/Pressures
(1) Personal financial obligations may create pressure on management or employees with access to cash or other assets susceptible to theft to
misappropriate those assets.
(2) Adverse relationships between the entity and employees with access to cash or other assets susceptible to theft may motivate those employees
to misappropriate those assets. For example, adverse relationships may be created by the following:

Known or anticipated future employee layoffs.


Recent or anticipated changes to employee compensation or benefit plans.
Promotions, compensation, or other rewards inconsistent with expectations.

Opportunities
(1) Certain characteristics or circumstances may increase the susceptibility of assets to misappropriation. For example, opportunities to
misappropriate assets increase when there are the following:

Large amounts of cash on hand or processed.


Inventory items that are small in size, of high value, or in high demand.
Easily convertible assets, such as bearer bonds, diamonds, or computer chips.
Fixed assets that are small in size, marketable, or lacking observable identification of ownership.

(2) Inadequate internal control over assets may increase the susceptibility of misappropriation over those assets. For example, misappropriation
of assets may occur because there is the following:

Inadequate segregation of duties or independent checks.

Inadequate management oversight of employees responsible for assets, for example, inadequate supervision or monitoring of remote
locations.

Inadequate job applicant screening of employees with access to assets.


Inadequate record keeping with respect to assets.
Inadequate system of authorization and approval of transactions, for example, in purchasing.
Inadequate physical safeguards over cash, investments, inventory, or fixed assets.
Lack of complete and timely reconciliations of assets.
Lack of timely and appropriate documentation of transactions, for example, credits for merchandise returns.
Lack of mandatory vacations for employees performing key control functions.

Inadequate management understanding of information technology, which enables information technology employees to perpetrate a
misappropriation.

Inadequate access of controls over automated records, including controls over and review of computer systems event logs.

Attitudes/Rationalizations
Risk factors reflective of employee attitudes/rationalizations that allow them to justify misappropriations of assets, are generally not susceptible
to observation by the auditor. Nevertheless, the auditor who becomes aware of the existence of such information should consider it in identifying
the risks of material misstatement arising from misappropriation of assets. For example, auditors may become aware of the following attitudes or
behavior of employees who have access to assets susceptible to misappropriation:

Disregard for the need for monitoring or reducing risks related to misappropriations of assets.
Disregard for internal control over misappropriation of assets by overriding existing controls or by failing to correct known internal

Financial and Integrated Audits - Frederick Choo

Fraud Risk Factors for Misappropriation of Assets

control deficiencies.
Behavior indicating displeasure or dissatisfaction with the company or its treatment of the employee.
Changes in behavior or lifestyle that may indicate assets have been misappropriated.

Source: AU 240

Table 6-3 Examples of the Three Common Fraud Conditions the Auditor Should Consider Throughout the
Audit

Common Fraud Conditions

Discrepancies in the accounting


records.

Conflicting or missing evidential


matter.

Problematic
or
unusual
relationships between the auditor and
management.

Examples
(1) Transactions that are not recorded in a complete or timely manner.
(2) Transactions that are improperly recorded as to amount, accounting period, or classification.
(3) Unsupported or unauthorized balances or transactions.
(4) Last-minute adjustments that significantly affect financial results.
(5) Evidence of employees access to systems and records inconsistent with their authorized duties.
(6) Tips or complaints to the auditor about alleged fraud.
(1) Missing documents.
(2) Documents that appear to have been altered.
(3) Photocopied or electronically transmitted documents when original documents are expected.
(4) Significant unexplained items on reconciliations.
(5) Inconsistent, vague, or implausible responses from management or employee to inquiries.
(6) Unusual discrepancies between the clients records and confirmation replies.
(7) Missing inventory or physical assets of significant magnitude.
(8) Unavailable or missing electronic evidence inconsistent with the record retention policies.
(9) No record of key systems development, program changes, and implementations.
(1) Denial of access to records, facilities, certain employees, customers, vendors, or others.
(2) Undue time pressure imposed by management to resolve complex or contentious issues.
(3) Complaints by management about the conduct of the audit.
(4) Management intimidation of audit team members in resolution of disagreements.
(5) Unusual delays by the management in providing requested information.
(6) Unwillingness to facilitate auditors testing using computer-assisted audit techniques (CAATs).
(7) Denial of access to key IT operations staff and facilities.
(8) Unwillingness to add or revise disclosures in the financial statements.

Table 6-4 Three Fraud Testing Procedures the Auditor Must Perform to Test for Management Override of
Controls on Every Audit

Procedure

Examine journal entries and other


adjustments for evidence of possible
misstatements due to fraud.

Review accounting estimates for


biases that could result in material
misstatement due to fraud.

Evaluate the business rationale for


significant unusual transactions.

Brief Description
Fraud often involves the recording of inappropriate or unauthorized journal entries even when
there are effective internal controls in place. The auditor is required to:
(1) Obtain an understanding of the clients financial reporting process and the controls over journal
entries and other adjustments.
(2) Identify and select journal entries and other adjustments for testing.
(3) Determining the timing of the testing.
(4) Inquire of individuals involved in the financial reporting process about inappropriate or
unusual activity in processing journal entries and other adjustments.
Fraudulent financial reporting is often accomplished through intentional misstatement of
accounting estimates. The auditor is required to:
(1) Consider the potential for management bias when reviewing current year estimates.
(2) Perform a retrospective review of prior year estimates to identify any changes in the
managements judgments and assumptions that might indicate a potential bias.
(3) Evaluate whether circumstances producing bias estimates represent a risk of a material
misstatement due to fraud.
The auditor should gain an understanding of the clients rational for significant unusual
transactions that suggest fraudulent financial reporting or misappropriation of assets. The auditor is
required to consider whether:
(1) The form of such transactions is overly complex.
(2) Management has discussed the nature of and accounting for such transactions with the audit
committee.
(3) Management is placing more emphasis on the need for a particular accounting treatment (i.e.,
its form) than on the underlying economics of the transaction (i.e., its substance).
(4) Transactions that involve unconsolidated related parties, including special purpose entities,
have been properly reviewed and approved by the audit committee.
(5) Transactions involve previously unidentified related parties that do not have the substance or
the financial strength without assistance from the client.

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Reporting Errors and Fraud


Errors detected by the auditor should be corrected through journal entries, whereas frauds detected by the auditor, in
contrast, should be handled as shown in Table 6-5.
Table 6-5 Auditor's Reporting of Fraud
Condition
(1) The auditor determines that
has no material effect on the
statements.
(2) The auditor determines that
has material effect on the
statements.

Reporting Requirement
the fraud
financial
the fraud
financial

(3) The auditor is precluded


investigating the effect of the fraud.

from

The auditor should:


(a) Refer the fraud to a level of management that is at least one level above those involved.
(b) Be satisfied that the fraud has no implications for other parts of the audit.
The auditor should:
(a) Insist that the financial statements be revised. If management agrees, should issue an
unqualified opinion. If management refuses, should issue a qualified or an adverse opinion.
(b) Report the fraud to the board of directors or the audit committee.
The auditor should:
(a) Issue a qualified opinion or disclaimer on the basis of a scope limitation.
(b) Report the matter to the board of directors or the audit committee

Detecting Illegal Acts


An auditor's professional responsibility to illegal acts by clients first surfaced in the late 1970s, after Congress
passed the Foreign Corrupt Practices Act of 1977. This Act requires public companies to refrain from making bribes
to foreign governments and to maintain adequate internal control to prevent bribes from occurring. Arguing that
auditors generally lack the expertise in detecting illegal acts, the AICPA issued AU 328 Illegal Acts by Clients,
which stated that the auditors have no responsibility for detecting illegal acts committed by their clients. They are
only responsible for reporting suspected illegal acts to the appropriate authorities of their clients.
In 1988, the AICPA issued AU 317 Illegal Acts by Clients, which superseded AU 328. AU 317 defines
illegal acts by clients as violations of laws or governmental regulations. It also expands and clarifies an auditors
responsibility to illegal acts by clients. Recently, under the Auditing Standards Boards Clarity Project, this
standard is now known as AU 250 Considerations of Laws and Regulations in an Audit of Financial Statements ,
which requires the auditor to detect two different types of illegal acts committed by clients:
1. Illegal acts with direct effects on the financial statements.
These are material illegal acts relating to laws and governmental regulations that have a direct effect on the financial
statements, for example, whether a provision for income taxes has been properly reflected in the financial statements
in conformity with the IRS. Here, the auditor has the responsibility to design the audit to provide reasonable
assurance of detecting such illegal acts. In other words, the responsibility to detect illegal acts that have a direct
effect on the financial statements is the same as the responsibility to detect errors and frauds.
2. Illegal acts with indirect effects on the financial statements.
These are material illegal acts relating to laws and governmental regulations that have only an indirect effect on the
financial statements, for example, activities that violate regulations under the Food and Drug Administration (FDA),
environmental protection agencies and equal employment opportunity agencies. These activities should be accrued
or disclosed as contingent liability in the financial statements. However, the auditor may not be aware of such illegal
acts unless s/he is informed about them. An example is insider trading. While the direct effects of the purchase or
sale of securities may be disclosed, their indirect effect, the possible contingent liability for violating securities laws,
may not be disclosed. If the auditor is informed or aware of illegal acts that indirectly affect the financial statements,
s/he has the responsibility to apply audit procedures specifically directed to ascertaining the probability of such
illegal acts as follows:
When there is no suspicion (no probability) of illegal acts.
The auditor should inquire of management concerning: 1. the client's compliance with laws and regulations, 2. the
client's policies that may prevent illegal acts, and 3. directives issued by the client and periodic representations
obtained by the client concerning compliance with laws and regulations. The auditor should also request a written
representation from the client's management (also known as a client's representation letter) stating that no violation
or possible violation of laws or regulations has occurred that need to be disclosed or accrued (i.e., provision for
contingency).

Financial and Integrated Audits - Frederick Choo

When there is suspicion (probability) of illegal acts.


The auditor should 1. Inquire of management at a level above the persons involved to obtain information on the
nature of the acts and the circumstances surrounding the acts. 2. Consult with the client's legal counsel or other
specialists about applications of law and possible effects of the act on the financial statements. 3. Perform additional
audit procedures as necessary to obtain a further understanding of the nature of the acts such as a. Examine
supporting documentation and compare with accounting records, b. Confirm information with third parties, c.
determine if the transaction has been properly authorized, and d. Consider whether similar transactions have
occurred and perform procedures to identify them.
Finally, it should be noted that AU 250 requires the auditor to provide reasonable assurance that direct
effect illegal acts are detected (the same reasonable assurance that error and frauds are detected), but it has no such
requirement for indirect effect illegal acts.
Reporting Illegal Acts
The auditor is responsible to communicate and report illegal acts as follows:
Communication
The auditor should inform the audit committee or any other group inside the client having equivalent authority about
the illegal acts. The communication may be oral or written. If oral, the auditor should document it. Moreover, if it
is necessary to disclose the illegal acts to outside parties such as the SEC, a successor auditor or a subpoena issued
by a court, the auditor should seek legal advice.
Reporting
The auditor must report illegal acts by clients whether the illegal acts have material direct or indirect effects on the
clients' financial statements. The reporting requirements are as shown in Table 6-4 below:
TABLE 6-4 Auditors' Reporting of Illegal Acts
Illegal Acts
(1) Material illegal acts are not accrued for or disclosed by the client.
(2) The auditor is prevented by the client from obtaining sufficient appropriate evidence
concerning the illegal acts.
(3) The auditor is not prevented by the client but is unable to obtain sufficient
appropriate evidence concerning the illegal acts.
(4) The client refuses to accept the qualified, adverse, or disclaimer opinion issued by
the auditor concerning the illegal acts.

Reporting Requirement
Issue a qualified or an adverse opinion depending on
the extent of materiality.
Issue a disclaimer opinion.
Issue a qualified opinion.
Contact the audit committee
withdrawing from the engagement.

and

consider

Specific Audit Objectives


In conducting either a financial audit or an integrated audit, the auditor accomplishes specific audit objectives in
four distinctive steps:
1. Divide the financial statements into five major transaction cycles.
2. Identify five basic categories of management assertions within each transaction cycle.
3. Map the five basic categories of management assertions into eight specific audit objectives.
4. Groups the five basic categories of management assertions and the eight specific audit objectives into three
aspects of information reflected in the financial statements.
Divide the Financial Statements into Five Major Transaction Cycles
In a typical financial statement audit, a client's financial statements are divided into smaller segments. The division
makes the audit more manageable and facilitates the assignment of members of the audit team to each segment. A
conventional way to segment the financial statements is to keep closely related types of transactions and account
balances in the same segment, also known as the Transaction Cycle Approach. An example of the transaction cycles
approach is to group related class of transactions, such as sales and sales returns, and account balances, such as
accounts receivable and cash in bank, in the trial balance to a revenue cycle.
A client's financial statements are usually divided into the following five interrelated transaction cycles:

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6 Audit Plan - Objectives

1. Capital cycle. A client begins by obtaining capital, usually in the form of cash which links the capital cycle to the
general cash.
2. Expenditure cycle. Cash is used to purchase raw materials to produce goods and services which link the general
cash to the expenditure cycle.
3. Payroll cycle. Cash is also used to hire labor and administrative personnel which link the general cash to the
payroll cycle.
4. Inventory cycle. The combined output of the expenditure and payroll cycles is the input to the inventory cycle.
The inventory is subsequently sold and the billings and collection activities link the inventory cycle to the revenue
cycle.
5. Revenue cycle. The cash generated in the revenue cycle is used to pay dividends and interest in the capital cycle
and to restart the cycles again.
General cash and investments are usually not stand alone transaction cycles. They are usually audited as
part of the above five transaction cycles.
Identify Five Basic Categories of Management Assertions within each Transaction Cycle
Assertions are explicit and implicit representations by management that are embodied in financial statements. Much
of an auditor's work during a financial audit or an integrated audit is to attest these financial statement assertions
made by the management. AU 500 Audit Evidence and AS 15 Audit Evidence identify five basic categories of
implicit or explicit assertions made by the management:
1. Existence or Occurrence. Implicit or explicit assertion made by the management that asset and liability balances
stated in the balance sheet actually exist at the balance sheet date and that revenue and expense transactions stated in
the income statement actually occurred during the accounting period. For example, management asserts that
inventories in the balance sheet actually exist at balance date and that sales in the income statement actually
occurred during the accounting period.
2. Completeness. Implicit or explicit assertion made by the management that all accounting transactions and
balances that should have been recorded in the financial statements have been recorded. For example, management
asserts that there are no unrecorded inventories and that all sales occurred are included in the income statement.
3. Rights and Obligations. Implicit or explicit assertion made by the management that assets stated in the financial
statements are actually owned by the client and liabilities stated in the financial statements are actually owed by the
client. For example, management asserts that inventories are owned by the company and that accounts payable are
owed to other parties.
4. Valuation and Allocation. Implicit or explicit assertion made by the management that asset and liability balances
stated in the balance sheet, and revenue and expenses transactions stated in the income statement have all been
recorded in the financial statement at the appropriate amount. For example, management asserts that inventories are
valued at the lower of cost or market and that depreciation is made to plant and equipment in the appropriate
amount.
5. Presentation and Disclosure. Implicit or explicit assertion made by the management that all components of the
financial statements are properly classified, described, and disclosed in conformity with GAAP. For example,
management asserts that amounts presented as extraordinary items in the income statement are properly classified
and described.
The auditor identifies the above five basic categories of implicit or explicit assertions for each account
within a particular transaction cycle.
Map the Five Basic Categories of Management Assertions into Eight Types of Specific Audit Objectives
The auditor maps the management's assertions that have been identified into specific audit objectives. These specific
audit objectives are almost identical to the management's financial statement assertions because the auditor's work is
to attest these financial statement assertions made by the management. The reasons that specific audit objectives and
management assertions are not identical are management's assertions are not always those of the auditor and the
auditor needs additional guidance (specific audit objectives) in considering the client's internal control and in
accumulating sufficient appropriate evidence required by the Performance category of the AICPAs four
fundamental principles underlying an audit.
The eight types of specific audit objectives are:
1. Validity. The specific objective of verifying that the financial items included in the financial statements should
actually be included.

Financial and Integrated Audits - Frederick Choo

2. Completeness. The specific objective of verifying that the financial items that should be included in the financial
statements have actually been included.
3. Ownership. The specific objective of verifying that assets included in the financial statements are indeed owned
by the client.
4. Valuation. The specific objective of verifying that financial items included in the financial statements are properly
valued.
5. Classification. The specific objective of verifying that financial items have been properly classified in the
financial statements.
6. Cutoff. The specific objective of verifying that transactions occurring near the balance sheet date have been
recorded in the proper accounting period.
7. Accuracy. The specific objective of verifying that account balances agree with related subsidiary ledger amounts
and the total in the general ledger.
8. Disclosure. The specific objective of verifying that financial items are properly presented in the financial
statements and the related disclosures are clearly expressed.
The five basic categories of management assertions are mapped into the eight types of specific audit
objectives as follows:
Management Assertions
1. Existence or Occurrence
2. Completeness
3. Rights and Obligations
4. Valuation or Allocation

5. Presentation and Disclosure

Specific Audit Objectives


1. Validity (change to Existence or Occurrence)
2. Completeness
3. Ownership (change to Rights and Obligations)
4. Valuation (change to Valuation and Allocation)
5. Classification
6. Cutoff
7. Accuracy
8. Disclosure (change to Understandability)

Group the Five Basic Categories of Management Assertions and the Eight Types of Specific Audit Objectives
into Three Aspects of Information Reflected in the Financial Statements
In 2006, consistent with international auditing standards (ISAs), AU 500 Audit Evidence groups the five basic
categories of management assertions and the eight types of specific audit objectives into three aspects of information
reflected in the financial statements as follows:
1. Transaction-related information. Assertions (objectives) about classes of transactions and events during the period
under audit.
2. Balance-related information. Assertions (objectives) about account balances at period end.
3. Presentation-related information. Assertions (objectives) about presentation and disclosure.
Under these three aspects of information, the specific audit objectives of validity is now changed to
existence or occurrence; ownership to rights and obligations; valuation to valuation and allocation, and
disclosure to understandability. The eight types of specific audit objectives are now defined as follows:
1. Existence the specific audit objective of verifying that all assets, liabilities, and equity interests included in the
financial statements actually exist at the date of the financial statements.
Occurrence the specific audit objective of verifying that all transactions and events that have been recorded have
occurred, disclosed, and pertain to the client.
2. Completeness the specific audit objective of verifying that all transactions and events, assets, liabilities, and
equity interests that should have been recorded and included in the financial statements have been recorded and
included.
3. Rights and Obligations the specific audit objective of verifying that the client holds or controls the rights to
assets and that liabilities are the obligation of the client.
4. Valuation and Allocation the specific audit objective of verifying that all assets, liabilities, and equity interests
are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments
are recorded appropriately.
5. Classification the specific audit objective of verifying that all transactions and events have been recorded in the
proper accounts and that financial and other information is presented and described appropriately.
6. Cutoff the specific audit objective of verifying that all transactions and events have been recorded in the correct
accounting period.

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7. Accuracy the specific audit objective of verifying that amounts and other data relating to recorded transactions
and events have been recorded appropriately and that financial and other information are disclosed fairly.
8. Understandability the specific audit objective of verifying that financial and other information in disclosures are
expressed clearly.
Table 6-5 describes the five management assertions and the eight specific audit objectives grouped into the
three aspects of information reflected in the financial statements.
Table 6-5 Management Assertions and Specific Audit Objectives Grouped into Three Aspects of Information
Reflected in the Financial Statements
1. Transaction-Related
Information
Assertions (Objectives) about Classes
of Transactions and Events during the
Period under Audit

Occurrence
Transactions and events that have been
recorded have occurred and pertain to the
client.
Completeness
All transactions and events that should
have been recorded have been recorded.
Accuracy
Amounts and other data relating to
recorded transactions and events have
been recorded appropriately.

2. Balance-Related Information
Assertions
(Objectives)
about
Account Balances at Period End

Existence
Assets, liabilities, and equity interests
exist.
Completeness
All assets, liabilities, and equity
interests that should have been recorded
have been recorded.
Valuation and Allocation
Assets, liabilities, and equity interests
are included in the financial statements
at appropriate amounts and any
resulting valuation or allocation
adjustments are recorded appropriately.

Classification
Transactions and events have been
recorded in the proper accounts.
Cutoff
Transactions and events have been
recorded in the correct accounting period.

3. Presentation-Related
Information
Assertions
(Objectives)
about
Presentation and Disclosure

Occurrence
Disclosed events and transactions have
occurred.
Completeness
All disclosures that should have been
included in the financial statements
have been included.
Accuracy and Valuation
Financial and other information are
disclosed fairly and at appropriate
amounts.

Classification and Understandability


Financial and other information is
presented and described appropriately,
and disclosures are expressed clearly.

Rights and Obligations


The client holds or controls the rights to
assets, and liabilities are the obligation
of the client.

An Audit Program for Transaction-, Balance-, and Presentation-Related Information


Following a certain audit test methodology, auditors develop an audit program (to be discussed in Chapter 10) that
contains all the audit procedures they would use to test the three aspects (transaction-, balance-, and presentationrelated) of information reflected in the financial statements. For example, an audit program may prescribe audit
procedures for transaction-related information such as transactions relating to inventory actual occurred (i.e.,
occurrence), that they are completed (i.e., completeness or no valid transactions were left out), that they are
classified properly (i.e., classification, e.g., as an asset rather than an expense), and that they are recorded accurately
(i.e., accuracy) and in the correct period (i.e., cutoff). Similarly, the audit program may prescribe audit procedures
for balance-related information such as inventory represented in the inventory account balance exists (i.e. existence),
the client owns (i.e., rights and obligations) the inventory, that the balance is complete (i.e., completeness), and that
the inventory is properly valued (i.e., valuation and allocation). Finally, the audit program may prescribe audit
procedures for presentation-related information such as the financial statements properly classify and present (i.e.,
classification) the inventory (e.g., inventory is appropriately presented as a current asset on the balance sheet) and
that all required disclosures (i.e., understandability) having to do with inventory (e.g., footnote indicating that the
client uses the LIFO inventory method) are complete (i.e., completeness), accurate (i.e., accuracy), and
understandable (i.e., understandability).

Financial and Integrated Audits - Frederick Choo

Finally, it should be noted that:


1. Auditors in practice may use different terms to express the management assertions and specified audit objectives
as long as all the three aspects of information (i.e., transaction-, balance, and presentation-related) in Table 6-7 are
addressed by prescribing the appropriate audit procedures.
2. There are overlaps among some of the transaction-related and balance-related information. For example:
a. If some sales were recorded in the current year that should have been recorded in the subsequent year (i.e.
transaction-related cutoff), the related accounts receivable do not exist at the balance sheet date (i.e., balance-related
existence).
b. If some sales that took place in the current year were not recorded until the subsequent year (i.e., transactionrelated cutoff), current year sales and accounts receivable are not complete (i.e., balance-related completeness).
c. If some expenses are inappropriately capitalized (i.e., transaction-related classification), the related expenses are
not complete (i.e. transaction-related completeness) and the related assets for not exist ( i.e., balance-related
existence).
3. Although all balance-related assertions (objectives) apply to nearly every account, not every assertion (objective)
is equally important for each account. Recognizing the assertions (objectives) that deserve the most emphasis
depends on an understanding of the clients business and of the particular type of account being audited. For
example, auditors typically consider the completeness assertion (objective) to be the most important assertion
(objective) for liability accounts for two reasons. First, when all obligations are not properly included in the liability
account, the result is an understatement of liabilities and often an overstatement of net income. Second, management
is more likely to have an incentive to understate a liability than to overstate it.

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Multiple-Choice Questions
6-1

Which of the following statements is true?


a. The auditor is responsible to search for errors and frauds.
b. The auditor is responsible to provide complete assurance of detecting errors and fraud.
c. The auditor is not responsible for detecting errors and frauds.
d. The auditor is responsible to provide reasonable assurance of detecting errors and fraud.

6-2

When an auditor is informed or aware of illegal acts that indirectly affect the client's financial statements, the auditor has the
responsibility to
a. design the audit to provide reasonable assurance of detecting such illegal acts.
b. apply audit procedures specifically directed to ascertaining the probability that such illegal acts have occurred.
c. design the audit to provide complete assurance of detecting such illegal acts.
d. apply specific audit procedures that will ferret out such illegal acts.

6-3

Implicit or explicit assertion made by the management that asset and liability balances stated in the balance sheet actually exist at the
balance sheet date and that revenue and expense transactions stated in the income statement actually occurred during the accounting
period is classified as
a. valuation and allocation assertion.
b. rights and obligation assertion.
c. completeness assertion.
d. existence or occurrence assertion.

6-4

Confirmation of accounts receivable by the auditor is


a. a test of control.
b. a test of transaction.
c. a test of balance.
d. a test of control and transaction.

6-5

Which of the following confirmations is least likely used by an auditor in connection with the tests of balances?
a. Bond trustees on bond payable.
b. Customers on accounts receivable balances.
c. IRS on refundable income taxes.
d. Suppliers on accounts payable balances.

6-6

Which of the following factors is most important concerning an auditors responsibility to detect errors and frauds?
a. The susceptibility of the accounting records to intentional manipulations, alterations, and the misapplication of
accounting principles.
b. The probability that unreasonable accounting estimates result from unintentional bias or intentional attempts to misstate
the financial statements.
c. The possibility that management fraud, defalcations, and the misappropriation of assets may indicate the existence of
illegal acts.
d. The risk that mistakes, falsifications, and omissions may cause the financial statements to contain material
misstatements.

6-7

An auditor should recognize that the application of auditing procedures may produce evidential matter indicating the
possibility of errors or frauds and therefore should
a. plan and perform the engagement with an attitude of professional skepticism.
b. not depend on internal accounting control features that are designed to prevent or detect errors or frauds.
c. design audit tests to detect unrecorded transactions.
d. extend the work to audit most recorded transactions and records of an entity.

6-8

When using the transaction cycle approach in the audit plan, the reason for treating the capital cycle separately from
expenditure cycle is that
a. the transactions are related to financing a company rather than to its operations.
b. most capital cycle accounts involve few transactions, but each is often highly material and therefore should be audited
extensively.
c. both a and b above.
d. neither a nor b above.

Financial and Integrated Audits - Frederick Choo

6-9

Which of the following statements best describes the auditors responsibility with respect to illegal acts that do not have a material
effect on the clients financial statements?
a. Generally, the auditor is under no obligation to notify parties other than personnel within the clients organization.
b. Generally, the auditor is under an obligation to see that stockholders are notified.
c. Generally, the auditor is obligated to disclose the relevant facts in the auditors report.
d. Generally, the auditor is expected to compel the client to adhere to requirements of the Foreign Corrupt Practices Act.

6-10

Which of the following is not a proper match of an auditors specific objective with managements assertion?
a. Ownership matches with rights and obligations.
b. Existence matches with existence or occurrence.
c. Classification matches presentation and disclosure.
d. Completeness matches with completeness.

6-11

Which of the following statements is not true?


a. Balance-related audit objectives are applied to account balances.
b. Transaction-related audit objectives are applied to classes of transactions.
c. Balance-related audit objectives are applied to the ending balance in balance sheet accounts.
d. Balance-related audit objectives are applied to both beginning and ending balances in balance sheet accounts.

6-12

Which of the following statements is true?


a. The auditors specific objectives follow and are closely related to management assertions.
b. Managements assertions follow and are closely related to the auditors objectives.
c. The auditors primary responsibility is to find and disclose fraudulent management assertions.
d. Assertions about presentation and disclosure deal with whether the accounts have been included in the financial
statements at appropriate amounts.

6-13

Which of the following statements is not true?


a. An example of a completeness assertion would be that the notes payable account in the balance sheet includes all such
obligations of the entity.
b. An example of a valuation or allocation assertion would be that property, plant, and equipment are recorded at current
market value.
c. An example of an existence or occurrence assertion would be that sales in the income statement represent exchanges of
goods or services that actually took place.
d. An example of a rights and obligations assertion would be that amounts capitalized for leases in the balance sheet
represent the cost of the entitys rights to leased property.

6-14

When planning the audit, if the auditor has no reason to believe that illegal acts exist, the auditor should
a. include audit procedures which have a strong probability of detecting illegal acts.
b. include some audit procedures designed specifically to uncover illegalities.
c. make inquiries of management regarding their policies and regarding their knowledge of violations, and then rely on
normal audit procedures to detect errors, frauds, and illegalities.
d. do nothing.

6-15

If a long-term note receivable is included on an accounts receivable listing, there is a violation of the
a. completeness objective.
b. existence objective.
c. timing objective.
d. classification objective.

6-16

Which of the following procedures would an auditor most likely perform in planning a financial statement audit?
a. Inquiring the clients legal counsel concerning pending litigation.
b. Identifying the clients management assertions relating to individual accounts.
c. Searching for unauthorized transactions that may aid in detecting unrecorded liabilities.
d. Examining control procedures to verify the effectiveness of internal controls.

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6-17

At the planning phase, which of the following is most likely to be agreed upon with the audit client before implementation
of the audit procedures?
a. Evidence to be gathered to provide a sufficient basis for the auditors opinion.
b. Timing of inventory observation procedures to be performed.
c. Procedures to be undertaken to discover litigation, claims, and assessments.
d. Procedures to be included in the testing the internal controls.

6-18

When an auditor becomes aware of a probable illegal act by a client, the auditor should
a. consult with the clients legal counsel or other specialists about the effect of the act on the financial statements.
b. determine the reliability of the managements representations in the clients representation letter.
c. consider whether other similar acts may have occurred.
d. recommend remedial actions to the audit committee.

6-19

Which of the following immaterial amount of misstatement could most likely have a material effect on a clients financial
statements?
a. A piece of obsolete office equipment that has not retired.
b. A petty cash fund disbursement that was not properly authorized.
c. An illegal payment to a foreign official that was not recorded.
d. An uncollectible account receivable that was not written off.

6-20

Which of the following information discovered during an audit most likely would raise a question concerning a possible
illegal act?
a. Related party transactions, although properly disclosed, were pervasive during the year.
b. The entity prepared several very large checks payable to cash during the year.
c. Material internal control weaknesses previously reported to management were not corrected.
d. The entity was a campaign contributor to several local political candidates during the year.

6-21

Which of the following circumstances most likely would cause an auditor to consider whether material misstatements due
to fraud exist in an entitys financial statements?
a. Differences are discovered during the clients annual physical inventory count.
b. Material weaknesses previously communicated to those charged with governance have not been corrected.
c. Clerical errors are listed on a monthly computer-generated exception report.
d. Supporting accounting records and documents are frequently denied access to the auditor when requested.

6-22

What assurance should an auditor provide on direct effect illegal acts and indirect effect illegal acts that are both material to a clients
financial statements?
a.
b.
c.
d.

6-23

Direct effect illegal act


Reasonable
Reasonable
Limited
Limited

Indirect effect illegal act


None
Limited
None
Limited

The primary objective of tests of transactions performed as substantive tests is to


a. comply with generally accepted auditing standards.
b. attain assurance about the reliability of the accounting system.
c. detect material misstatements in the financial statements.
d. evaluate whether managements policies and procedures operated effectively.

6-24

Which of the following is a false statement about specific audit objectives?


a. There should be a one-to-one relationship between specific audit objectives and procedures.
b. Specific audit objectives should be developed in light of management assertions about the financial statement
components.
c. Selection of tests to meet audit objectives should depend upon the understanding of internal control.
d. The auditor should resolve any substantial doubt about any of managements material financial statement assertions.

Financial and Integrated Audits - Frederick Choo

6-25

The objective of tests of transactions performed as substantive tests is to


a. comply with generally accepted auditing standard.
b. attain assurance about the reliability of the accounting system.
c. detect material misstatements in the financial statements.
d. evaluate whether managements policies and procedures operated effectively.

6-26

An auditor observes the mailing of monthly statements to a clients customers and reviews evidence of follow-up on errors
reported by the customers. This test of controls most likely is performed to support managements financial assertion(s) of
a.
b.
c.
d.

6-27

Presentation and Disclosure


Yes
Yes
No
No

Existence or Occurrence
Yes
No
Yes
No

Each of the following might, by itself, form a valid basis for an auditor to decide to omit an audit test except for the
a. difficulty and expense involved in testing a particular item.
b. assessment of control risk at a low level (i.e., small %).
c. inherent risk involved.
d. relationship between the cost of obtaining evidence and its usefulness.

6-28

Which of the following statements reflects an auditors responsibility for detecting errors and fraud?
a. An auditor is responsible for detecting employee errors and simple fraud, but not for discovering fraudulent acts
involving employee collusion or management override.
b. An auditor should plan the audit to detect errors and fraud that are caused by departure from GAAP.
c. An auditor is not responsible for detecting errors and fraud unless the application of GAAS would result in such
detection.
d. An auditor should design the audit to provide reasonable assurance of detecting errors and fraud that are material to the
financial statements.

6-29

Which of the following circumstances most likely would cause an auditor to consider whether material misstatements exist
in a clients financial statements?
a. The client is in a declining industry with increasing business failures and a significant decline in customer demand.
b. Employees who handle cash receipts are not bonded.
c. Bank reconciliations usually include in-transit deposits.
d. Equipment is often sold at a loss before being fully depreciated.

6-30

Which of the following characteristics most likely would heighten an auditors concern about the risk of intentional
manipulation of financial statements?
a. Turnover of senior accounting personnel is low.
b. Insiders recently purchased additional shares of the clients stock.
c. Management places substantial emphasis on meeting earning projections.
d. The rate of change in the entitys industry is slow.

6-31

Disclosure of illegal acts to parties other than a clients senior management and its audit committee or board of directors
ordinarily is not part of an auditors responsibility. However, to which of the following outside parties may a duty to disclose illegal
acts exist?

a.
b.
c.
d.

To the SEC when the


Client reports an
Auditor change ___
Yes
Yes
No
Yes

To a Successor Auditor
when the Successor makes
appropriate inquiries_____
Yes
No
Yes
Yes

To a Governmental Agency
from which the Client receives
financial assistance_________
No
Yes
Yes
Yes

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6-32

An auditor concludes that a client has committed an illegal act that has not been properly accounted for or disclosed. The
auditor should withdraw from the engagement if the
a. auditor is precluded from obtaining sufficient appropriate evidence about the illegal act.
b. illegal act has an effect on the financial statements that is both material and direct.
c. auditor cannot reasonable estimate the effect of the illegal act on the financial statements.
d. effect of the illegal act on the financial statements is material, and the client refuses to accept the auditors report as
modified for the illegal act.

6-33

Three conditions generally present for fraud to occur are often refer to as the fraud triangle. Which of the following
conditions is not present in this fraud triangle?
a. Management or other employees lack professional skepticism to commit fraud.
b. Circumstances provide opportunities for management or employees to commit fraud
c. Management or other employees have incentives or pressures to commit fraud
d. An attitude exist that allows management or employees to commit fraud.

6-34

Management is often in a position to override internal controls in order to commit fraud. Which of the following
procedures is not required to test for management override of controls on every audit?
a. Review accounting estimates for biases that could result in material misstatement due to fraud.
b. Evaluate the business rationale for significant unusual transactions.
c. Test the existence and occurrence of separation of duties.
d. Examine journal entries and other adjustments for evidence of possible misstatements due to fraud.

6-35

An auditor must assess the risks of material misstatement due to common fraud conditions throughout the audit. Which of the
following is not a common fraud condition that the auditor must assess throughout the audit?
a. Conflicting or missing evidential matter.
b. Unrealistic audit time budget constraint.
c. Discrepancies in the accounting records.
d. Problematic or unusual relationships between the auditor and management.

6-36

An independent audit has the responsibility to design the audit to provide reasonable assurance of detecting errors and
fraud that might have a material effect on the financial statements. Which of the following, if material, is a fraud as defined
in auditing standards?
a. Misappropriation of an asset or groups of assets.
b. Clerical mistakes in the accounting data underlying the financial statements.
c. Mistakes in the application of accounting principles.
d. Misinterpretation of facts that existed when the financial statements were prepared/

6-37

What assurance does the auditor provide that errors, fraud, and direct-effect illegal acts that are material to the financial
statements will be detected?
a.
b.
c.
d.

6-38

Errors
Limited
Reasonable
Limited
Reasonable

Fraud
Negative
Reasonable
Limited
Limited

Direct-Effect Illegal Act


Limited
Reasonable
Reasonable
Limited

If some sales were recorded in the current year that should have been recorded in the subsequent year, the related accounts
receivable do not exist at the balance sheet date. Which of the following overlaps between transaction- and balance-related
information is true?
a.
b.
c.
d.

Transaction-related Information
Rights and Obligation
Valuation and Allocation
Occurrence
Cutoff

Balance-related Information
Completeness
Classification
Accuracy
Existence

Financial and Integrated Audits - Frederick Choo

Key to Multiple-Choice Questions


6-1 d. 6-2 b. 6-3 d. 6-4 c. 6-5 d. 6-6 d. 6-7 a. 6-8 c. 6-9 a. 6-10 c. 6-11 c.
6-12 a. 6-13 b. 6-14 c. 6-15 d. 6-16 b. 6-17 b. 6-18 a. 6-19 c. 6-20 b. 6-21 d.
6-22 a. 6-23 c. 6-24 a. 6-25 c. 6-26 c. 6-27 a.

6-28 d. 6-29 a. 6-30 c. 6-31 d.

6-32 d. 6-33 a. 6-34 c. 6-35 b. 6-36 a. 6-37 b. 6-38 d.

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6 Audit Plan - Objectives

Simulation Question 6-1


Simulation Question 6-1 is an adaptation with permission from a case by Strand, C. A., S.T. Welch, S.A. Holmes, and S.L. Judd in the Issues in
Accounting Education, a publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true
set of facts; however, the names and places have been changed.

Background Information for all Scenarios

Crystal Smith had been the Director of the Finance Department of Junction Falls, USA, for nearly eight years. On a recent trip to
Florida, she visited her sister and decided that she would like a change of scenery. Crystal interviewed for several jobs and accepted an
accounting position in the Finance Department of a large Florida city. Her replacement in Junction Falls is Joe Metros. Joe, who had been the
Deputy Director of the Finance department in a nearby town for the past five years, is very pleased with this new position because it represents a
promotion.
A reporter from the Junction Falls Daily Observer interviewed Joe for a feature article in the business section. Joe talked about his
family and the many civic activities that he supported, both financially and by volunteering his time. He also discussed his vision for the future of
the Finance Department and identified a number of short-term and long-term goals. Initially, Joe wants to implement a number of changes
designed to improve the efficiency and effectiveness of departmental operations. He plans to eliminate a number of accounts that are rarely used.
He also hopes that financial information can be provided more quickly when requested by citizens or other city agencies. He notes that prompt
responses should increase public confidence in the Finance Department. Joe is especially concerned about the extent of employee turnover. Five
of the seven department employees have held their current positions less than one year, and training costs can be rather significant. Joe has been
told that the previous Director, Crystal Smith, was very controlling and task-oriented, and that this may have caused employees to seek
employment elsewhere.
Joe notes that the city does not have an internal audit staff. However, the local accounting firm of Watson & Watson, LLP has audited
the citys Comprehensive Annual Financial Report for each of the past 13 years. The city has been growing steadily for the past several decades
and currently has a population just over 73,000. Last year, Junction Falls collected over $89 million in gross operating revenues. In addition to
Joe, the Finance Department includes the following personnel:

You should access Data File 6-1 in iLearn for Figure 1, which presents the organizational chart of the Finance and Accounting
Services of Junction Falls.

Libby Jones, Chief Accountant. She manages and maintains the General Ledger. Libby is also responsible for general office
management and day-to-day operations in the department. She earned a degree in accounting from the local university and has worked for the
department for 15 years. Libby is 37; her husband owns a local hardware store.

Marsee Weston, Senior Accountant. She is responsible for monitoring fixed assets. She also maintains all records of city fixed/real assets
and maintains/monitors all city construction and acquisition of real asset contracts. Marsee has been employed by the department for eight
months. She is 39; her husband teaches mathematics at the local high school.

Scott Smyth, Senior Accountant. He is the Cash Manager; maintains bank relations; manages all city investments; monitors debt-service
requirements; performs all wire transfers of city funds; and reconciles all bank accounts. Scott is 32 and has been employed by the department
for seven months. Scotts wife is a sales associate at one of the local automobile dealers.

Cathy Elign, Staff Accountant. She maintains all records pertaining to Accounts Receivable; invoices those who owe funds; maintains
control of all Petty Cash Funds within the city; accounts for all daily deposits from departments and divisions within the city; and is also the
secondary payroll clerk. Cathy is 27 and has been employed by the department for almost nine months. Her husband is employed by the U.S.
Postal Service.

Bob Thomas, Accounts Payable Clerk. He processes all city payments to payees for last names beginning with A through L. Bob is 36
and has worked in the department for almost two years. He is single and has lived in town his entire life except for the five years he served in
the U.S. Navy.

Nora Stewart, Accounts Payable Clerk. She processes all city payments to payees for last names beginning with M through Z. Nora is
20, and has been employed by the department for six months. She is single and lives in an apartment complex near an university campus.

Chuck Sanchez, Payroll Clerk. He processes all bi-weekly and monthly payrolls and maintains all payroll records. Chuck is 31, recently
divorced, and has been working in the department for ten months. Chuck lives in an older neighborhood with his 7-year-old son.

Scenario #1

Joe has recently implemented several changes within the Finance Department; changes he believes will improve operations and boost
morale. First, he informed all employees that he expects them to take full advantage of all of their earned vacation days. Since employees must
work in the department for at least one year before they can apply for vacation, Bob and Libby are currently the only employees who are eligible
to take any paid vacation days. Bob is planning a one-week fishing trip to Lost Pines Lake this summer, but Libby insists that she cannot take nay
vacation because there are so many new employees. Libby does appear to be busy. She is usually the first to arrive at work each day and the
last to leave at night. However, Libby will lose quite a few days of leave time if she does not take a vacation soon. Joe has insisted that she take a
break. Libby agrees to do this, but only takes one day at a time.
Joe has also created new controls within the accounts payable function. First, the two accounts payable clerks (Nora and Bob) check
each others documents for accuracy at the close of each workday. Each Tuesday, Libby collects the invoices to be paid for that week and
prepares the documentation so that checks can be drawn and mechanically signed in the nightly cycle. The following morning, Libby collects the
printed checks, verifies the amount of each check with the register, confirms that all supporting documentation is attached, sends the checks to the
mailroom for delivery to the vendors, forwards the daily check register to Scott for use in the bank reconciliation, and returns the invoices to Nora
and Bob for inclusion in the vendor files. Libby is also responsible for periodically reconciling the Accounts Payable subsidiary ledger to the
control account.
Joe arrives at work on Wednesday and is surprised to find the office locked. As he opens the door, he hears the phone ringing. It is
Libbys husband, who informs Joe that Libby had an automobile accident on the way to work and is being admitted to Junction Falls Hospital for

Financial and Integrated Audits - Frederick Choo

observation. Joe plans to take over Libbys duties until she recovers. He begins by collecting the checks that were printed the previous night,
along with their supporting documentation. After completing the necessary reconciliation, he hands over the paid invoices to Bob and Nora for
filing. Nora is surprised to find an invoice made payable to Zenith Enterprises. She does not recall processing this invoice the previous day.

Scenario #2

Scenario #3

Scenario #4

Scenario #5

In addition to his other duties, Chuck makes arrangements for the hiring of temporary help for Junction Falls. Departments submit
formal request forms to Chuck a week in advance detailing what type of temporary help is needed and estimating how long the associated labor
shortage would persist. Chuck then relays the information to Manpower Staffing Services, a local temporary agency that provides Junction Falls
with the needed employees. Manpower bills the city once a month for all services provided since the last billing period. Chuck receives the bill
directly from the temporary agency. After examining the accompanying documentation for accuracy, he forwards the bill to Nora for payment.
Joe recently asked Libby to compile a list of significant budget variances for his review. Libby noted that a problem appeared to be
developing in personnel services (which represented more than 10 percent of all expenditures). She did some quick calculations and discovered
that two-thirds of the budgeted amount for salaries and benefits was spent in just seven months. Overall, personnel-related expenditures are 15
percent greater than they were at this same time last year. When asked if he had any ideas on what could have caused this budget shortage, Chuck
suggested that perhaps the hiring of additional employees and the 3 percent across-the-board pay raise that was awarded everyone at the start of
the fiscal year were not reflected in the current year budget.
Each Tuesday evening, the city runs checks for the invoices that are due that week. Then, on Wednesday morning, Libby verifies the
amount of each check with the register and confirms that all supporting documents are attached. After conducting the reconciliation, Libby
forwards the paid invoices to Bob and Nora for filing. Nora is curious. The documentation attached to the Manpower Staffing Services check is
vague. There are no specifics as to the days worked or the work performed. She has placed a call to the temp agency requesting more information,
but has not yet received a reply.
In an attempt to discover new areas where cost savings might be achieved, Joe has spent much of his spare time examining the files
containing the Junction Falls RFPs (Requests for Proposal). Joe concludes that most low bidders are awarded a contract. Occasionally, however,
the low bid is not accepted. For example, because the low bidder was notorious for delivering spoiled merchandise, they did not get the contract.
Instead, the Lone Start Farm Patch was awarded the bid to supply fruits and vegetables to the Junction falls Jail. Joe notes that most files contain
several bids, some as many as a dozen. Joe finds one file (to supply computers to certain city offices) that contains only a solitary bid from Able
Computers. Joe asks Marsee, who prepares all specs for fixed asset RFPs and approves all contracts, what caused such a poor response from
potential suppliers. Marsee points out to Joe that the RFP specified that supplier personnel must be able to respond to a city call for maintenance,
upgrades, or repairs within 30 minutes. She suggests that perhaps many suppliers were not willing to guarantee such a prompt response time.
In preparation for the upcoming annual audit, Bill Watson, the external auditor, asked Marsee to provide him with a list of all fixed
assets, including the inventory identification number, date of purchase cost, and current location of each item on the list. After a week, Marsee
still has not printed out the list for the auditor. The audit starts in two weeks. When asked about the delay, Marsee says that she has been so busy
that she has not had time to think about any new projects. Marsee is busy, and often arrives very early for work and leaves the office late at
night.
One Monday during lunchtime, Bob receives a phone call from Able Computers, asking whether Ables last request for payment has
been processed. Since Marsee is unavailable to respond to this query, Bob calls the city office that was to have received the computers and learns
that no such delivery from Able Computers.
Joe is collecting information to start the annual Junction Falls budget. By next week he should have a detailed budget request package
from each operating department, which contains not only financial and statistical data about prior period activities, but also wish lists for the
next fiscal year. Joe notes that ad valorem taxes (levied as a percentage of the value of the property being taxed) have provided the major source
of city funds for several years. One trend disturbs him, however. Cash collections have declined this year, despite the fact that the mayor had
announced a significant increase in the tax base. Joe decides to spend the weekend checking out this anomaly. He discovers one possible
explanation: numerous modifications or credits of billed tax amounts have been recorded in the receivable ledger. The following week, Joe asks
Cathy about the large number of tax adjustments. She explains that an apparent computer glitch in the individual taxpayer assessment software
created the need to reduce originally recorded amounts to their lower, correct totals.
Cathy calls in sick with a virus one Thursday and Scott agrees to substitute as the cashier. At the end of the day he is exhausted. He
never has a minute to even catch his breath. He wonders what caused people to pick this day to come in and pay their taxes. He tells Joe they
must have known that Cathy was absent and decided to take this opportunity to pick on Scott. As he is preparing the deposit, Scott confirms that
it has indeed been a busy day. The deposit is much larger than usual.
The following Wednesday, Libby receives a phone call from a taxpayer who is very irritated about an overdue notice that has just
come in the mail for property taxes that, according to the county, are now 60 days delinquent. According to the caller, these taxes were paid
several weeks ago and the taxpayer has a receipt to prove it. Libby asks Cathy to print out a copy of the taxpayers accounts receivable record.
After some searching, Cathy informs Libby that she cannot locate any record to the account.
The auditors from Watson & Watson, LLP have just started their work on the Comprehensive Annual Financial Report for Junction
Falls. Bill Watson, the partner-in-charge of the city audit, is chatting with Scott Smyth and discovers that they share a mutual interest in investing.
Scott says that he particularly enjoys investing in options, futures, and commodities. He notes that his investing interest is what attracted him to
his current position in Junction Falls. Scott indicates that he was pleasantly surprised to discover that Junction Falls needed someone to manage
its investment portfolio. He admits that even though the pay is not particularly great, he really likes the autonomy inherent in the position. He
decides what to buy and when to sell (within certain very broad guidelines), and apart from creating a report of his investing activities for the
Junction Falls Council each quarter, he manages the investment portfolio as he sees fit. Bill notes in his working papers that Scott also has broad
authority to make wire transfers between each of the citys four bank accounts. No external approval is required.
Bill, Scott, Joe, and Marsee decide to go to a local caf for lunch. Scott offers to drive his Jaguar sedan since it can easily
accommodate four individuals. Marsee, Scott, and Joe have been with the Department for less than one year, so the luncheon conversation centers
on where everyone worked before coming to the Finance Department, and how long each has lived in Junction Falls. Joe and Marsee discover
that they grew up in Junction Falls, just three blocks from each other. Scott only recently moved here from Big City. At that point, the waitress
arrives with their orders, and the conversation turned to other topics for the duration of the meal.

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Later that afternoon, Bill continues his conversation with Scott about his move to Junction Falls, and the many differences between
Junction Falls and Big City. Scott admits that he misses the fast pace of his former hometown, but says that it was best that he left Big City to
gain a fresh start on life. Although he owned a consulting firm in Big City, he had overextended his credit cards by taking too many cash
advances. Ultimately, he filed for personal bankruptcy.

Required
For each of the five scenarios above answer the following three questions:
1. List all the fraud risk factors in each of the five scenario.
2. Identify all other circumstances or information that are of concern in each of the five scenario
3. Explain whether it is probable, reasonably possible, or remote that fraud (misappropriation of assets) may be occurring in the Finance
Department in each of the five scenario. You should research FASB SFAS No.5 (AICPA 1975), Accounting for Contingencies, to learn more
about the distinction between these terms.
Note: Probable is a future event(s) that is (are) likely to occur; reasonably possible means the possibility of the event is more than remote but less
than likely; and, remote means the chance of the event is slight.

Simulation Question 6-2


Simulation Question 6-2 is an adaptation with permission from a case by Ballou, B. and J. M. Mueller in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the
names and places have been changed.

Humble Beginning

Brian Techno, CEO and founder of Speedcom, was born in 1938 in San Jose, California. The first in his family to attend college,
Brian earned good grades in his engineering curriculum at The California Institute of Technology. This was also where he discovered his natural
ability to build and wire just about anything. After graduating in 1960, Brian married Mindy, his high school sweetheart, and moved to Modesto
about 100 miles north of San Jose. This was where it all began, through the haphazard purchase of a farm lot in the neighboring town of Tracy. It
just happened to have on it an 18-foot tall antenna.
In his spare time, Brian put his wiring skills to use and convinced nearby residence to let him string some wires to their television sets.
Soon Brian was urging the rest of Tracy to trade their rabbit ears for wires to his antenna, making Brian an early pioneer of the cable television
industry. Over the next several years, Brian acquired other plots of land in neighboring towns and built more antennas and strung more wires.
One week before quitting his job with a factory, he went into the First National Bank at Tracy to borrow $45,000 to purchase a failing cable
franchise in Tracy. Brian convinced several local businessmen to contribute $25,000, and the local bank agreed to lend the remaining $20,000.
Brian told Mindy that they would either make a mint or go broke. Mindy had no idea that Brian would make that claim many more times in the
future.
By the late 1960s, Brians cable business was doing well and he purchased a 60-acre farm property in Tracy and built a large home for
Mindy and their two sons, Tony and Sam. Brian and Mindy were easily the most successful residents in the history of Tracy, and the more
successful they became, the less popular they became. As in most small towns, all 2,900 townspeople in Tracy were at about the same
socioeconomic level, at least until Brians success. Brian and Mindy wanted to feel at home in Tracy and tried everything to earn acceptance in
the town. Brian ran for a position on the school board and lost. He hosted barbeques at his home few came. He went as far as attending the
church preferred by the mayor, which differed from his own religious denomination. Finally, in 1975, his goal to be accepted in the community
was realized when he was invited to sit on the board of the local bank. Not only was this a great personal triumph, but also he foresaw needing a
loan from time to time.

Growing Pains

Success

Tony and Sam both returned to the family business after finishing their degrees at California Institute of Technology. Brians ambition
was contagious, and as it grew, the family took significant risks and leveraged the company in order to acquire and develop more rural cable
systems in Central California. Often, they were only one step ahead of the creditors. By the mid-1980s, as a result of several large acquisitions,
the company had 160,000 subscribers and 250 employees. Based on Brians financial management strategy, there was not a bank within a 200mile radius to which he was not in debt. Frankly, he had borrowed about as much as he could. Over a plate of Mindys meatloaf one fall evening
in 1987, they decided to go public Speedcom was born.

By the late-1990s, Speedcom was among the five largest cable companies in the country, with over 15,000,000 subscribers. The public
offering had given Brian the cash needed to take the company to the next level. Although the greatest cluster of subscribers was in the Central
California, Brian had developed other clusters in the Northern California. Sam developed the strategy of clustering subscribers in geographic
areas, which was lauded by analysts. Clustering helped to keep operating costs low and gave Speedcom a much greater cash margin than its
competitors.
Based on age, experience, and interests, the top Speedcoms governance hierarchy was structured with Brian as CEO, Sam as COO,
and Tony as CFO and Chair of the Audit Committee. Based on the requirements in the Sarbanes-Oxley Act of 2002, Tony later resigned from the
Audit Committee, and the President of First National Bank at Tracy, Jonny Kinsey, took Tonys place as Chair.

Brian and Tony designed the IPO such that Class A shares with one vote each were issued. The Techno family retained all Class B shares,
with five votes per share, five the Techno family final word on who would hold board seats. Most other members of the Board of Directors were
good friends of Brian. Mindys cousin from San Jose also held a seat. Coincidentally, these were about the only shareholders willing to travel to
small town Tracy for board meetings or annual shareholder meetings. Board and shareholder meetings alike were mostly informational where

Financial and Integrated Audits - Frederick Choo

Brian shared with those present about the companys recent victories and the deals put together by the two sons and him. Figure 1 provides an
organizational chart for Speedcoms directors and senior executives. You should access Data File 6-2 in iLearn for Figure 1, which presents
the organizational chart of Speedcom.
Outside the boardroom, the Techno family continued to run the business just as they always had at the dinner table over Mindys
cooking with little thought to investors, analysts, or other stakeholders. Brian continued to make the deals that had made Speedcom successful.
He sought smaller competitors within geographic clusters for acquisition, most of which had unused capacity that could be developed by Sam to
further expand Speedcoms subscriber base. In November 2002, Brian had six to eight deals on the table, most with commitments to purchase
stock at some agreed upon price. Brians deal-making required him to keep Speedcom highly leveraged. But, in his mind, he had mastered that art
and he knew that Speedcoms goal to become industry giant depended on it. At times, Speedcoms debt was ten times its market capitalization
and ten times that of any competitor. However, annual revenues approached $4 billion, and the stock price continued to climb. Brian, Sam, and
Tony increased their ownership by purchasing a large volume of stock. Brian had faith that the company would continue to prosper, enabling him
to divest some of his shares upon retirement.
Like his father, Sam was always looking for a profitable deal in new service lines such as wireless and digital. In 2000, for example,
Sam discovered Neo Wireless, a new cellular company in rural Southern California. Though available at quite a discount, Neo Wireless was in
the midst of a lawsuit with the FCC (Federal Communications Commission) over a disputed tie bid for a wireless spectrum (the FCC auctions
wireless airspace to wireless companies). Sam believed that although Neo Wireless was much smaller than the other tie-bidder, it would
eventually come out of the lawsuit with the spectrum and would be a profitable company with high growth potential. Sam wanted to create a new
cluster in the Southern California, where Neo Wireless would be a stand-alone entity and a personal project for Sam.

Brian also had established various privately owned business over the years. He insisted upon keeping his salary from Speedcom at a
conservative amount, for example, his average salary over the years 1998 to 2004 was $800,000 per year, and these businesses allowed him to
subsidize his personal income. In addition, Brian insisted that Tony and Sam also draw modest salaries; Tony was earning an average of
$550,000 and Sam an average of $400,000 per year. One of Brians businesses, MediaMarket LLC, was an advertising company that that focused
primarily on telemarketing services. It had several small Tracy area clients and Speedcom. MediaMarket handled the majority of Speedcoms
marketing to potential subscribers for services in areas where it had services available. Brian also created ServiceLink LLC, a customer service
outsourcing agency. Its primary revenue stream was from Speedcom, but other clients included the local First National Bank and two other banks
from surrounding towns. Both MediaMarket and ServiceLink were located in Speedcoms office building. Mindy and Sams wife, Emily, also
operated a florist and home interiors business. Often, Brian would redecorate Speedcoms offices to provide business for Mindy and Emily. Brian
could see the value in his small companies. MediaMarket and ServiceLink lowered Speedcoms operating costs and both of the companies
received professional management services from Speedcom. Figure 2 presents a summary of Speedcoms financial statements. You should
access Data File 6-2 in iLearn for Figure 2, which presents a summary of Speedcoms financial statements.

By 2003, the sentiment toward the Techno family was warm. After all, the Techno family treated folks in Tracy like extended family.
They built youth recreation facilities, sponsored an annual fair, and built a library and seniors center. Brian was rumored to have never turned
away anyone who came to him in financial difficulty. Further, townsfolk were often invited as personal guests of the Techno family to San
Francisco 49ers pro football games and shows at the historic San Francisco Theatre (they had acquired both in the 1990s). Brian was finally
admired by all and wealthy beyond belief. He had realized his dreams hose for his company and for himself.

Required
1. AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate fraud audit into the audit of financial
statements. Step 1 requires the auditor to understand the nature of fraud and the manner in which fraud may be committed at the audit preplan.
This understanding is to be integrated with the auditors understanding of a clients business at the audit preplan phase (refer to Chapter 5).
Research the Internet or other relevant sources for a better understanding of Speedcoms telecommunication industry. Using the format below,
document at least three pieces of information of your understanding of the history, products, regulation, and risk of telecommunication industry.
Reference/cite the source of your information. One piece of information is provided under each of the four subheadings to help you complete the
rest.
Your Understanding of Speedcoms Telecommunication Industry
A. History of the Telecommunication Industry
1. The telecommunication industry experienced unprecedented, rapid growth in the mid-1990s, introducing an array of services and competitors
to an industry once known only for home phone service and the industry giant AT&T.
2. (source: http://...)
3.
4.
B. Products in the Telecommunication Industry
1. Products offered by the telecommunication industry can be sorted into three categories: phone-related, television-related, and Internet-related.
2. (source: http://...)
3.
4.
C. Regulation of the Telecommunication Industry
1. The telecommunication industry is regulated by the Federal Communication Commissions various Acts: the Communications Act of 1934,
the Cable Communications Policy Act of 1984, the Cable Television Consumer Protection Competition Act of 1992, and the
Telecommunications Act of 1996.
2. (source: http://...)
3.
4.
D. Risks in the Telecommunication Industry
1. Telecommunications historically has been an industry with a high level of merger-and-acquisition activity. Larger companies frequently
acquire smaller companies for their capacity or existing customer revenue streams. In the late 1990s, however, the acquiring firms share prices

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6 Audit Plan - Objectives

began to tumble as the purchased capacity could not be turned into revenue.
2. (source: http://...)
3.
4.
2. AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate fraud audit into the audit of financial
statements. Step 5 requires the auditor to identify specific fraud risks at the audit plan. This identification of fraud risks is to be integrated with
the auditors consideration of the Fraud Triangle at the audit plan phase (refer to Table 6-1 and Table 6-2 in Chapter 6). Based on your
understanding and documentation of the telecommunication industry in 1. above, state what you believe to be factors that would increase the risk
of fraud at Speedcom. Using the format below, state at least three fraud risk factors of Speedcom for each of the three characteristics of the
Fraud Triangle. If you make any assumption for your answer, state your assumption.
Your Identification of Speedcoms Fraud Risk Factors
A. Incentives/Pressures
1. (assumption, if any)
2.
3.
B. Opportunities
1. (assumption if any)
2.
3.
C. Attitudes/Rationalization
1. (assumption, if any)
2.
3.

Simulation Question 6-3


Simulation Question 6-3 is an adaptation with permission from a case by Knapp, M. C. and C. A. Knapp in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts; however, the
names and places have been changed.

Humble Beginning

The Brooks Brothers Tangle with the SEC

As a small child, Brooklyn native David Brooks loved horses. In 1969, when he was 14 years old, Brooks went to work at a local
racetrack as a groom to help support his family. Brooks loved the tough job, which involved arriving at the racetrack in the wee hours of the
morning, wiping down sweaty horses, wrestling large bales of hay, and mucking (cleaning out) horse stalls. Although he wanted to spend his
life working in the horseracing industry, Brooks' family encouraged him to pursue a more stable and pragmatic career after he graduated from
high school. Because he was intrigued by the stock market, David Brooks eventually decided to major in business at one of New York City's
prominent universities. The young extrovert relied on a variety of part-time jobs to finance an undergraduate business degree with a concentration
in accounting at New York University.
Ironically, Brooks' successful business career provided the path for him to return to his first love. More than three decades after having
worked at one of the lowest ranking jobs in horseracing, David Brooks quickly rose to the pinnacle of that sport by spending tens of millions of
dollars to establish his own stable, Bulletproof Enterprises. At its height, Brooks' stable included more than 400 racehorses. In 2004, one of
Brooks' horses, Timesareachanging, won the Little Brown Jug, which is the equivalent of the Kentucky Derby for standardbred horses that
specialize in pacing.1
In the mid-1980s, Jeffrey Brooks, David Brooks' brother and best friend, founded a small brokerage firm, Jeffrey Brooks Securities.
Jeffrey recruited David to join the firm and become his right-hand man. Several years later, in 1992, the two brothers ran afoul of the Securities
and Exchange Commission (SEC) when one of their subordinates was charged with insider trading. The SEC alleged that the Brooks brothers had
failed to establish proper control procedures to prevent their subordinates from improperly using material non-public information obtained from
their clients.
In addition to a $405,000 fine, the SEC filed separate injunctions against the brothers. The SEC banned David Brooks from serving as
a director, officer, or employee of a brokerage firm or an investment company for five years. The injunction did not prohibit him from serving as
an executive of an SEC registrant that was other than a brokerage or investment company.
A few months before the SEC sanctioned the Brooks brothers, David, with the financial backing of his brother, organized a small
company based in Westbury, New York, a Long Island suburb of New York City. That company, DHB Capital Group, Inc., which was
subsequently renamed DHB Industries, Inc. (DHB is David Brooks' initials), was intended to serve as the umbrella organization for a corporate
conglomerate that Brooks hoped to build. Brooks' goal was to identify and then purchase small, underperforming companies and convert them
into profitable operations by retooling their business models.
In 1994, Brooks attempted to register DHB on the NASDAQ stock exchange to provide it greater access to the nation's capital
markets. The NASDAQ denied Brooks' application because of the sanctions that had been levied against him by the SEC. In defending that
decision, the NASDAQ observed that given the extremely serious nature of the SEC allegations made against Brooks, and the fact that he was
only recently enjoined it was necessary to exclude his company from the NASDAQ to protect investors and the public interest and to maintain
1
Standardbreds are a breed of horses developed in North America that dominates harness racing. There are two types of harness races: trotting
and pacing races.

Financial and Integrated Audits - Frederick Choo

public confidence in that market. Brooks appealed the NASDAQ's decision to the SEC. After reviewing the matter, the SEC ruled in favor of the
NASDAQ:
The facts remain that Brooks has a history of serious securities laws violations and a significant ownership
interest in DHB, and proposes to retain his position as a DHB director. We do not find it unreasonable that the
NASD2 reviewing both Brooks' past conduct and his proposed level of involvement in DHB, remains uneasy
about the potential for illicit conduct in connection with the operation of DHB or the market for its securities,
and unwilling to expose public investors to that possibility.
Despite being rejected by the NASDAQ, the strong-willed Brooks persevered in his effort to have DHB's securities listed on a national stock
exchange. A few years later, he finally accomplished that goal when those securities were registered on the American Stock Exchange.

Timing is Everything

Patriot or Profiteer?

Hurricane Brooks

Brooks used the initial financing provided to him by his brother and the capital that DHB raised through a public stock offering to
acquire five small firms during the 1990s. DHB's principal operating unit would become Point Blank Body Armor, a Florida-based firm
purchased out of bankruptcy for a cash payment of $2 million. Throughout the existence of DHB, the Point Blank subsidiary accounted for
upward of 95 percent of its annual consolidated revenues. Point Blank's primary product was the Interceptor Vest, a bullet-resistant vest used by
all branches of the U.S. military and by law enforcement agencies.
Brooks' acquisition of Point Blank was a timely decision. The small company had struggled for decades, but three circumstances
ultimately triggered a surge in the demand for bullet-resistant vests after Point Blank was acquired by DHB. First, the September 11, 2001,
terrorist attacks convinced law enforcement agencies throughout the nation to increase their budgets for weaponry and protective equipment for
their personnel. Second, in early 2003, President George W. Bush's launching of Operation Iraqi Freedom, commonly referred to by the press as
the Second Gulf War, prompted the U.S. Army and U.S. Marine Corps to purchase large quantities of bullet-resistant vests. Finally, one of Point
Blank's primary competitors, Second Chance Body Armor, was forced into bankruptcy in 2004 after being sued repeatedly by law enforcement
agencies for allegedly manufacturing a large number of defective protective vests.
Brooks relied on his outgoing personality, persistent manner, and, most importantly, three Washington, DC-based political lobbyists to
outmaneuver his competitors when vying for protective vest contracts put up for competitive bids by the U.S. military. Between 2001 and 2005,
the U.S. military purchased nearly one million protective vests from DHB, accounting for the majority of the company's revenues during that time
frame. In a period of only six months in 2004, Brooks landed three large contracts for body armor from the Pentagon totaling nearly $500 million.
By comparison, DHB's total revenues in 2000 had been only $70 million, while the company's total stockholders' equity at the end of that year
had been a negative $5 million due to a retained earnings deficit of more than $29 million.
The rapid expansion of DHB's Point Blank subsidiary caused the company's revenues and profits to soar. By 2004, DHB's annual
revenues were approaching $350 million, and the company's net income had topped $30 million. Despite those impressive figures, some analysts
were concerned by the company's weak operating cash flows. In 2004, for example, the company had a negative net operating cash flow of $10
million despite reporting the $30 million profit. You should access Data File 6-3 in iLearn for Exhibit 1, which presents the audited income
statements and balance sheets included in DHB's 2004 Form 10-K, filed with the SEC in early 2005.
DHB's sudden financial success focused considerable attention on David Brooks, the company's chairman of the board and chief
executive officer (CEO). The Industrial College of the Armed Forces, a military agency administered by the Joint Chiefs of Staff, lauded Brooks
for developing life-saving body armor technology for hundreds of thousands of U.S. soldiers. Military officials also praised Brooks for
establishing a charitable foundation that provided financial assistance for wounded veterans.
Not all of the attention focused on Brooks and his company was favorable. In 2003, a group of DHB employees maintained that the
company's protective vests suffered from flaws similar to those evident in the products of Second Chance Body Armor. In November 2004,
Brooks and his two top subordinates, Sandra Hatfield, DHB's chief operating officer (COO), and Dawn Schlegel, DHB's chief financial officer
CFO), were disparaged by the press when they received financial windfalls upon selling most of their DHB stock. Brooks, alone, received more
than $180 million from the sale of the majority of his DHB stock, an amount that was six times greater than DHB's net income for 2004. News
reports of Brooks' huge stock market gain caused one organization to label him a body armor profiteer. A DHB spokesperson responded by
defending Brooks' sale of his stock. The American economic system rewards those who take great risks with commensurate benefits. The
compensation Mr. Brooks received is directly attributable to the risk he undertook in aiding the capitalization of DHB and achieving
extraordinary results for the company.
The large stock sales by Brooks, Hatfield, and Schlegel were followed by a sharp decline in DHB's stock price. More bad news was
soon to follow for the company. Within a few months, additional allegations surfaced that a large number of Point Blank vests being used by
military personnel in Iraq had critical, life-threatening flaws. Those allegations were followed by the U.S. military recalling more than 20,000
Point Blank vests. Then, in April 2005, DHB's audit firm resigned, citing deficiencies in the method used by the company to value its
inventory. The announcement was particularly unsettling to investors because it was the third time since 2001 that a DHB audit firm had resigned
after commenting on major problems involving the company's internal controls.
David Brooks' public image was sullied even more in November 2005, when several major publications reported that he had spent
more than $10 million on a bat mitzvah party for his 13-year-old daughter in the elegant Rainbow Room in midtown Manhattan. Brooks used
DHB's corporate jet to fly several famous musicians to the party to serenade invited guests, including 50 Cent, Aerosmith, Kenny G, Stevie
Nicks, and Tom Petty. Brooks, who was decked out in a hot pink suede bodysuit during the affair, also handed out party bags to the bat mitzvah
guests that contained a wide range of merchandise, including a digital camera and an Apple iPod, allegedly purchased with DHB corporate funds.
In July 2006, amid growing concerns regarding the reliability of DHB's accounting records, the company's board dismissed David
Brooks and hired a team of forensic accountants to investigate those records. That investigation revealed that Brooks and his two top
subordinates, Sandra Hatfield and Dawn Schlegel, had orchestrated a large-scale accounting fraud that had grossly inflated DHB's reported

At the time, the National Association of Securities Dealers (NASD) oversaw the operations of the NASDAQ.

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operating results and financial condition.3 In addition to uncovering the massive fraud, the year-long forensic investigation yielded disturbing
insights into the company's corporate culture during David Brooks' reign:
Brooks exercised absolute control over every aspect of DHB's business, using the company's weak corporate
governance and almost nonexistent internal controls to facilitate and hide the financial fraud he directed through
Schlegel and Hatfield Brooks' control extended to DHB's board of directors, which consisted of Brooks'
friends and neighbors and Schlegel. At all times, Brooks had a chokehold over DHB's board which exercised no
real oversight Brooks also controlled the flow of information with DHB's outside auditors, who regarded
Brooks as the key decision-maker.
Brooks used threats of physical harm to enforce his policies and directives. When anyone questioned the accounting and financial reporting
practices underlying the fraud at DHB, Brooks became furious and threatening. During one board meeting, Brooks told a board member who
questioned one of his decisions, You know what we do to outsiders you know what we do to people that are not on the team.
A primary target of Brooks' anger and threats was the company's independent auditor. When DHB's audit engagement partner
questioned the authenticity of certain journal entries, Brooks told another company official that if she [the audit partner] were not careful, she
would be wearing cement blocks on her feet in the Atlantic Ocean. Later, during that same audit, the audit engagement partner questioned
Brooks directly regarding circumstances that took place during the company's prior audit, which was performed by a different accounting firm.
During this conversation, Brooks stated that someone should put a bullet in the brain of the previous year's audit engagement partner.
Brooks also routinely withheld critical information from DHB's auditors, including information regarding significant related-party
transactions. DHB purchased many of the components used to manufacture its protective vests from Tactical Armor Products (TAP), a privately
owned company based in Florida. In early 2003, after discovering that Brooks' wife was TAP's CEO, DHB's auditors insisted that the company
issue an amended Form 10-K for fiscal 2002 to disclose that fact. In truth, Brooks exercised total control over TAP's operations, a fact that was
not divulged to the auditors nor disclosed in the amended Form 10-K.4
In addition to repeatedly failing to disclose that TAP was a related-party entity, Brooks also failed to disclose in DHB's SEC
registration statements that he had been sanctioned by the federal agency in 1992. This information was allegedly a material fact that would have
been of significant interest to DHB's stockholders, prospective investors, and a wide range of other parties involved with the company.
According to a federal prosecutor, a principal goal of Brooks' accounting fraud was to ensure that DHB consistently reported gross
profit margins of 27 percent or more and increased earnings, to correspond to the expectations of professional stock analysts. One facet of the
fraud was a series of bogus journal entries. From 2003 through 2005, Dawn Schlegel instructed her subordinates on DHB's accounting staff to
record multimillion-dollar entries that reclassified components of cost of goods sold as operating expenses. Although these reclassification entries
did not improve the company's bottom line profits, they did serve the purpose of significantly inflating DHB's gross profit ratio each period.
The major focus of the DHB fraud was the company's inventory accounts. From 2003 through 2005, DHB's period-ending inventories
were consistently and materially inflated. Throughout that three-year period, Hatfield was responsible for assigning values to inventory and
Schlegel was responsible for reviewing and approving the inventory valuation before incorporating it into the company's consolidated financial
statements. Brooks directly supervised Schlegel and Hatfield in performing all their duties, and demanded to review all financial statements
and disclosures DHB included in its [SEC] filings.
Near the end of fiscal 2004, Hatfield realized that DHB would fall well short of the 27 percent gross profit margin that Brooks
believed was necessary to satisfy financial analysts tracking the company's stock. To solve this problem, Hatfield increased the already overstated
value of the company's year-end inventory by several million dollars through various pricing manipulations. The offsetting reduction of cost of
goods sold allowed DHB to reach the 27 percent threshold for gross profit margin and to inflate its reported net income.
When DHB's controller reviewed the company's year-end inventory values for 2004, he immediately realized that they were
overstated. After preparing schedules documenting the inventory overstatements, the controller went to Hatfield and Schlegel, who
acknowledged that the inventory was overstated. Despite that acknowledgment, the two executives refused to correct the inventory values.
Troubled by concerns over the company's inflated inventory values, the controller turned in his resignation.
Before leaving DHB, the controller informed the company's independent auditors that he believed the year-end inventory values were
overstated. The auditors then raised this matter directly with Brooks. Brooks and Hatfield told the auditors that the controller's inventory analysis
was incorrect and that there were no real problems in the inventory.
After meeting with the auditors, Brooks stormed into the controller's office. During Brooks' subsequent trial, the controller testified
that an enraged Brooks called him a ___ snake and flung water all over me. While an unidentified man blocked the door to the
controller's office, Brooks shouted I am going to kick your ___. Brooks then confiscated the controller's inventory analysis and violently
ejected him from the premises. When DHB's auditors subsequently questioned Brooks regarding the controller's ejection from the company's
headquarters, Brooks responded that the controller had violated internal policies and procedures when he had told them of his concerns
regarding the valuation of inventory.
The circumstances surrounding the resignation of DHB's controller served to heighten the auditors' concern regarding the valuation of
year-end inventory. Making matters worse, Brooks instructed his subordinates to file the company's 2004 Form 10-K with the SEC before the
auditors had concluded their investigation of DHB's inventory, a decision that deeply troubled the auditors. To placate the auditors, Brooks
amended the company's 2004 Form 10-K. This amendment disclosed a material weakness in DHB's inventory valuation process.5
DHB's Management Report on Internal Control over Financial Reporting in the amended 2004 Form 10-K noted that there existed
certain significant deficiencies in the Company's systems of inventory valuation rendering it inadequate to accurately capture cost of materials
and labor components of certain work in progress and finished goods inventory. The report went on to observe, however, that the material
weakness did not affect the Company's financial statements or require any adjustment to the valuation of its inventory or any other item in its
financial statements.
DHB's auditors insisted on including an updated version of their report on the company's internal controls in the amended Form 10-K.
This updated report identified two additional material weaknesses in internal controls that were not documented in DHB's management report on

Hatfield had worked for Brooks in several capacities after he organized the company in 1992. Brooks eventually appointed her as DHB's COO
in December 2000. Schlegel's first connection with DHB was as an independent auditor. In late 1999, Brooks hired her to serve as DHB's CFO.
Schlegel, who was a CPA, also served on the company's board of directors.
4
Brooks used his control of both companies to funnel millions of dollars from DHB to himself via TAP.
5
The amended Form 10-K was filed with the SEC prior to the date that the original 2004 Form 10-K was released to the public.

Financial and Integrated Audits - Frederick Choo

internal controls. You should access Data File 6-3 in iLearn for Exhibit 2, which contains excerpts from the auditors' updated internal control
report that described these two items. The first item involved DHB's decision to file its original 2004 Form 10-K prior to the auditors completing
their final review of key financial statement amounts in that document. The second of the two additional material weaknesses indicated that
DHB's audit committee did not have a proper understanding of its important oversight role for the company's financial reporting process.
To mitigate the damage caused by the reporting of these two additional material weaknesses, Brooks took the unusual step of
including an insert in the amended 2004 Form 10-K that challenged the auditors' updated internal control report. In this insert, DHB maintained
that the two additional material weaknesses identified by the auditors were not, in fact, true material weaknesses. See Exhibit 3 of Data File 6-3
in iLearn. DHB's auditors resigned shortly after this contentious disagreement was aired in the company's SEC filings.
DHB's Form 10-Q for the first quarter of fiscal 2005 reported a net income of $7.6 millionthe company's net operating cash flow for
that period was a negative $5.0 million. The company's gross profit margin for that quarter was 27.4 percent, a figure that was almost identical to
the gross profit margins realized by the company for fiscal 2003 and 2004. DHB surpassed the magic 27 percent gross profit threshold for the
first quarter of 2005 because Hatfield and Schlegel had inflated the quarter-ending inventory by adding 63,000 nonexistent vest components to
the company's inventory accounting records.
The decision to add fictitious items to DHB's inventory posed a vexing problem for the co-conspirators that they had not anticipated;
namely, how to conceal that fact from the company's new auditors, the company's fourth audit firm in four years. (In prior periods, the three
executives had overstated DHB's inventory values by increasing the cost-per-unit assigned to individual inventory items rather than by adding
fictitious items to the accounting records.) Near the end of 2005, Brooks came up with a plan for solving the problem posed b y the fictitious
inventory. Brooks told Schlegel to include the cost of the $7 million of bogus vest components in a large write-off entry that was necessary for a
line of business that DHB was discontinuing.6
A few months later, during the fiscal 2005 audit, DHB's auditors questioned Brooks regarding the inventory included in the loss from
discontinued operations. Brooks told the auditors that the $7 million of vest components had to be written off because the U.S. military had
changed its color requirements for the vests in which those components were to be incorporated. When asked where the obsolete vest components
were, the quick-thinking Brooks replied that they no longer existed because the warehouse in which they had been stored had been destroyed by a
hurricane a few months earlier. Brooks later relayed this bogus explanation to Schlegel so that she would be prepared to corroborate it with the
auditors. In exasperation, Schlegel asked Brooks why he had told that story, since they had nothing to support it, and the auditors would want
support and details. Despite her concern, Schlegel did as she was instructed and confirmed the story when DHB's auditors queried her regarding
the $7 million inventory item.
When the auditors continued to press for additional details regarding the written-off inventory, a flummoxed Brooks altered his story.
He told the auditors that the hurricane explanation was a lie made up by his subordinates, which he had not known when he passed that
information to the auditors. This troubling about-face and the inability of Brooks or his subordinates to account for the mysterious $7 million of
inventory caused DHB's auditors to begin seriously questioning whether they could issue an opinion on the company's 2005 financial statements.
In early March 2006, the auditors told Brooks that they would not be able to release their audit report on DHB's 2005 financial
statements in time for the company to meet the SEC filing deadline for its 2005 Form 10-K. Law enforcement authorities subsequently
discovered that Brooks attempted to shop for a favorable audit opinion by replacing those auditors with another audit firm that he had secretly
contacted. That effort proved unsuccessful. A few months later, in July 2006, Brooks' turbulent tenure as DHB's founder and top executive came
to an end when he was dismissed by the company's board.
The following month, DHB recalled its audited financial statements for 2003 and 2004 and warned third parties that they should no
longer rely on them. DHB issued restated financial statements for those two years that radically altered the company's previously reported
operating results. DHB's restated income statement for 2004, for example, reported a $9.5 million net loss, compared to the $30 million net
income the company had originally reported for that year. You should access Data File 6-3 in iLearn for Exhibit 4, which presents DHB's
restated income statements and balances sheets for 2003 and 2004.
The SEC filed a civil complaint against Hatfield and Schlegel on August 18, 2006. The SEC alleged that the two individuals had
participated in an accounting fraud that had grossly inflated DHB's reported operating results and financial condition. Law enforcement
authorities subsequently filed criminal fraud charges against both Hatfield and Schlegel.
On October 25, 2007, the SEC filed a civil complaint against David Brooks that alleged he was the master architect of the DHB fraud.
Later that morning, federal law enforcement authorities arrested Brooks in his lavish home on Long Island, and then filed more than one dozen
criminal charges against him during his arraignment. Two days prior to Brooks' arrest, his former close friend and confidante, Dawn Schlegel,
had pleaded guilty to two criminal charges, conspiracy to defraud the government, and conspiracy to conceal tax information. In exchange for
sentencing considerations, Schlegel agreed to serve as the government's star witness during the criminal trial of Brooks and Hatfield.

Required
1. AU 240 Consideration of Fraud in a Financial Statement Audit suggests a 10-step approach to integrate fraud audit into the audit of financial
statements. Step 5 requires the auditor to identify specific fraud risks at the audit plan. This identification of fraud risks is to be integrated with
the auditors consideration of the Fraud Triangle at the audit plan phase (refer to Table 6-1 and Table 6-2 in Chapter 6). Based on your reading
of the case above, document what you believe to be factors that would increase the risk of fraud at DHB. Using the format below, document at
least three fraud risk factors of DHB for each of the three characteristics of the Fraud Triangle. If you make any assumption for your answer,
state your assumption.
Your Identification of DHBs Fraud Risk Factors
A. Incentives/Pressures
1. (assumption, if any)
2.
3.
B. Opportunities
1. (assumption if any)
6
In August 2005, a government agency decertified the bullet-resistant material being used in the manufacture of a certain product line of
DHB's vests, which caused DHB to discontinue that product line.

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6 Audit Plan - Objectives

Your Identification of DHBs Fraud Risk Factors


2.
3.
C. Attitudes/Rationalization
1. (assumption, if any)
2.
3.
2. Exhibits 1 and 4 in iLearn present DHB's original 20032004 balance sheets and income statements and the restated balance sheets and income
statements for those two years, respectively. Review the original and restated financial statements for 2004 and identify the material differences
between them. Using the format below, identify at least four material differences and state what could be the probable cause of these material
differences. If you make any assumption for your answer, state your assumption.

1.
2.
3.
4.

Material Differences

Probable Cause of the Material Differences


(state assumption, if any)
(state assumption, if any)
(state assumption, if any)
(state assumption, if any)

Financial and Integrated Audits - Frederick Choo

Chapter 7
Audit Plan - Evidence
Chapter Learning Outcomes (LOs) Checklist
After reading this chapter, you should be able to:
LO7-1 Understand the terminology of audit evidence.
LO7-2 Distinguish between vouching and tracing for evidence.
LO7-3 Describe the relationships among seven broad categories of evidence, eight
categories of specific audit objectives, and sixteen prescriptive terms of audit
procedures.
LO7-4 Apply analytical procedures in audit plan.
LO7-5 Apply analytical procedures in tests of balances.
LO7-6 Understand Benfords Law in tests of balances.
LO7-7 Apply analytical procedures in completing the audit.
LO7-8 Apply other audit procedures to assess a clients going concern status.

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Chapter 7 Audit Plan - Evidence


This chapter discusses the auditors main consideration of audit evidence in financial and integrated audits. Figure
7-1 presents the auditors main consideration of audit evidence.
Figure 7-1 Main Considerations of Audit Evidence in Financial and Integrated Audits
The Audit Process

Audit Plan

Preplan and
Documentation CH 5

Tests of Controls

Tests of Balances

Completing the Audit

Financial Audit

Audit Report

Integrated Audit

Consider Persuasiveness
of Evidence
Objectives CH 6

Consider Appropriateness
(Reliability and Relevant)

Evidence CH 7

Internal Control CH 8

External Evidence
(More Reliable)

Consider Sufficiency
(Quantity or Sample size)

Internal Evidence
(Less Reliable)

Strong Internal Control


(More Reliable)

Materiality and Risk CH 9

Program and
Technology CH 10

Weak Internal Control


(Less Reliable)

Obtain Indirectly
(Less Reliable)

Obtain directly
(More Reliable)

From Qualified Person


(More Reliable)

Objective Nature
(More Reliable)

Obtain Timely
(More Reliable)

From Unqualified Person


(Less Reliable)

Subjective Nature
(Less Reliable)

Obtain Untimely
(Less Reliable)

Financial and Integrated Audits - Frederick Choo

Terminology of Audit Evidence


In practice, an auditor typically finds it necessary to rely on evidence that is persuasive rather than convincing
beyond all doubt in issuing an audit opinion. The persuasiveness of evidence is the degree to which the auditor is
convinced that the evidence supports the audit opinion. The AICPAs third Fundamental Principle underlying an
audit requires the auditor to consider two determinants of the persuasiveness of evidence appropriateness and
sufficiency. The appropriateness of evidence is the measure of the quality of audit evidence in providing
support for, or detecting misstatements in, the classes of transactions, account balances, and disclosures and related
assertions. The sufficiency of evidence is the measure of the quantity of evidence. AU 500 Audit Evidence and AS
15 Audit Evidence s refer "appropriateness" to the reliability and relevance of evidence, and "sufficiency" to the
quantity of evidence. In practice, the auditor uses the term reliability of evidence as being synonymous to
appropriateness of evidence. In addition, the auditor uses the term sample size as being synonymous to
sufficiency of evidence.
The reliability of evidence depends upon several factors that are briefly discussed in Table 7-1.
Table 7-1 Factors Affecting the Reliability of Evidence

Factors Affecting the Reliability of Evidence


Source

Internal Control

Direct Knowledge

Qualification of Provider

Objectivity

Timeliness

Evidence obtained from independent external source is more reliable than evidence obtained from within
the client's organization. For example, external evidence such as communications from banks, attorneys, or
customers is more reliable than internal evidence such as answers obtained from inquiries of the client.
Similarly, external documents such as a bank statement from external source are more reliable than internal
documents such as a check.
When the clients internal controls are strong, evidence obtained is more reliable than when they are weak.
For example, if internal controls over sales and billing are strong, the auditor can obtain more reliable
evidence from sales invoices and shipping documents than if the controls are weak.
Evidence obtained directly by the auditor through examination, observation, computation, or inspection is
more reliable than evidence obtained indirectly via the client. For example, if the auditor calculates the
gross profit margin and compares it with previous periods, the evidence would be more reliable than if the
auditor relied on the calculations of the controller.
Evidence obtained from a qualified person is more reliable than evidence obtained from an unqualified
person. For example, an accounts receivable confirmation from an accountant is more reliable than that
from a person who is not familiar with the business world.
Objective evidence is more reliable than subjective evidence that requires judgment. Examples of objective
evidence include the confirmation of accounts receivable and bank balances and the physical count of
securities and cash. Examples of subjective evidence include the observation of obsolescence of inventory
and the inquiry of allowance for uncollectible accounts receivable.
The timeliness of audit evidence can refer either to when it is obtained or to the period covered by the
audit. Evidence is more reliable for balance sheet accounts when it is obtained as close to the balance sheet
date as possible. For example, the auditors count of marketable securities on the balance sheet date would
be more reliable than a count few months earlier. Evidence is more reliable for income statement accounts
when there is a sample from the entire period under audit rather than from only a part of the period. For
example, a random sample of sales transactions for the entire year would be more reliable than a sample
from only the first six months.

The relevance of evidence means that evidence must be pertinent to the auditors specific objective or the
management assertion being tested. An example is if the auditors specific objective were to examine the existence
(i.e. existence objective) of inventory, the auditor would obtain relevant evidence by observing the clients physical
inventory count (inventory-taking). However, such evidence would not be relevant in determining whether the
goods were owned by the client (i.e., rights and obligations objective) or their costs (i.e. valuation and allocation
objective). Another example is if an auditor were concerned that a client was failing to bill customers for shipments
(i.e., completeness objective), the auditor would select a sample of shipping documents and traced each to recorded
sales transactions in the sales journal to determine whether shipments have been billed; the evidence would be
relevant for testing the specific audit objective of completeness. However, if the auditor were to select a sample of
sales transactions from the sales journal and vouched each to shipping documents to determine whether sales were
supported by adequate documentations (i.e., occurrence objective), the evidence would not be relevant for
completeness (but relevant for occurrence) and therefore would not be considered reliable evidence for the specific
audit objective of completeness. Figure 7-2 presents an overview the relationships among vouching and tracing (the
direction of testing) and occurrence and completeness (the specific objectives).

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7 Audit Plan - Evidence

Figure 7-2 Relationships among Vouching and Tracing (the direction of testing), and Occurrence and
Completeness (the specific audit objective)

Tracing for Completeness

Source Documents

Accounting Records

For example, the auditor traces a sample of sales invoices to their entries in the accounts receivable balance in the general ledgers to test the
completeness assertion (completeness objective).

Vouching for Occurrence

Source Documents

Accounting Records

For example, the auditor vouches the accounts receivable balance in the general ledger to the related sales invoices to test the existence or
occurrence assertion (occurrence objective).

The quantity of evidence is determined primarily by the sample size the auditor selected. For a given
TOC or TOB procedure, the evidence obtained from a sample of 100 would ordinarily be more sufficient than from
a sample of 50.
The persuasiveness of evidence can be evaluated only after considering the combination of reliability,
relevance and quantity of evidence. A large sample of evidence provided by an independent party is not persuasive
unless it is relevant to the audit objective being tested. A large sample of evidence that is relevant but not objective
is also not persuasive. Similarly, a small sample of only one or two pieces of highly reliable evidence also typically
lacks persuasiveness. The auditor must evaluate a combination of all factors influencing appropriateness and
sufficiency when determining the overall persuasiveness of evidence.
Finally, both persuasiveness and cost must be considered in deciding the type or types of evidence for
a given audit. The persuasiveness and cost of all alternative types of evidence should be considered before selecting
the best type or types of evidence. In practice, the auditors goal is to obtain a sufficient amount of appropriate
evidence at the lowest possible total cost. However, it should be noted that cost is never an adequate justification for
omitting a necessary evidence gathering procedure or not gathering an adequate sample size of evidence.
Seven Broad Category of Evidence
When planning an audit, the auditor considers seven broad categories of evidence. Brief comments on these seven
broad categories of evidence are provided in Table 7-2.
Table 7-2 Seven Broad Categories of Evidence
Category of Evidence
(1) Physical evidence

(2) Confirmations

Comments
Two common types of physical evidence obtained by the auditor are (a) examination of tangible assets, and
(b) observation of a client's activities. For example, the auditor counts and examines inventory to determine
that the inventory existed. Or, the auditor observes the receipt of incoming mail to determine that all checks
received through the mail are properly banked. In general, physical evidence meets the audit objective of
existence but it does little to meet the audit objective of valuation and allocation, and rights and
obligations.
Confirmations are written evidence obtained by the auditor through direct communication with

Financial and Integrated Audits - Frederick Choo

Category of Evidence

(3) Documentary evidence

(4) Written representation

(5) Oral evidence

(6) Mathematic evidence

(7) Analytical evidence

Comments
independent third parties outside of the client's organization. Typically, confirmations meet the audit
objective of existence. In general, the reliability of evidence obtained through confirmations depends upon
the third party's qualification and willingness to cooperate. The auditor frequently confirms with third
parties for the following evidence:
Third parties
Items Confirmed
(a) Bank
.........Checking account balances and cash in bank
(b) Bond trustees
.........Bond payable
(c) Customers
.........Accounts receivable balances
(d) Lessors
.........Lease terms
(e) Public warehouse managers .........Inventory stored in pubic warehouse
(f) Vendors or suppliers
.........Accounts payable balances
Two common types of documentary evidence obtained by the auditor are: (a) external documents created
outside the client's organization and held by the client, such as bank statements, vendors' invoices and
statements, contracts, and customer purchase orders, and (b) internal documents created by and held within
the client's organization which either (i) have been transmitted to and returned by outsiders to the client,
such as paid checks, or (ii) have never been transmitted to outsiders but have only been circulated within
the client's organization, such as copies of purchase orders, copies of sales invoices, receiving reports,
credit memoranda, bank reconciliation and trial balance. The auditor reads, inspects, examines, traces,
vouches or compares these documents to meet the audit objectives of occurrence, completeness and rights
and obligations. In general, external documentary evidence is more reliable than internal evidence. Table 73 presents some common internal and external documents.
Written representation is evidence in the form of a signed statement by responsible and knowledge persons
within or outside the client's organization. The auditor routinely asks for a signed management (client)
representation letter from the client's management revealing, among other things, the existence of
contingent liability or possible violation of laws or regulations by the client's personnel. The auditor also
requests the client's lawyer for a lawyer's representation letter regarding any pending litigation, claims and
assessments known to the lawyer. Written representation may pertain to any of the audit objectives.
Oral evidence is evidence obtained by the auditor through inquires of the client's key personnel. Oral
evidence is not sufficient appropriate evidence by itself. The auditor normally obtains further corroborating
evidence through other audit procedures.
Mathematical evidence involves re-computations, extensions, footings and cross-footings, reconciliation
and tracing by the auditor to verify the mathematical accuracy of the client's financial records.
Mathematical evidence provides reliable evidence for the audit objectives of valuation and allocation,
classification, cutoff and accuracy, but it does little to meet the audit objectives of existence or occurrence
and understandability.
Analytical evidence obtained by the auditor involves the use of ratio and comparisons of relationships
among financial items, such as industrial averages and prior year financial information, and non-financial
items, such as number of employees and direct labor hours. The auditor scans, compares, and analyzes
financial and non-financial information for analytical evidence. Analytical evidence meets the audit
objectives of existence or occurrence, completeness, valuation and allocation, and accuracy. In general, the
reliability of analytical evidence depends upon the plausibility of the relationships among the data, and the
availability and reliability of the data.

Table 7-3 Common Internal and External Documents

Common Internal Documents

Business Documents
Sales invoices
Purchase orders
Canceled checks
Payment vouchers
EDI agreements

Legal Documents
Labor and fringe benefit agreements
Sales contracts
Lease agreements
Royalty agreements
Maintenance contracts

Accounting Documents
Estimated warranty liability schedules
Depreciation and amortization schedules
Standard cost computations and schedules
Management exception reports

Other Documents
Employee time cards

Common External Documents

Business Documents
Vendor invoices and monthly statements
Customer orders
Sales and purchase contracts
Loan agreements

Third-party documents
Confirmation letters from legal counsel
Confirmation statements from banks
Confirmation replies from customers

Other Documents
Industry trade statistics
Credit rating reports
Data from computer service bureaus

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7 Audit Plan - Evidence

Common Internal Documents

Common External Documents

Shipping and receiving reports


Scrap or obsolescence inventory reports
Market research surveys
Pending litigation reports
Variance reports

The Relationships between Seven Categories of Evidence and Eight Types of Specific Audit Objectives
Recall the eight types specific objectives discussed in Chapter 6:
1. Existence the specific audit objective of verifying that all assets, liabilities, and equity interests included in the
financial statements actually exist at the date of the financial statements.
Occurrence the specific audit objective of verifying that all transactions and events that have been recorded have
occurred, disclosed, and pertain to the client.
2. Completeness the specific audit objective of verifying that all transactions and events, assets, liabilities, and
equity interests that should have been recorded and included in the financial statements have been recorded and
included.
3. Rights and Obligations the specific audit objective of verifying that the client holds or controls the rights to
assets and that liabilities are the obligation of the client.
4. Valuation and Allocation the specific audit objective of verifying that all assets, liabilities, and equity interests
are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments
are recorded appropriately.
5. Classification the specific audit objective of verifying that all transactions and events have been recorded in the
proper accounts and that financial and other information is presented and described appropriately.
6. Cutoff the specific audit objective of verifying that all transactions and events have been recorded in the correct
accounting period.
7. Accuracy the specific audit objective of verifying that amounts and other data relating to recorded transactions
and events have been recorded appropriately and that financial and other information are disclosed fairly.
8. Understandability the specific audit objective of verifying that financial and other information in disclosures are
expressed clearly.
Table 7-4 presents a summary of the relationships between the seven categories of evidence and the eight
types of specific audit objectives
Table 7-4 Relationships between Seven Categories of Evidence and Eight Types of Specific Audit Objectives
Category of Evidence
(1) Physical evidence
(2) Confirmations
(3) Documentary evidence
(4) Written representation
(5) Oral evidence
(6) Mathematic evidence
(7) Analytical evidence

Types of Specific Audit Objectives


Existence but not valuation and allocation, and rights and obligations.
Existence.
Occurrence, completeness and rights and obligations.
Any specific audit objectives.
None on its own.
Valuation and allocation, classification, cutoff, and accuracy but not existence or occurrence and
understandability.
Existence or occurrence, completeness, valuation and allocation, and accuracy.

The Relationships among Seven Categories of Audit Evidence, Eight Types of Specific Audit Objectives, and
Sixteen Prescriptive Terms of Audit Procedures
When planning an audit, the auditor prescribes audit procedures for obtaining audit evidence pertinent to specific
audit objectives. The auditor uses sixteen prescriptive terms to prescribe the audit procedures. These sixteen
prescriptive terms are based on the seven categories of evidence. Table 7-5 presents the sixteen prescriptive terms
based on the seven categories of evidence. Table 7-6 provides comments on the sixteen prescriptive terms.

Financial and Integrated Audits - Frederick Choo

Table 7-5 Sixteen Prescriptive Terms of Audit Procedures based on Seven Categories of Evidence
Category of Evidence
(1) Physical evidence
(2) Confirmation
(3) Documentary evidence
(4) Written representation
(5) Oral evidence
(6) Mathematic evidence
(7) Analytical evidence

Prescriptive Terms of Audit Procedures


Count, Inspect, Observe, Examine.
Confirm.
Compare, Examine, Read, Trace, Vouch, Inspect.
Request, Confirm
Inquire.
Foot, Cross-foot, Re-compute, Reconcile, Trace, Extend.
Compute, Scan, Compare, Analyze.

Table 7-6 Comments on the Sixteen Prescriptive Terms of Audit Procedures


Prescriptive Terms
(1) Analyze
(2) Compare
(3) Confirm

(4) Count
(5) Examine
(6) Extend
(7) Foot & Cross-Foot

(8) Inquire

(9) Inspect
(10) Observe

(11) Read
(12) Re-compute
(13) Reconcile

(14) Scan
(15) Trace

(16) Vouch

Comments
A procedure used by the auditor to study and compare relationships among financial and non-financial
items. For example, the auditor performs a trend analysis of the sales data.
A procedure used by the auditor to compare financial items from two different sources. For example, the
auditor compares the unit-selling price on the invoice to the standard price list.
A procedure used by the auditor to obtain information from an independent party outside the client's
organization. For example, the auditor confirms accounts receivable and payable with debtors and creditors,
respectively.
A procedure used by the auditor to provide physical evidence of the quantity of the financial items on hand.
For example, the auditor counts the cash on hand at the balance sheet date.
A procedure used by the auditor to conduct a detailed study of documents, records and tangible assets. For
example, the auditor examines a sample of vouchers to determine whether they are properly authorized.
A procedure used by the auditor to multiply a set of figures. For example, the auditor extends the client's
inventory listing by multiplying the quantities in units by the cost per unit.
A procedure used by the auditor to add a column of figures (footing) and a row of figures (cross-footing) to
determine whether a client's calculation is correct. For example the audit foots the accounts receivable aging
schedule to determine its accuracy.
A procedure used by the auditor to produce oral or written evidence of financial items. For example, the
auditor obtains a management representation letter, which states that the client's management has made all
accounting records available to the auditor.
A procedure used by the auditor to carefully scrutinize documents, records and tangible assets. For example,
the auditor inspects the physical condition of certain inventories.
A procedure used by the auditor to watch or witness the performance of some activities. From these
observations the auditor obtains direct evidence about the existence of physical evidence. For example, the
auditor observes the client's inventory count procedure.
A procedure used by the auditor to determine the facts of a written document. For example, the auditor reads
the minutes of the client's corporate meetings.
A procedure used by the auditor to independently recalculate financial items to determine their mathematical
accuracy. For example, the auditor re-computes the depreciation schedule.
A procedure used by the auditor to explain the differences between the balances of financial items shown in
the client's bank and that provided by the outside party. For example, the auditor reconciles the client's cash
on hand as per the cash-book with the cash in bank as per the bank statement.
A procedure used by the auditor to perform a less detailed scrutiny of documents, records and tangible
assets. For example, the auditor scans the sales journal for large and unusual transactions.
A procedure used by the auditor to test financial items from the source documents to the accounting records.
For example, the auditor traces a sample of sales invoices to their entries in the accounts receivable balance
in the general ledgers to test the completeness assertion (completeness objective).
A procedure used by the auditor to test financial items from the accounting records to the source documents.
For example, the auditor vouches the accounts receivable balance in the general ledger to the related sales
invoices to test the existence or occurrence assertion (occurrence objective).

Figure 7-3 depicts the relationships among the seven categories of audit evidence, the eight types
of specific audit objectives, and the sixteen prescriptive terms of audit procedures. Note that there is not necessary a
one-to-one relationship among audit evidence, specific audit objective and prescribed audit procedure. Audit
evidence pertinent to a specific audit objective is ordinarily obtained by prescribing several audit procedures. For
example, evidence pertinent to the specific audit objective of existence of inventory is ordinarily obtained by
prescribing several audit procedures such as count, inspect, observe, and examine physical inventory.

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Figure 7-3 Relationships among Seven Categories of Audit Evidence, Eight Types of Specific Audit
Objectives, and Sixteen Prescriptive Terms of Audit Procedures

Specific Audit Objectives


(8 broad types)

Pertinent to

Audit Evidence
(7 Broad Categories)

To obtain

Audit Procedures
(16 Prescriptive Terms)

Evaluation of Audit Evidence


Once the seven categories of evidence have been gathered (see Tables 7-2 through to 7-6), the auditor evaluates their
reliability (low, medium, or high) based on the factors that affect their reliability (see Table 7-1). For example, if the
auditor tested for the specific audit objective of existence of inventory and used the audit procedure of inquiry with
the warehouse manager to obtain the evidence, then the reliability of the evidence is generally regarded as low
because not only internal source of evidence is less reliable (see Table 7-1) but also oral evidence gathered through
inquiry alone is not sufficient to accomplish any specific audit objective (See Table 7-4 and Table 7-5). In other
words, to accomplish the existence objective, the auditor would need to corroborate the oral evidence with more
reliable direct knowledge evidence (see Table 7-1) such as conducting test counts of the inventory for physical
evidence (see Table 7-4 and Table 7-5).
Analytical Procedures
Recall in Table 7-5 the 7th category of evidence (analytical evidence) and the audit procedures associated with it
(compute, scan, compare, and analyze). The audit procedures for gathering the analytical evidence are collectively
known as analytical procedures. Analytical procedures are defined in AU 520 Analytical Procedures as "evaluations
of financial information made by a study of plausible relationships among both financial and non-financial data."
These procedures are based on the presumption that plausible relationship among data may reasonably be expected
to exist. For example, accounts receivable and sales should bear a plausible relationship to one another. Thus, if
gross sales for a company decrease substantially from one period to the next, an auditor might reasonably expect a
substantial decrease in accounts receivable as well.
Analytical procedures range from simple comparisons to complex statistical models. Auditor uses six
common types of analytical procedures in the audit process. These are:
1. Compare client and industry data.
2. Compare client data with similar prior-period data.
3. Compare client data with client-determined expected results.
4. Compare client data with auditor-determined expected results.
5. Compare client data with expected results, using non-financial data.
6. Perform financial ratio analysis on client data.
These six common types of analytical procedures are commonly used in the audit process as shown in Figure 7-4.

Financial and Integrated Audits - Frederick Choo

Figure 7-4 Analytical Procedures used in the Audit Process


The Audit Process

Audit Plan

Tests of Controls

Analytical
Procedures #1, #2
#5, #6

Not Applicable

Tests of Balance

Analytical
Procedures #3, #4,
#5

Completing the Audit

Analytical
Procedure #6,
Benfords Law

Audit Report

Not Applicable

Analytical Procedures in Audit Plan


An auditor uses analytical procedures in planning an audit to:
1. Enhance an understanding of the client's business.
2. Identify areas that may represent risk of misstatement.
3. Direct attention to areas of greater risk, and to plan for more effective and efficient audit procedures.
Analytical procedures used in planning an engagement include reviewing financial information to identifying
unexpected relationships or trends. For example, a comparison of general ledger balances with similar balances
from prior periods and with budgeted or forecasted balances. Various ratios or trends may also be computed to
facilitate the analysis. In addition to financial data, non-financial data may be used as part of the analytical
procedures. For example, quality control reports prepared near year-end may identify production problems, which
may suggest that significant amounts of inventory sold during the latter part of the year may be returned or may
significantly increase future warranty claims. The use of analytical procedures in planning an audit typically
involves five steps as shown in Table 7-7.
Table 7-7 Analytical Procedures in Audit Plan Phase
Steps in Analytical
Procedures
(1) Determine
computations/comparisons to be
made

(2) Develop expectations

Comments
Types of calculation and comparison commonly used include the following:
(a) Absolute data comparisons. For example, comparing the amount of an account balance with an expected
or predicted amount.
(b) Common-size financial statements. This involves calculating the percentage of a related total that a
financial statement item represents. For example, cash as a percentage of total assets. The percentage is
then compared with an expected amount.
(c) Ratio analysis. Ratios can be analyzed individually or in related groups such as activity, profitability,
liquidity, leverage, and solvency. Table 7-8 provides a summary of the common ratios and their
interpretations under each category of ratios.
(d) Trend analysis. Trend analysis involves comparing certain data (absolute, common-size, or ratio) across
accounting periods.
Typical information that an auditor uses for developing expectations
include:
(a) Financial information from comparable prior periods. For example, an expectation that total payroll
costs will equal last year's amount adjusted for a predictable increase resulting from higher wage rates
and/or higher payroll taxes.
(b) Anticipated results, such as projections or forecasts. For example, an expectation that current year data
can be extrapolated from prior interim or annual data.
(c) Relationships among elements of financial information. For example, an increase in the average
amount of debt outstanding would lead to an expected increase in interest expense.
(d) Information regarding the industry in which the client operates. For example, an expectation that

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7 Audit Plan - Evidence

Steps in Analytical
Procedures

(3) Perform the


computations/comparisons

(4) Analyze data and identify


significant differences

(5) Determine effects on audit


planning.

Comments
inventory turnover should be reasonably consistent across companies in the same industry. Data of other
companies within an industry may be obtained from sources such as Dun & Bradstreet, Robert Morris
Associates, and Standard & Poor
(e) Relationship between financial and non-financial information. For example, a client's share of the
market may be used to develop expectation about its sales.
This step involves gathering data to be used in computing the absolute amount, the common-size
percentage, ratios and so on. It also includes gathering the industry data for comparison purposes.
Computer software is commonly used in making the calculations and comparisons, and may also be used in
extracting information from company and industry databases.
This typically involves reconsidering the methods and variables used in developing the expectations and
making inquiries of management. Management's response should ordinarily be corroborated with other
evidential matter. When an explanation for the difference cannot be obtained, the auditor must determine
the impact on the audit plan.
Unexplained significant differences ordinarily indicate increase risk of misstatement in the account or
accounts involved in the computation and comparison. The auditor will then plan to perform more effective
and efficient tests on the accounts.

Table 7-8 Common Ratios Used for Ratio Analysis

Category

Activity
Activity ratios measure the
managements effectiveness in
managing available resources.

Profitability
Profitability ratios measure the
managements effectiveness in
generating return on investment
in assets and equity.

Liquidity
Liquidity ratios measure the
managements ability to meet
current obligations.

Ratio

Interpretation

Asset Turnover = Net Sales / Total Assets

Measures capital intensity: the larger the number the more a


client is able to generate sales with its asset base.

Inventory Turnover = Cost of Goods Sold /


Average Inventory

Measure inventory management: the larger the number the


faster a client is able to turn over its inventory.
Trends in the inventory turnover ratio are used by auditors to
identify potential inventory obsolescence.

Days in Inventory Turnover = 365 days /


Inventory Turnover

Measure inventory management: the larger the number the


longer a client is holding on the inventory.

Accounts Receivable Turnover = Net Sales


/ Average Accounts Receivable

Measure credit effectiveness: the larger the number the faster


a client is able to turn over its credit sales.
Trends in the accounts receivable turnover ratio are used by
auditor to assess the reasonableness of the allowance for
uncollectible accounts.

Days in Accounts Receivable Turnover =


365 days/ Accounts Receivable Turnover
Return on Total Assets = Operating Income
Before Interest and Taxes/ Average Total
Assets

Measure credit effectiveness: the larger the number the


longer a client takes to collect accounts receivable.
Measure asset management: the higher the number the
higher the rate of return on investment in assets.

Return on Common Equity = Operating


Income Before Interest and Taxes / Average
stockholders Equity

Measure equity management: the higher the number the


higher the rate of return on stockholders investment in the
company.

Profit Margin = Operating Income Before


Interest and Taxes / Net Sales

Measure operating profitability: the higher the number the


higher the rate of return on operations.
This ratio is useful to auditors in assessing potential
misstatements in operating expenses and related balance
sheet accounts.

Gross Profit Margin or Percentage = (Net


Sales Cost of Goods Sold )/ Net sales

Measure operating profitability: the larger the number the


larger the portion of the net sales available to cover all
expenses after deducting the cost of product.
This ratio is useful to auditors in assessing misstatements in
sales, cost of goods sold, and inventory.
Measure working capital management: the larger the ratio
the greater adequacy of current assets to cover current
liabilities.

Current Ratio = Current Assets / Current


Liabilities
Quick Ratio = (Cash + Marketable
Securities + Net Accounts Receivable) /
Current Liabilities

Measure working capital management: the larger the ratio


the greater a company is ability to meet its current liabilities
with cash or and near-cash assets.

Financial and Integrated Audits - Frederick Choo

Category

Solvency (Leverage)
Solvency ratios measure the
managements effectiveness in
managing borrowed funds or in
generating income on borrowed
funds.

Ratio

Interpretation

Free Cash Flow = Cash Flow from


Operations Capital Expenditure

Measure the cash flow remaining after covering cash


outflows for operations and capital expenditures: the larger
the number the higher a company has the capacity to finance
operations and capital expenditures with operating cash
flows.
Measure long-term debt management: if the ratio is too high,
a company may have used up its borrowing capacity; if the
ratio is too low, available debt leverage to a company is not
being used to the stockholders benefit.

Debt to Equity = Total Liabilities/


Stockholders Equity, or
Debt to Total assets = Total Debt/Total
Assets
Times Interest Earned = Operating Income
Before Interest and Taxes / Interest Expense

Measure interest expense management: the number of times


a company is able to make interest payments by generating
positive cash flow from operations.

Analytical Procedures in Tests of Balances


An auditor uses analytical procedures in tests of balances (TOB) either:
1. As a TOB procedure to achieve an audit objective related to a particular management assertion, or
2. To provide audit evidence to corroborate evidence obtained from other audit testing procedures.
For some assertions, analytical procedures are effective and efficient TOB procedures. For other assertions,
however, analytical procedures are not as effective and efficient. Several factors determine the effectiveness and
efficiency of an analytic procedure. These are shown in Table 7-9.
It should be note that AU 520 states that analytical procedures must be applied (mandatory) at audit plan
and completing the audit, but that analytical procedures may be applied (not mandatory) at tests of balances
(substantive tests).
Table 7-9 Factors Affecting the Effectiveness and Efficiency of an Analytical Procedure
Factors
(1) Nature of the assertion.

(2) Plausibility and predictability


of the relationship.

(3) Availability and reliability of


data.

(4) Precision of the expectation.

Comments
Analytical procedures are effective and efficient for assertions in which misstatements would not be
apparent from TOB of individual transaction. For example, comparisons of aggregate salaries paid with the
number of personnel may indicate unauthorized payments that may not be apparent from testing individual
transactions.
Analytical procedures are more effective and efficient for expected relationships that are plausible and
predictable. As a rule of thumb:
(a) Relationships are more predictable in a stable than a dynamic or unstable environment.
(b) Relationships are more predictable for income statement accounts (representing transactions over a
period of time) than balance sheet accounts (representing amounts at a point in time).
(c) Relationships involving transactions subject to management discretion are less predictable. For example,
management may delay advertising expenditures.
Analytical procedures are more effective and efficient when data is readily available and reliable. As a rule
of thumb:
(a) Audit data (current or prior year) is more reliable than un-audited data.
(b) Data is more reliable when obtained from sources outside than from sources within the client.
(c) Data is more reliable when the client has adequate separation of duty.
(d) Data is more reliable when the client has adequate internal controls.
(e) Reliability of expectations increases as sources of data increase.
Analytical procedures are more effective and efficient when the expected relationships are more precise.
The precision of the expected relationships depends on:
(a) The number of relevant variables that affect the amount being audited, e.g., sales are affected by prices,
volume and product mix. The more variables, the more precise is the expectation.
(b) The number of relevant variables that are evaluated by the auditor. The more variables evaluated, the
more precise the expectation.
(c) The level of detail in the data used to develop the expectation. The more detailed the data, the more
precise the expectation. For example, monthly amounts are more precise than annual amount; comparison by
location or line of business is more precise than company-wide comparisons.

Benfords Law in Tests of Balances


A complex analytical procedure that can be used as a TOB procedure is the application of Benfords Law. Benfords
Law is a numerical probability theory that establishes the probability of the appearance of numerical digits in
naturally occurring sets of numbers. The Benfords Law establishes the following approximate probabilities of

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occurrence as first digits: 1-30%, 2-18%, 3-12%, 4-10%, 5-8%, 6-7%, 7-6%, 8-5%, and 9-4%. A perpetrator, who
has no knowledge of the Benfords Law, would create accounting numbers by assuming that all the fraudulently
created numbers have an equal probability of occurrence as the first digit. Thus, by checking the probability of
occurrence of the first digit in a sample of accounting numbers under consideration, the auditor is able to detect
potential accounting frauds. For example, a purchasing officer in charge of the purchasing department is authorized
to approve payments of vouchers to a maximum limit of $5,000. If the auditor finds a higher than expected
probability of occurrence (i.e., more than 10%) of 4 as a first digit in a sample of vouchers (i.e., vouchers at $4,001
to $4,999), then it is very likely that the purchasing officer intentionally divided large voucher payments into smaller
voucher payments of just under the maximum limit of $5,000 to avoid seeking higher level of approval for the
voucher payments. Thus, the purchasing officers spending pattern is likely to be further investigated by the auditor.
It should be note that large samples of numbers adhere more closely to the probability of occurrence of the
Benfords Law than small samples. Moreover, the application of the Benfords Law can result in false positives (i.e.,
wrong conclusion) in practice. For example, an HMOs fee schedule can create clustering (i.e., groups of set fees),
and hence results in false non-compliant number repetition in a medical offices billing.
Analytical Procedures in Completing the Audit
An auditor uses analytical procedures at the completing the audit phase either as part of the final review of the
audited financial statements or to assess whether the client continues as a going concern. Table 7-10 provides some
comments on applying the analytical procedures for these two purposes.
Table 7-10 Applying Analytical Procedures at Completing the Audit Phase
As Part of the Final Review

Assessment of a Client's Going Concern Status

As part of the final review of the audited financial statements,


analytical procedures are used to determine whether the anticipated
opinion on the financial statements is appropriate. For this purpose, the
auditor should consider:
(1) The adequacy of data collected in response to unusual or
unexpected balances identified as part of the preliminary analysis.
(2) The existence of unusual or unexpected balances not otherwise
identified during the examination of the financial statements.
When the final review identifies unusual or unexpected balances not
addressed during other phases of the engagement, the auditor must
determine whether additional procedures should be performed before
expressing an opinion on the financial statements.

At the completion of the audit, an auditor uses analytical procedures to


assess whether a client will continue as a going concern, e.g., a low
current ratio indicates a potential going concern problem.
Altman (1968) developed a model for predicting bankruptcy as
follows:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Z = discriminant Z score
X1 = net working capital/total assets
X2 = retained earnings/total assets
X3 = earnings before interest and taxes/total assets
X4 = market value of equity/total debt (liabilities)
X5 = net sales/total assets
A client will be a going concern if Z is greater than 2.99
The predictive accuracy of Altman's model is about 95% one year
prior to bankruptcy. Since auditors are responsible for assessing a
client's going concern status for a reasonable period of time; and a
reasonable period of time is defined as one year beyond the date of
client's year-end financial date according to AU 570 Going Concern,
the model's high predictive accuracy of one year prior to bankruptcy
(95%) renders it a very effective analytical procedure for assessing a
client's going concern status.

Other Audit Procedures to Assess a Clients Going Concern Status


In addition to performing analytical procedures, an auditor also performs other audit procedures to identify
conditions and events that indicate there could be substantial doubt about a client's ability to continue as a going
concern. These other audit procedures include:
1. Review of subsequent events.
2. Review of compliance with the terms of debt and loan agreements.
3. Reading of minutes of meetings of stockbrokers, board of directors, and important committees of the board.
In performing these audit procedures, the auditor seeks to identify conditions and events that indicate a
substantial doubt about a client's ability to continue as a going concern. Table 7-11 shows some of these conditions
and events. After considering these conditions and events in the aggregate; if the auditor believes there is substantial
doubt about a client's ability to continue as a going concern, s/he should identify the management's plan, if any, for

Financial and Integrated Audits - Frederick Choo

mitigating the adverse conditions and events, and consider the effectiveness and feasibility of the management's
plan. Table 7-12 describes the auditors considerations about the managements plan.
Table 7-11 Conditions and Events that Indicate a Substantial Doubt
Conditions and Events
(1) Negative financial trend

(2) Non-financial indicators

(3) Internal factors

(4) External factors

Examples
(a) Recurring operation losses
(b) Working capital deficiencies
(c) Negative cash flows
(d) Adverse key financial ratios
(a) Arrearages in dividends
(b) Denial of trade credit from suppliers
(c) Restructuring of debt
(d) Noncompliance with statutory capital requirements
(e) Need new source/method of financing
(f) Need to dispose substantial assets
(a) Work stoppages/labor difficulties
(b) Over dependence on the success of a particular project
(c) Uneconomic long-term commitments
(d) Need to significantly revise operation
(a) Adverse legal proceedings
(b) Loss of a key franchise, license, patents, copyright , trademark
(c) Loss of a principal customer or supplier
(d) Uninsured or underinsured policies against drought, earthquake, fire or flood.

Table 7-12 Managements Plan and Auditors Consideration


Managements Plan
(1) Plans to dispose of assets

(2) Plans to borrow money or


restructure debt
(3) Plans to reduce or delay
expenditure
(4) Plans to increase ownership
equity

Auditors Consideration
(a) Restrictions on disposal of assets, e.g., covenants on assets
(b) Marketability of assets
(c) Direct/indirect effects of disposal of assets
(a) Availability of debt financing, e.g., new credit line, factoring of receivables, sale -leaseback of assets
(b) Availability/committed loans to the client
(c) Effects of additional borrowings
(a) Feasibility of reducing overheads or administrative expenditures
(b) Postponing maintenance or research and development projects
(c) Lease rather than purchase assets
(a) Feasibility of increasing ownership equity
(b) Arrangements to raise additional capital
(c) Arrangements to reduce dividend requirement
(d) Arrangements to accelerate cash disbursement from affiliates or other investors.

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Multiple-Choice Questions
7-1

Which of the following statements is true with regard to audit evidence?


a. Evidence obtained from sources external to the client is less reliable than those from sources internal to the client.
b. Evidence obtained from sources internal to the client is more reliable when its internal control is strong than weak.
c. Evidence supplied by the client is more reliable than those personally obtained by the auditor.
d. Evidence obtained through confirmation is less reliable than those obtained through observation.

7-2

Which of the following audit procedures would produce the least reliable audit evidence?
a. Test counts of inventory made by the auditor.
b. Notes on inquiry with the warehouse manager.
c. Correspondence with the suppliers of the inventory.
d. An analysis of the perpetual inventory records.

7-3

The auditor's analytical procedures will not be very effective in determining which of the following assertions?
a. Rights and obligations.
b. Completeness.
c. Valuation and allocation.
d. Presentation and disclosure.

7-4

Analytical procedures are best described as


a. tests of controls designed to evaluate the strength of internal controls.
b. tests of balances designed to substantiate financial information.
c. audit tests designed to evaluate the reasonableness of financial and non-financial information.
d. audit tests designed to investigate unrecorded accounting transactions.

7-5

Analytical procedure may be performed


a. at the planning and completion phases of an audit.
b. at the tests of controls and tests of balances phases of an audit.
c. at the tests of transactions and tests of balances phases of an audit.
d. at the planning, testing, and completion phases of an audit.

7-6

Which of the following ratios is an indicator of a client's ability to pay its long-term debt?
a. Debt to equity ratio.
b. Gross profit margin ratio.
c. Quick ratio.
d. Accounts receivable turnover ratio.

7-7

If accounts receivable turnover ratio for a client is 4 times in 20x0 and 2 times in 20x1, it is most likely that
a. there were fictitious credit sales in 20x1.
b. there was a better management of credit granting procedure in 20x0.
c. there were unrecorded credit sales in 20x0.
d. there was a poorer management of credit granting procedure in 20x0.

7-8

If inventory turnover ratio for a client is 5 times in 20x0 and 10 times in 20x1 , it is most likely that (Hint: obsolete inventory is
deducted from closing inventory)
a. there was an increase in the cost of goods sold in 20x0.
b. there was an increase in purchases in 20x0.
c. there was a decrease in obsolete inventory in 20x1.
d. there was an increase in obsolete inventory in 20x1.

7-9

When an auditor compares a set of financial data with a set of expected data computed by the auditor, which of the following
characteristics should the auditor pay most attention to?
a. The reliability of the original data from which the auditor computed the expected results.
b. The availability of the original data from which the auditor computed the expected results.
c. The size of the original data from which the auditor computed the expected results.
d. The realism of the original data from which the auditor computed the expected results.

Financial and Integrated Audits - Frederick Choo

7-10

Which of the following ratios is an indicator of a client's effectiveness in its operation?


a. Quick ratio.
b. Return on total assets.
c. Times interest earned.
d. Average inventory turnover ratio.

7-11

Which of the following ratios is least likely to be used in comparing clients in the same industry?
a. Average inventory turnover ratio.
b. Return on total assets ratio.
c. Current ratio.
d. Return on common equity ratio.

7-12

Which of the following ratios is least likely to be used in checking the liquidity position of a client?
a. Debt to equity ratio.
b. Gross profit margin ratio.
c. Current ratio.
d. Quick ratio.

7-13

Evidence is generally considered appropriate when


a. it has been obtained by a random selection.
b. there is enough of it to afford a reasonable basis for an opinion on financial statements.
c. it has the qualities of being relevant and reliable.
d. it consists of written statements made by managers of the audit client.

7-14

When the auditor examines the clients documents and records to substantiate the information on the financial statements,
it is commonly referred to as
a. inquiry.
b. confirmation.
c. vouching.
d. physical examination.

7-15

Evidence obtained directly by the auditor will not be reliable if


a. the auditor lacks the qualifications to evaluate the evidence.
b. it is provided by the clients attorney.
c. the client denies its veracity.
d. it is impossible for the auditor to obtain additional corroboratory evidence.

7-16

Which of the following factors would least influence an auditors consideration of the reliability of data for purposes of
analytical procedures?
a. Whether sources within the client were independent of those who are responsible for the amount being audited.
b. Whether the data were processed in an EDP system or in a manual accounting system.
c. Whether the data were subjected to audit testing in the current or prior year.
d. Whether the data were obtained from independent sources outside the entity or from sources within the entity.

7-17

Which of the following procedures would provide the most reliable audit evidence?
a. Inquiries of the clients internal audit staff held in private.
b. Inspection of prenumbered client purchase orders filed in the vouchers payable department.
c. Analytical procedures performed by the auditor on the entitys trial balance.
d. Examine of bank statements obtained directly from the clients financial institution.

7-18

Which of the following statements concerning audit evidence is correct?


a. To be appropriate, audit evidence should be either reliable or relevant, but need not be both.
b. The auditor exercises judgment in determining the reliability of audit evidence.
c. The difficulty and cost of obtaining audit evidence concerning an account balance is a valid basis for omitting the test.
d. A clients accounting data can be sufficient audit evidence to support the financial statements.

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7-19

Which of the following presumptions is correct about the reliability of evidence?


a. Information obtained indirectly from outside sources is the most reliable evidence.
b. To be reliable, evidence should be convincing rather than persuasive.
c. Reliability of evidence refers to the amount of corroborative evidence obtained.
d. A strong internal control provides more assurance about the reliability of evidence.

7-20

In testing the existence or occurrence assertion for an asset, an auditor ordinarily vouches from the
a. financial statement s to the potentially unrecorded items.
b. potentially unrecorded items to the financial statements.
c. accounting records to the supporting documents.
d. supporting documents to the accounting records.

7-21

In determining whether transactions have been recorded (completeness objective), the direction (tracing versus vouching)
should be from the
a. general ledger balance.
b. adjusted trial balance.
c. original source documents.
d. general journal entries.

7-22

A clients income statements were misstated due to the recording of journal entries that involved debits and credits to an
unusual combination of expense and revenue accounts. The auditor would most likely detect these misstatements by
a. tracing a sample of source documents to the related general ledger.
b. evaluating the effectiveness of internal control policies and procedures.
c. investigating the reconciliations between controlling accounts and subsidiary records.
d. performing analytical procedures designed to disclose differences from expectations.

7-23

Which of the following non-financial information would an auditor most likely consider in performing analytical
procedures during the planning phase of an audit?
a. Work stoppages and labor difficulties.
b. Objectivity of audit committee member.
c. Square footage of selling space and market share.
d. Management plans to repurchase stock.

7-24

Analytical procedures performed at the completing the audit phase as part of the final review of the audited financial
statements suggest that several accounts have unexpected relationships. The results of these analytical procedures most
likely would indicate that
a. additional tests of balances are required.
b. fraud exists among the relevant account balances.
c. internal controls of the relevant account are not effective.
d. previous communication with the audit committee should be revised.

7-25

Which of the following would not be considered an analytical procedure?


a. Estimating payroll expense by multiplying the number of employee by the average hourly wage rate and the total hours
worked.
b. Estimating the maximum population misstatement rate of inventory based on the results of a statistical sample.
c. Computing accounts receivable turnover by dividing credit sales by the average net receivable.
d. Developing the expected current-year sales based on the sales trend of the prior five years.

7-26

Which of the following factors least affects the effectiveness and efficiency of an analytical procedure?
a. Segregation of obsolete inventory before the physical inventory count.
b. A standard cost system that produces variance reports.
c. Collection of data from sources with strong internal controls.
d. The level of detail in the data used to develop the expected relationships.

7-27

Analytical procedures used in the planning phase of an audit process should focus on
a. reducing the scope of tests of controls and tests of balances.
b. providing assurance that potential material misstatements will be identified.
c. enhancing the auditors understanding of the clients business.
d. assessing the sufficiency of the available evidential matter.

Financial and Integrated Audits - Frederick Choo

7-28

An auditors decision either to apply analytical procedures as tests of balances or to perform tests of balances usually is
determined by the
a. availability of the tests of balances procedures.
b. auditors familiarity with industry trend.
c. timing of performing the tests of balances procedures.
d. relative effectiveness and efficiency of the testing procedures.

7-29

Which of the following statements concerning analytical procedures is correct?


a. Analytical procedures should be used when there is no plausible relationships among non-financial information.
b. Analytical procedures used in planning the audit should not use non-financial information.
c. Analytical procedures usually are effective and efficient for tests of controls.
d. Analytical procedures alone may provide the appropriate level of assurance for some assertions.

7-30

Which of the following tends to be most predictable for purposes of analytical procedures applied as tests of balances?
a. Data subjected to auditing in the prior year.
b. Transactions subject to management discretion.
c. Relationships involving income statement accounts.
d. Relationships involving balance sheet accounts.

7-31

Which of the following comparisons is the most useful analytical procedure an auditor could make in evaluating a clients
expenses?
a. The current years accounts receivable with the prior years accounts receivable.
b. The current years payroll expense with the prior years payroll expense.
c. The current years budgeted sales with the prior years sales.
d. The current years budgeted contingent liabilities with prior years contingent liabilities.

7-32

Which of the following conditions or events most likely would cause an auditor to have substantial doubt about a clients
ability to continue as a going concern?
a. Significant related party transactions are pervasive.
b. Usual trade credit from suppliers is denied.
c. Arrearages in preferred stock dividends are paid.
d. Restrictions on the disposal of principal assets are present.

7-33

An auditor believes there is substantial doubt about the ability of a client to continue as a going concern for a reasonable
period of time. In evaluating the clients plans for dealing with the adverse effects of future conditions and events,
the auditor most likely would consider, as a mitigating factor, the clients plans to
a. discuss with lenders the terms of all debt and loan agreements.
b. strengthen internal controls over cash disbursements.
c. purchase production facilities currently being leased from a related party.
d. postpone expenditures for research and development projects.

7-34

An auditor believes there is substantial doubt about the ability of a client to continue as a going concern for a reasonable
period of time. In evaluating the clients plans for dealing with the adverse effects of future conditions and events,
the auditor most likely would consider, as a mitigating factor, the clients plans to
a. accelerate research and development projects related to future products.
b. accumulate treasury stock at prices favorable to the clients historic price range.
c. purchase equipment and production facilities currently being leased.
d. negotiate reductions in required dividends being paid on preferred stock.

7-35

Which of the following auditing procedures most likely would assist an auditor in identifying conditions and events that
may indicate substantial doubt about a clients ability to continue as a going concern?
a. Inspecting title documents to verify whether any assets are pledged as collateral.
b. Confirm with third parties the details of arrangements to maintain financial support.
c. Reconciling the cash balance per books with the cutoff bank statement and the bank reconciliation.
d. Comparing the clients depreciation and asset capitalization policies to other entities in the industry.

181

182

7 Audit Plan - Evidence

7-36

When an auditor concludes there is substantial doubt about a continuing clients ability to continue as a going concern for a reasonable
period of time, the auditors responsibility is to
a. express a qualified or adverse opinion, depending upon materiality, due to the possible effects on the financial
statements.
b. consider the adequacy of disclosure about the clients possible inability to continue as a going concern.
c. report to the clients audit committee that managements accounting estimates may need to be adjusted.
d. reissue the prior years auditors report and add an explanatory paragraph that specially refers to substantial doubt and
going concern.

7-37

The third standard of field work requires the auditor to collect sufficient appropriate evidential matter in support of the
opinion. Which procedure for collecting evidential matter is not identified in this standard?
a. Inspection.
b. Inquiries.
c. Observation.
d. Rechecks.

7-38

AU 500 Audit Evidential, states that management makes certain assertions that are embodied in financial
statement components; for example, two such categories of assertions are completeness and valuation or allocation. Which of the
following is not a broad category of management assertions according to the auditing standards?
a. Rights and obligations.
b. Presentation and disclosure.
c. Existence or occurrence.
d. Errors or fraud.

7-39

Which of the following is an example of corroborating information (note: versus underlying information) that could be used by an
auditor as evidential matter supporting the financial statements?
a. Worksheets supporting cost allocations.
b. Confirmation of accounts receivable.
c. General and subsidiary ledgers.
d. Accounting manuals.

7-40

Audit evidence can come in different forms with different degrees of persuasiveness. Which of the following is the least
persuasive type of evidence?
a. Bank statement obtained from the client.
b. Test counts of inventory made by the auditor.
c. Prenumbered purchase order forms.
d. Correspondence from the clients attorney about litigation.

7-41

Audit evidence can come in different forms with different degrees of persuasiveness. Which of the following is the most
persuasive type of evidence?
a. Prenumbered client purchase order forms.
b. Client work sheets supporting cost allocations.
c. Bank statements obtained from the client.
d. Client representation letter.

7-42

Which of the following presumptions does not relate to the appropriateness (note: versus sufficiency) of audit evidence?
a. The more effective internal control, the more assurance it provides about the accounting data and financial statements.
b. An auditors opinion, to be economically useful, is formed within reasonable time and based on evidence obtained at a
reasonable cost.
c. Evidence obtained from independent sources outside the entity is more reliable than evidence secured solely within the
client.
d. The independent auditors direct personal knowledge, obtained through observation and inspection, is more persuasive
than information obtained indirectly.

7-43

A basic premise underlying analytical procedures is that


a. these procedures cannot replace tests of balances and transactions.
b. statistical tests of financial information may lead to the discovery of material misstatements in the financial statements.
c. the study of financial ratios is the only alternative to the investigation of unusual fluctuation.
d. plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions
to the contrary.

Financial and Integrated Audits - Frederick Choo

7-44

An objective of performing analytical procedures in planning an audit is to identify the existence of


a. unusual transactions and events.
b. illegal acts that went undetected because of internal control weaknesses.
c. related party transactions.
d. recorded transactions that were not properly authorized.

7-45

For audits of financial statements made in accordance with generally accepted auditing standards (GAAS), the use of
analytical procedures is required (mandatory) to some extent
a.
b.
c.
d.

7-46

In Planning
No
Yes
Yes
No

In Tests of Balances
Yes
Yes
No
No

In Completing the Audit


Yes
No
Yes
No

A primary objective of analytical procedures used in the final review stage of completing the audit is to
a. obtain evidence from details testing to corroborate particular assertions.
b. identify areas that represent specific risks relevant to the audit.
c. assist the auditor in assessing the validity of the conclusions reached.
d. satisfy doubts when questions arise about a clients ability to continue in existence.

7-47

Analytical procedures used in the final review stage of completing the audit generally include
a. considering unusual or unexpected account balances that were not previously identified.
b. performing tests of transactions to corroborate managements financial statement assertions.
c. gathering evidence concerning account balances that have not changed from the prior year.
d. retesting controls that appeared to be ineffective during the assessment of control.

7-48

If an auditor were concerned that a client was failing to bill customers for shipments (i.e., completeness objective), the
auditor would
a. select a sample of sales transactions from the sales journal and vouched each to shipping documents to determine
whether sales are supported by adequate documentations.
b. select a sample of shipping documents and traced each to recorded sales transactions in the sales journal to determine
whether shipments have been billed.
c. select a sample of sales account balances and observed the inventory count for shipments to examine existence.
d. select a sample of sales transactions and recomputed the costs of shipments to determine accuracy.

7-49

If an auditor selects a sample of sales transactions from the sales journal and vouches each to shipping documents to
determine whether sales are supported by adequate documentations, the auditor is most likely testing for the specific audit
objective of
a. Completeness
b. Rights and Obligations
c. Accuracy and Valuation
d. Occurrence

183

184

7 Audit Plan - Evidence

Key to Multiple-Choice Questions


7-1 b. 7-2 b. 7-3 a.

7-4 c. 7-5 d. 7-6 a. 7-7 b. 7-8 d. 7-9 a. 7-10 b. 7-11 d.

7-12 b. 7-13 c. 7-14 c. 7-15 a. 7-16 b. 7-17 d. 7-18 b. 7-19 d. 7-20 c. 7-21 c.
7-22 d. 7-23 c. 7-24 a. 7-25 b. 7-26 a. 7-27 c. 7-28 d. 7-29 d. 7-30 c. 7-31 b.
7-32 b. 7-33 d. 7-34 d. 7-35 b. 7-36 b. 7-37 d. 7-38 d. 7-39 b. 7-40 c. 7-41 c.
7-42 b. 7-43 d. 7-44 a. 7-45 c. 7-46 c. 7-47 a.

7-48 b. 7-49 d.

Financial and Integrated Audits - Frederick Choo

Simulation Question 7-1


Simulation Question 7-1 is an adaptation with permission from an article by Lanza, R. B. in the The White Paper , a publication of the Association
of Certified Fraud Examiners in Austin, Texas. This simulation question is based upon a true set of facts; however, the names and places have
been changed.
Bruce Lee was a member of an audit team who was assigned to investigate possible embezzlement at one retail store. Bruces
responsibility was to examine the questionable actions of one of the cashiers named Helen Uddin. The regional manager of that retail store
informed Bruce that he knew Helen was up to no good. Maybe she is playing with her refunds or discounts, but something fishy is going on! he
lamented.
Helen knew the store cameras and informants were watching her and that management regularly counted the cash. Therefore, Bruce
determined that he would not be able to detect any unrecorded cash skimming schemes because, obviously, if there were no recorded sales then
there were no sales transaction data. But Bruce knew that he could look for register adjustment schemes such as phony discounts, refunds, and
sales voids. For example, Helen might say to a customer that her computer was down, wrote a manual receipt at the full price, and accepted cash
for the sale. Then, after the customer left, she would book the sale with a large discount and take the difference in cash. Another scenario was
Helen might book the sale with the large discount but never gave the receipt to the customer. Finally, Helen could fake a large number of refunds
and sales voids.
Bruce obtained a copy of the sales register data file from the MIS department of the retail store. You should access Data File 7-1 in
iLearn for the sales register data file, which contains 10,240 sales transactions. After reviewing the sales register data file, Bruce planned to
analyze the data to find out if Helen was in fact posting large number of phony discounts, sales voids and refunds. He planned to:

Extract sales with discounts over 90% and summarize by employee;

Identify employees that have produced register adjustments (discounts, refunds, and sales voids) over 300 % more than the average
employee; and

List the top 10 employees by register adjustments (discounts, refunds, and sales voids).
Bruce was confident that the data analyses would identify Helen as the number one suspect in the retail store.

Required
Access Data File 7-1 in iLearn for the sales register data file, which contains 10,240 sales transactions.
1. Analyze the sales register data file to produce the following three reports:
i. Report No.1 Extract sales with discounts over 90% and summarize by employee.
ii. Report No.2 List the top 10 employees by register adjustments (discounts, refunds, and sales voids).
iii. Report No.3 Identify employees that have produced register adjustments over 300% more than the average employee.
2. Review the three reports in 1 above and explain why you think whether Helen should or should not be the number one suspect.
Note: State your assumption, if any, about Helens employee number.

Simulation Question 7-2


Simulation Question 7-2 is an adaptation with permission from a case by Coulter, J.M. and T.J. Vogel in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.

Pets.com, Inc.

During the 1990s, the establishment and growth of the Internet created a dot-com euphoria. Venture capitalists were eager to invest
their funds in Internet start-ups that offered the potential to provide large returns with the growth of the Internet. Among the most popular new
dot-com companies were online retailers, or e-tailers. Because there was no required investment in brick and mortar needed for these etailers, the common perception was that e-tailers could sell their products for less. The lower prices and customer convenience of shopping from a
computer made these business very attractive investments.
One such company that was established during the period was Pets.com, Inc. (hereafter, P). P incorporated in February 1999 as an
online retailer of pet products. The corporate headquarters were located in San Francisco. Ps online store was designed to service the needs of
the owners of many pets including dogs, cats, birds, fish, reptiles, and ferrets, among others. Approximately 12,000 products were available. P
also integrated this broad product selection with extensive pet-related information and resources designed to help customers make informed
purchasing decisions. Ps strategy included the following key components:
a. Building enduring brand equity through an advertising strategy that included its Ps sock puppet brand icon, relationships with selected online
companies, and support for national events and pet-related local market activities.
b. Offering the broadest possible pet product selection available to its customers at competitive prices.
c. Establishing its private label brands for pet products marketed under the Petsplete and Pets brand names.
d. Providing increasingly comprehensive and relevant content in conjunction with a range of consumer and veterinary care partners.
e. Delivering superior customer service and promoting repeat purchases through investments in people, technology, and distribution facilities.
f. Continuing to maintain and expand its relationships with Amazon.com, which was its largest shareholder, and Go.com.
g. Expanding internationally in order to capitalize on the global market.

185

186

7 Audit Plan - Evidence

Like all business start-ups, the main challenge to achieving these ambitious goals was to gain market share. P set out to establish and
grow a customer base with an aggressive marketing campaign and discounted prices. The marketing campaign included the creation of its sock
puppet and extensive advertising at national events. With product pricing, company officials decided to offer severe discounts to attract
customers. They were successful in gaining market share, but their strategy resulted in a negative gross margin over the first year of operations. .
You should access Data File 7-2 in iLearn for Exhibits 1, 2, and 3 that contain the financial statements for Ps first year of operations.
The income statement in Exhibit 2 demonstrates Ps increasing customer base. Sales grew from a mere $39k in its first quarter of operations to
nearly $5.2m in the final quarter of 1999. Unfortunately, P was experiencing the financial hardships encountered by many start-ups. As the
MD&A in Exhibit 4 indicates, extensive marketing costs and severe price discounts created a large operating loss for the period. You should
access Data File 7-2 in iLearn for Exhibits 4 that contains Ps Managements Discussion and Analysis. The balance sheet in Exhibit 2
reports available cash of $30.2 million, but company officials knew that this was not enough to support the growth planned for subsequent
periods. The statement of cash flows in Exhibit 3 shows that P used $65.3 million in its 1999 operations. Certainly this use would grow in 2000 as
the company extended its customer base. Additional funding would have to be acquired to support this growth. Despite the companys brief time
in existence to that point, company officials determined it was time to go forward with its initial public offering (IPO) of common stock.

The Planned IPO

P planned to go public in February 2000. The principal purposes of the offering were to fund operating losses, increase working
capital, fund capital expenditures, create a public market for Ps common stock, and facilitate future access to the public capital markets. The net
proceeds of the offering would be used primarily for working capital and general corporate purposes, including marketing and brand building
efforts, capital expenditures associated with the expansion and building of distribution centers, and technology and system upgrades.
Pets executives believed that their extensive product offering along with an efficient and convenient web shopping store would enable
it to attract an increasing share of the pet product retail industry. The most recent data on this industry showed an annual growth rate of 9 percent
between 1993 and 1997. Total industry sales for 1997 exceeded $22 billion. It was believed that if P could establish itself as a market leader for
the online purchase of pet products, it could capture an increasing share of the growing market. Unfortunately, because P was such a young
company, many business risks existed. Together with the interested underwriters, P executives evaluated the risks that potential investors would
encounter with the purchase of Ps common stock. You should access Data File 7-2 in iLearn for Exhibits 5 that contains a summary of the
risks disclosed in Ps prospectus.
After evaluating the risks and the potential payoffs to investors, four companies agreed to underwrite the issue: Merrill Lynch $ Co.,
Bear, Stearns & Co. Inc., Thomas Weisel Partners LLC, and Warbury Dillon Read LLC. Ps initial offering of 7.5 million shares at an offering
price of $11 per share was scheduled for February 16, 1999. The shares were approved for listing on the NASDAQ national Market under the
symbol IPET. The offering was expected to provide net proceeds to Pets of $76.725 million as follows:

Gross Proceeds (7.5 million shares at $11)


Less: Underwriting discount ($0.77 per share)
Net proceeds to P

$82,500,000
5,775,000
$76,725,000
=========

The Audit

P hired Ernst & Young LLP (hereafter, E&Y) to audit the 1999 financial statements summarized in Exhibits 2 through 4. As part of
the opinion formulation process, E&Y needed to consider the companys poor operating performance. After all, the companys strategies had thus
far led to a substantial loss in its first year of existence, including a negative gross profit. It is questionable whether a company with this type of
performance can be reasonably expected to survive financially in the foreseeable future. If E&Y has substantial doubt about Ps ability to
continue as a going concern, they would have to indicate this in an explanatory paragraph accompanying their audit opinion. However, such an
opinion would certainly hinder any chance for a successful public offering of stock. E&Ys auditors would certainly have to examine the situation
thoroughly before making this critical decision.
In order to guide them in this decision, the auditors would utilize AU 570 Going Concern. This standard requires the auditors to obtain
additional information about conditions and events that could create substantial doubt about the entitys ability to continue as a going concern.
You should refer to Table 7-11 Conditions and Events that Indicate a Substantial Doubt in Chapter 7. Certainly, the financial performance
of P, along with the information on business risks contained in Exhibit 5, suggests that some of the conditions and events did indeed exist for P.
In addition to the information above, auditors often utilize bankruptcy prediction models to assist in the going concern analysis. These
models are designed to predict financial distress within one year. Studies suggest that the key factors in determining the likelihood of financial
distress are profitability, the volatility of that profitability, and the companys degree of financial leverage (solvency). Interestingly, liquidity
measures turn out to be of less importance. You should access Data File 7-2 in iLearn for Exhibits 6 that contains the most popular of the
bankruptcy prediction models the Altman Z-score model.
The auditors also should evaluate their clients industry for any macro-economic impact from the external environment. P operated in
the e-tailing industry where companies were relatively young and characterized by fast growth and cash shortages. In fact, operating losses and
cash shortages are the norm for the industry. These are necessary in the short run to gain the market share that hopefully provides a large payoff
in the long run. You should access Data File 7-2 in iLearn for Exhibits 7 that provides selected financial information for three other etailers: Amazon.com Inc., eToys Inc., and priceline.com Inc. These companies were characterized by increasing losses, even as they gained
market share, and negative cash flows from operations. Despite this normally poor operating performance, e-tailers had established favor among
the investing community. eToys and priceline.com each had a fairly large share price in their first year as a publicly traded company despite the
large operating losses. Amazon.com had really become a market favorite. Despite mounting operating losses, its stock price had jumped from a
split-adjusted $17.85 at the end of 1998 to $76.13 at the end of 1999. It certainly appeared that the market was confident of the future success of
these e-tailers. Thus e-tailers in need of additional funding to support their short-term operating losses had reasonable expectations of being able
to obtain the funds through subsequent stock issuances.
E&Ys auditors had a tremendous amount of information to digest regarding the risks facing P. The anticipated date for the IPO was
soon approaching. Without a standard unqualified audit opinion, questions would arise regarding the viability of P as a viable investment
alternative, and the initial public offering would most likely fail. A decision had to be made regarding the type of opinion that E&Y would
provide in the IPO prospectus.

Financial and Integrated Audits - Frederick Choo

Required
To answer the following questions, in addition to the information provided in Exhibits 1 through to 7 in iLearn, you are encourage to use other
information available in SEC reports such as Ps prospectus, proxy statements, and the 10-Ks for other e-commerce companies. These reports are
available at the SECs EDGAR database http://www.sec.gov/cgi_bin/srch-edgar
1. Refer to the four categories of common ratios used for ratio analysis in Table 7-8 of Chapter 7.
a. Compute the financial ratios of P that you believe are relevant to evaluate the ability of the company to continue as a going concern.
b. In your opinion, will P continue as a going concern based on the results of 1a? Explain your opinion.
2. Refer to the Altman Z-score model in Table 7-10 of Chapter 7 and Exhibit 6 in iLearn.
a. Compute Model 1 (1968) of Altman Z-score for P as a public company. Assume P was publicly traded at a stock price of $411 (i.e., the IPO
price in February 2000) and that all preferred stock outstanding had been converted into common stock. The conversion rate is one share of
common for each share of preferred.
b. Compute Model 2 (1983) of Altman Z score for P as a private company.
c. In your opinion, will P continue as a going concern based on the combined results of 1a, 2a, and 2b? Explain your opinion.
3. Refer to selected financial information from other e-tailers in Exhibit 7 in iLearn.
a. Compare your financial analysis in 1a, 2a, and 2b for P with the financial information provided for other e-tailers in Exhibit 7 in iLearn.
b. In your opinion, will P continue as a going concern based on the combined results of 1a, 2a, 2b, and 3a? Explain your opinion.
4. Considering all your work done in 1, 2, and 3 above, and assume you are E&Ys auditor, which of the following opinions would you issue?
Provide justification for your chosen opinion.
a. A standard unqualified opinion.
b. An unqualified opinion with an additional paragraph about P will not continue as a going concern.
c. A qualified opinion.
d. A qualified opinion with an additional paragraph about P will not continue as a going concern.

Simulation Question 7-3


Simulation Question 7-3 is an adaptation with permission from a case by Coulter, J.M. and T.J. Vogel in the Issues in Accounting Education , a
publication of the American Accounting Association in Sarasota, Florida. This simulation question is based upon a true set of facts.

Pets.com, Inc.

During the 1990s, the establishment and growth of the Internet created a dot-com euphoria. Venture capitalists were eager to invest
their funds in Internet start-ups that offered the potential to provide large returns with the growth of the Internet. Among the most popular new
dot-com companies were online retailers, or e-tailers. Because there was no required investment in brick and mortar needed for these etailers, the common perception was that e-tailers could sell their products for less. The lower prices and customer convenience of shopping from a
computer made these business very attractive investments.
One such company that was established during the period was Pets.com, Inc. (hereafter, P). P incorporated in February 1999 as an
online retailer of pet products. The corporate headquarters were located in San Francisco. Ps online store was designed to service the needs of
the owners of many pets including dogs, cats, birds, fish, reptiles, and ferrets, among others. Approximately 12,000 products were available. P
also integrated this broad product selection with extensive pet-related information and resources designed to help customers make informed
purchasing decisions. Ps strategy included the following key components:
a. Building enduring brand equity through an advertising strategy that included its Ps sock puppet brand icon, relationships with selected online
companies, and support for national events and pet-related local market activities.
b. Offering the broadest possible pet product selection available to its customers at competitive prices.
c. Establishing its private label brands for pet products marketed under the Petsplete and Pets brand names.
d. Providing increasingly comprehensive and relevant content in conjunction with a range of consumer and veterinary care partners.
e. Delivering superior customer service and promoting repeat purchases through investments in people, technology, and distribution facilities.
f. Continuing to maintain and expand its relationships with Amazon.com, which was its largest shareholder, and Go.com.
g. Expanding internationally in order to capitalize on the global market.
Like all business start-ups, the main challenge to achieving these ambitious goals was to gain market share. P set out to establish and
grow a customer base with an aggressive marketing campaign and discounted prices. The marketing campaign included the creation of its sock
puppet and extensive advertising at national events. With product pricing, company officials decided to offer severe discounts to attract
customers. They were successful in gaining market share, but their strategy resulted in a negative gross margin over the first year of operations. .
You should access Data File 7-3 in iLearn for Exhibits 1, 2, and 3 that contain the financial statements for Ps first year of operations.
The income statement in Exhibit 2 demonstrates Ps increasing customer base. Sales grew from a mere $39k in its first quarter of operations to
nearly $5.2m in the final quarter of 1999. Unfortunately, P was experiencing the financial hardships encountered by many start-ups. As the
MD&A in Exhibit 4 indicates, extensive marketing costs and severe price discounts created a large operating loss for the period. You should
access Data File 7-3 in iLearn for Exhibits 4 that contains Ps Managements Discussion and Analysis. The balance sheet in Exhibit 2
reports available cash of $30.2 million, but company officials knew that this was not enough to support the growth planned for subsequent
periods. The statement of cash flows in Exhibit 3 shows that P used $65.3 million in its 1999 operations. Certainly this use would grow in 2000 as
the company extended its customer base. Additional funding would have to be acquired to support this growth. Despite the companys brief time
in existence to that point, company officials determined it was time to go forward with its initial public offering (IPO) of common stock.

The Planned IPO

187

188

7 Audit Plan - Evidence

P planned to go public in February 2000. The principal purposes of the offering were to fund operating losses, increase working
capital, fund capital expenditures, create a public market for Ps common stock, and facilitate future access to the public capital markets. The net
proceeds of the offering would be used primarily for working capital and general corporate purposes, including marketing and brand building
efforts, capital expenditures associated with the expansion and building of distribution centers, and technology and system upgrades.
Pets executives believed that their extensive product offering along with an efficient and convenient web shopping store would enable
it to attract an increasing share of the pet product retail industry. The most recent data on this industry showed an annual growth rate of 9 percent
between 1993 and 1997. Total industry sales for 1997 exceeded $22 billion. It was believed that if P could establish itself as a market leader for
the online purchase of pet products, it could capture an increasing share of the growing market. Unfortunately, because P was such a young
company, many business risks existed. Together with the interested underwriters, P executives evaluated the risks that potential investors would
encounter with the purchase of Ps common stock. You should access Data File 7-3 in iLearn for Exhibits 5 that contains a summary of the
risks disclosed in Ps prospectus.
After evaluating the risks and the potential payoffs to investors, four companies agreed to underwrite the issue: Merrill Lynch $ Co.,
Bear, Stearns & Co. Inc., Thomas Weisel Partners LLC, and Warbury Dillon Read LLC. Ps initial offering of 7.5 million shares at an offering
price of $11 per share was scheduled for February 16, 1999. The shares were approved for listing on the NASDAQ national Market under the
symbol IPET. The offering was expected to provide net proceeds to Pets of $76.725 million as follows:

Gross Proceeds (7.5 million shares at $11)


Less: Underwriting discount ($0.77 per share)
Net proceeds to P

$82,500,000
5,775,000
$76,725,000
=========

The Audit

P hired Ernst & Young LLP (hereafter, E&Y) to audit the 1999 financial statements summarized in Exhibits 2 through 4. As part of
the opinion formulation process, E&Y needed to consider the companys poor operating performance. After all, the companys strategies had thus
far led to a substantial loss in its first year of existence, including a negative gross profit. It is questionable whether a company with this type of
performance can be reasonably expected to survive financially in the foreseeable future. If E&Y has substantial doubt about Ps ability to
continue as a going concern, they would have to indicate this in an explanatory paragraph accompanying their audit opinion. However, such an
opinion would certainly hinder any chance for a successful public offering of stock. E&Ys auditors would certainly have to examine the situation
thoroughly before making this critical decision.
In order to guide them in this decision, the auditors would utilize AU 570 Going Concern. This standard requires the auditors to obtain
additional information about conditions and events that could create substantial doubt about the entitys ability to continue as a going concern.
You should refer to Table 7-11 Conditions and Events that Indicate a Substantial Doubt in Chapter 7. Certainly, the financial performance
of P, along with the information on business risks contained in Exhibit 5, suggests that some of the conditions and events did indeed exist for P.
In addition to the information above, auditors often utilize bankruptcy prediction models to assist in the going concern analysis. These
models are designed to predict financial distress within one year. Studies suggest that the key factors in determining the likelihood of financial
distress are profitability, the volatility of that profitability, and the companys degree of financial leverage (solvency). Interestingly, liquidity
measures turn out to be of less importance. You should access Data File 7-3 in iLearn for Exhibits 6 that contains the most popular of the
bankruptcy prediction models the Altman Z-score model.
The auditors also should evaluate their clients industry for any macro-economic impact from the external environment. P operated in
the e-tailing industry where companies were relatively young and characterized by fast growth and cash shortages. In fact, operating losses and
cash shortages are the norm for the industry. These are necessary in the short run to gain the market share that hopefully provides a large payoff
in the long run. You should access Data File 7-3 in iLearn for Exhibits 7 that provides selected financial information for three other etailers: Amazon.com Inc., eToys Inc., and priceline.com Inc. These companies were characterized by increasing losses, even as they gained
market share, and negative cash flows from operations. Despite this normally poor operating performance, e-tailers had established favor among
the investing community. eToys and priceline.com each had a fairly large share price in their first year as a publicly traded company despite the
large operating losses. Amazon.com had really become a market favorite. Despite mounting operating losses, its stock price had jumped from a
split-adjusted $17.85 at the end of 1998 to $76.13 at the end of 1999. It certainly appeared that the market was confident of the future success of
these e-tailers. Thus e-tailers in need of additional funding to support their short-term operating losses had reasonable expectations of being able
to obtain the funds through subsequent stock issuances.
E&Ys auditors had a tremendous amount of information to digest regarding the risks facing P. The anticipated date for the IPO was
soon approaching. Without a standard unqualified audit opinion, questions would arise regarding the viability of P as a viable investment
alternative, and the initial public offering would most likely fail. A decision had to be made regarding the type of opinion that E&Y would
provide in the IPO prospectus.

Required
To answer the following questions, in addition to the information provided in Exhibits 1 through to 7 in iLearn, you are encourage to use other
information available in SEC reports such as Ps prospectus, proxy statements, and the 10-Ks for other e-commerce companies. These reports are
available at the SECs EDGAR database http://www.sec.gov/cgi_bin/srch-edgar
1. Refer to the four categories of common ratios used for ratio analysis in Table 7-8 of Chapter 7.
a. Compute the financial ratios of P that you believe are relevant to evaluate the ability of the company to continue as a going concern.
b. In your opinion, will P continue as a going concern based on the results of 1a? Explain your opinion.
2. Refer to selected financial information from other e-tailers in Exhibit 7 in iLearn.
a. Compare your financial analysis in 1a for P with the financial information provided for other e-tailers in Exhibit 7 in iLearn.
b. In your opinion, will P continue as a going concern based on the combined results of 1a and 2a? Explain your opinion.
3. Refer to the four categories of conditions and events that indicate a substantial doubt about going concern in Table 7-11 of Chapter 7.

Financial and Integrated Audits - Frederick Choo

a. Access Exhibit 5 in iLearn and sort the 39 risk factors in Exhibit 5 into the four categories of conditions and events in Table 7-11. List them
under four headings: 1. Negative financial trend, 2. Non-financial indicator, 3. Internal factors, and 4. External factors.
b. Review the risk factors in each of the four categories in 3a. Identify and state those risk factors in each of the four categories that you believe
are relevant for forming an opinion on whether P will continue as a going concern.
c. In your opinion, will P continue as a going concern based on the combined results of 1a, 2a, and 3b? Explain your opinion.
4. Considering all your work done in 1, 2, and 3 above, and assume you are E&Ys auditor, which of the following opinions would you issue?
Provide justification for your chosen opinion.
a. A standard unqualified opinion.
b. An unqualified opinion with an additional paragraph about P will not continue as a going concern.
c. A qualified opinion.
d. A qualified opinion with an additional paragraph about P will not continue as a going concern.

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Financial and Integrated Audits - Frederick Choo

Chapter 8
Audit Plan Internal Control
Chapter Learning Outcomes (LOs) Checklist
After reading this chapter, you should be able to:
LO8-1 Understand the 5 components of internal control.
LO8-2 Distinguish among the 3 methods of documenting internal control.
LO8-3 Explain how the auditor assesses control risk (CR).
LO8-4 Understand the definition of a material weakness according to AICPAs
AU 265 and PCAOBs AS 5.
LO8-5 Describe how the auditor communicates internal control-related matters.
LO8-6 Describe the managements responsibilities on Internal Control over Financial
Reporting (ICFR) under Section 404 of the Sarbanes-Oxley Act of 2002 and
guided by the PCAOBs AS 5.
LO8-7 Describe the auditors responsibilities on Internal Control over Financial
Reporting (ICFR) under Section 404 of the Sarbanes-Oxley Act of 2002 and
guided by the PCAOBs AS 5.

LO8-8 Describe the Top-Down approach for obtaining an understanding of ICFR and
identifying controls to test.
LO8-9 Describe how the auditor form an opinion on the effectiveness of ICFR under
Section 404 of the Sarbanes-Oxley Act of 2002 and guided by the PCAOBs
AS 5 and AS 4.
LO8-10 Compare internal control of an integrated audit with internal control of a
financial audit.

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Chapter 8 Audit Plan Internal Control


Figure 8-1 shows the sequential steps in which an auditor considers a clients internal control.
Figure 8-1 Steps in Internal Control Consideration
The Audit Process

Audit Plan

Preplan CH 5

Tests of Controls

Tests of Balances

Financial Audit

Completing the Audit

Audit Report

Integrated Audit

Objectives CH 6
1. Understanding of Internal
Control

1. Plan the Audit of ICFR

2. Document the Understanding


of Internal Control

2. Obtaining an Understanding of
ICFR and Identifying Controls to
Test

3. Assess Control Risk (CR)

3. Test and Evaluate Design


Effectiveness of Controls

4. Perform Tests of Controls


Procedures

4. Test and Evaluate Operating


Effectiveness of Controls

5. Communicate Internal ControlRelated Matters

4. Form an Opinion on the


Effectiveness of ICFR

Evidence CH 7

Internal Control CH 8

Materiality and Risk CH 9


(Chapter 9)

Program and
Technology CH 10

Financial and Integrated Audits - Frederick Choo

Financial Audit of Internal Control


AU 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement defines
internal control as The policies and procedures established by management to provide reasonable assurance that
specific objectives of the entity will be achieved. According to the definition, an audit should only expect
reasonably assurance, not absolute assurance, that a client's control objectives will be accomplished. This is because
there are two inherent limitations of a clients internal control: 1. Human errors. For example, an effective internal
control may be undermined by employee's unintentional errors or management's intentional acts of overriding the
control. 2. Changing circumstances. For example, controls over a manual data processing system may not be
appropriate for a new computerized data processing system. An auditor should also recognize that the cost of a
client's internal control should not exceed the expected benefit derived from its implementation. This adds another
limitation to the client's internal control. Finally an auditor should understand a clients internal control according to
the AICPAs third fundamental Performance principle, which states, [T]he auditor identifies and assesses risks of
material misstatement, whether due to due to fraud or error, based on an understanding of the entity and the
environment, including the entitys internal control.
Understanding of Internal Control
The auditor should understand five components of a clients internal control based on the Committee of Sponsoring
Organizations of the Treadway Commission - COSOs Internal Control-Integrated Framework. Table 8-1 describes
these five components and the auditors understanding of them
Table 8-1 Understanding the Five Components of Internal Control
Components of Internal Control

Understanding the Components

1. Control Environment
This consists of actions, policies, and procedures that reflect the
overall attitude of the top management, directors, and owners of a
client about internal control and its importance. Seven key factors
that affect the control environment are:

The auditor should learn enough about the control environment to


understand the managements and board of directors attitude,
awareness, and actions concerning the control environment. In addition,
the auditor should focus on the substance of controls rather than on their
form because controls may be established but not acted on. Thus, the
most important aspect of any internal control is having competent and
trustworthy personnel who follow internal control policies and
procedures.

Integrity and ethical values.


Commitment to competence.

Participation of those charged with governance (e.g., board of


directors or audit committee).

Management philosophy and operating style.


Organizational structure.
Assignment of authority and responsibility.

Human resource policies and practices.


2. Risk Assessment
This consists of managements identification and analysis of risks
relevant to the preparation of financial statements in accordance with
GAAP. The managements risk assessment process should consider
external and internal events and circumstances that may arise and
adversely affect the companys ability to record, process, summarize,
and report financial data consistent with the assertions of the
management in the financial statements. Five basic assertions that
must be met by the managements risk assessment are:

The auditor should obtain sufficient information about a clients risk


assessment process to understand how the management considers risks
relevant to financial reporting objectives and decides what to do to
address those risks.

Existence or occurrence.
Completeness.
Valuation or allocation.
Rights and obligations.

Presentation and disclosure.


3. Control Activities
This consists of policies and procedures that the management has
established to meet its objectives for financial reporting. Five basic
control activities that the management must establish are:

The auditors understanding of control activities is a function of the


audit plan adopted. If the auditor plans to conduct only TOB, then little
or no work is done on understanding control activities. If the auditor
plans to conduct both TOC and TOB, then s/he needs to understand the
control activities relating to specific audit objectives and for the purpose

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8 Audit Plan - Internal Control

Components of Internal Control

Adequate Separation of Duties

Proper Authorization of Transactions and Activities (or


Information Process Controls)

Adequate Documentations and Records.

Physical Control over Assets and Records (or Physical


Controls)

Independent checks on performance (or Performance


Reviews)

4. Information and communication


The information system consists of methods used to identify,
assemble, classify, record, and report a companys transactions and to
maintain accountability for related assets and liabilities. An effective
accounting system should:

Understanding the Components


of assessing control risk (CR).

Identify and record all valid transactions.

Describe on a timely basis the transactions in sufficient


detail to permit proper classification of transactions for financial
reporting.

Measure the value of transactions in a manner that permits


recording their proper monetary value in the financial statements.

Determine the time period in which transactions occurred to


permit recording of transactions in the proper accounting period.

Present properly the transactions and related disclosures in


the financial statements.
Communication involves providing an understanding of individual
roles and responsibilities so that the personnel understand how their
financial reporting activities are related to the work of others and the
means of reporting exceptions to an appropriate higher level within
the company.
5. Monitoring
This consists of the managements ongoing and periodic assessment
of the performance of internal control. The Management may use
internal auditors to monitor the operating effectiveness and efficiency
of internal control.

Documenting the Understanding of Internal Control

Separation of duties controls include (1) Separation of the custody of


assets from accounting. (2) Separation of the authorization of
transactions from the custody of related assets. (3) Separation of
operational responsibility from record-keeping responsibility. (4)
Separation of IT duties from user departments.
Proper authorization controls include (1) General authorization in that
management establishes polices and subordinates are instructed to
implement these general authorizations by approving all transactions
within the limits set by the policy. (2) Specific authorization in that
management authorizes a specific transaction. In an information
processing system, information processing controls are performed to
check accuracy, completeness, and authorization of transactions. They
include (1) General controls, which relate to the overall information
processing environment such as controls over data center and network
operations; system software acquisition, change, and maintenance. (2)
Application controls, which apply to the processing of individual
applications and help ensure the occurrence, completeness, and
accuracy of transaction processing.
Adequate documentations and records include (1) Prenumbered
documents to facilitate the control of, and accountability for,
transactions for the completeness assertion. (2) Prepared documents on
a timely basis to minimize timing errors. (3) Designed documents for
multiple use, when possible, to minimize the number of different form.
(4) Constructed documents in a manner that encourages self-input
correction and verification.
Physical controls include (1) Physical security of assets, including
adequate safeguards, such as secured facilities over access to assets and
records. (2) Authorization for access to computer programs and data
files. (3) Periodic counting and comparison with amounts shown on
control records such as comparing the results of inventory counts with
inventory records.
Performance reviews controls include (1) Managements independent
checks on the performance of individuals. (2) Managements active
participation in the supervision of operations. (3) Managements study
of budget variances with follow-up action.
The auditor must obtain sufficient knowledge of a clients information
system:
I. To understand (1) the classes of significant transactions, (2) the ways
those transactions are initiated, (3) the accounting records and
supporting documents for those transactions, (4) the accounting
processing involved, and (5) the financial reporting process, including
significant accounting estimates and disclosures.
II. To ensure that the TOC and TOB procedures meet the following
types of specific audit objectives (recall Chapter 6):
(1) Existence or Occurrence
(2) Completeness.
(3) Rights and Obligations.
(4) Valuation and Allocation.
(5) Classification.
(6) Cutoff.
(7) Accuracy.
(8) Understandability.
In addition, the auditor should obtain sufficient knowledge of how the
client communicates financial reporting roles and responsibilities and
significant matters relating to financial reporting.

The auditor should know how a client monitors the performance of


internal control over time, including how corrective action is initiated.

Financial and Integrated Audits - Frederick Choo

AU 230 Audit Documentation requires auditors to document their understanding of a clients internal control. The
form and extent of this documentation are influenced by the size and complexity of the client, as well as the nature
of the client's internal control. The three most common methods used by the auditors to document their
understanding of the client's internal control are described in Table 8-2.
Table 8-2 Three Methods of Documenting Internal Control
Narrative Description

Internal Control Questionnaires

Flow Chart

A narrative description is a written


memorandum
of
the
auditor's
understanding of the client's internal
control. Narrative descriptions generally
are more appropriate for documenting the
internal control of a small client. They
can be cumbersome to use as the size of
the client increases.
Figure 8-2 shows an example of using a
narrative description to document the
auditors understanding of a clients
control environment.

An internal control questionnaire is a checklist of


questions designed to detect internal control
deficiencies. The questionnaires typically require
a "yes," "no," or "not applicable (n/a)," response.
"Yes" responses suggest strong or satisfactory
internal controls, and "no" responses suggest
weak or no internal controls.
The internal control questionnaires may not be
efficient in documenting a client's internal control
for various reasons:

A flow chart is a symbolic, diagrammatic


representation of a client's internal control.
A flow chart is especially useful in
documenting the internal control of a large
and complex client. Separate flowcharts are
prepared for each major transaction cycle.
Typically, the departmental units are shown
in columns across the top of the chart, and
the flow of documents is from left to right.
Figure 8-4 shows an example of using a
flowchart to document the auditors
understanding of a clients information and
communication.
Figure 8-5 shows some common symbols
used in flowcharting a clients information
and communication.

They can lack flexibility. For example,


they may contain many questions that are "not
applicable" to a specific client.

Compensatory controls are not obvious.


The situation where a strong internal control
may compensate for a weak internal control
elsewhere is not obvious from examining the
completed set of questionnaires.

Client
employees
may
respond
inaccurately to internal control questions asked
by the auditor.
Figure 8-3 shows an example of using an internal
control questionnaire to document the auditors
understanding of a clients risk assessment.

The auditors may use a combination of narrative descriptions, flowcharts, and questionnaires to document their
understanding of the internal controls, thereby maximizing the advantages of each. After the auditors have
documented their understanding of the client's internal control, they generally verify that the client's internal control
in actual operation matches with the documented internal control by performing a walk-through test. In this walkthrough test, the auditors trace a few transactions through each step, from beginning to end, of the documented
internal control to familiarize the auditors with the audit trail and to identify differences between internal control in
operation and internal control as documented in the working papers.
Figure 8-2 An Example of Using a Narrative Description to Document the Auditors Understanding of a
Clients Control Environment
Audit Memo Control Environment
Client: XYZ Company
Completed by __________________
Reviewed by ___________________

Date ________________
Date ________________

The company manufactures sophisticated computer components. There is one location in Silicon Valley, San Jose. Mr. A is the chairman of the
board and chief executive officer. His son, Mr. B, is the chief operating officer. The family controls 80 percent of the common stock. The board
of directors is composed of family members, but Mr. A and Mr. B monitor the business and make most of the business decisions.
Mr. C, the controller, and Mrs. D, the bookkeeper, handle most of the significant accounting functions. Both Mr. C and Mr. D are competent and
committed to the company. Mr. B reviews cash receipts and cash disbursements. Both Mr. A and Mr. B have conservative attitudes towards
accounting, and they consider lower taxes to be important. Our CPA firm is consulted on the accounting for unusual transactions, and there are
rarely any adjustments for errors from routine transaction processing.
The company uses a standard accounting software package. Access to the computer files is limited to Mr. B, Mr. C, and Mrs. D. Mr. A and Mr. B
monitor revenues and expenses by comparing them to the budget and prior-year results.

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8 Audit Plan - Internal Control

Figure 8-3 An Example of Using an Internal Control Questionnaire to Document the Auditors
Understanding of a Clients Risk Assessment
Internal Control Questionnaire Risk Assessment
Client: XYZ Company
Completed by __________________
Date ________________
Reviewed by ___________________
Date ________________
Does the client set broad objectives that state what the client
desires to achieve, and are they supported by strategic plans?
Does the client have a risk analysis process that includes
estimating the significance of the risks, assessing the
likelihood of their occurring, and determining the actions
needed to respond to the risks?
Does the client have mechanisms to identify and react to
changes that may dramatically and pervasively affect the
client?

Yes, No, N/A


Yes

Yes

Yes

Comments
Management has prepared a five-year business plan that
includes goals for the companys products, responsibilities,
and growth plan.
The companys business plan and budgeting process
include analyzing risks that might affect the company.
Senior management meets monthly to discuss recent events
and how they may affect the company.
Management has a number of mechanisms to identify risks
that may affect the company. These include review of
business and industry publications, participation in industry
trade groups, and a strategic analysis group.

Assessing Control Risk (CR)


After obtaining an understanding and documentation of the client's internal control, the auditor assesses the control
risk (CR). AU 315 defines control risk as "the risk that a material misstatement that could occur in an assertion will
not be prevented or detected on a timely basis by the entity's internal controls. In practice, an auditor regards a
client's CR as the risk of material misstatement of assertions relating to an individual account-balance or class of
transactions that is not prevented or detected by a client's internal control. In addition, as noted previously, CR exists
independent of the audit of a client's financial statements. Thus, the auditor cannot change the actual level of CR.
Finally, there is no authoritative guideline for assessing the level of CR. In practice, a percentage between 0% and
100%, with 0% as the minimum and 100% as the maximum control risk, is commonly used to indicate the level of
CR. Based on the auditor's understanding and documentation of a client's internal controls, the auditor assesses the
level of CR in two ways as described in Table 8-3.
On occasion, an auditor may desire to fine-tune (i.e., to further reduce) the assessed level of CR below the
maximum of 100% by conducting some TOC at the audit plan phase. In such a case, the auditor considers (a)
whether additional evidential matter is available to support the fine-tuning, and (b) whether the expected effort to
perform some TOC is likely to result in less effort in TOB.
After assessing the level of CR at the audit plan phase, and together with the assessment of inherent risk
(IR), the auditor derives the level of detect risk (DR) based on an audit risk model, AR = IR X CR X DR (discussed
in Chapter 9) and determines the nature, timing, and extent of TOB that are needed to achieve the derived level of
DR, given a pre-specified level of audit risk (AR).
Although the inverse relationship between CR and DR permits the auditor to alter the nature, timing, and
extent of the TOB, the assessed level of CR cannot be so low (e.g., close to zero) as to eliminate the need to perform
any TOB. In addition, the auditor's understanding and documentation of the client's internal control and the
assessment of CR provide the basis for communicating internal control-related matters to those charged with
governance (e.g., audit committee or board of directors), a requirement of AU 265 Communication of Internal
Control Related Matters Identified in an Audit .

Financial and Integrated Audits - Frederick Choo

Figure 8-4 An Example of Using a Flowchart to Document the Auditors Understanding of a Clients
Information and Communication
______________________________________________________________________________________
Flow Chart Information and Communication
Client: XYZ Company
Completed by __________________
Reviewed by ___________________

Date ________________
Date ________________

Order Entry Portion of the Revenue Cycle


______________________________________________________________________________________
Order Entry Department

IT Department

Shipping Department

____________________________________________________________________________________________________________
By phone/mail/internet or from
sales representative

Customer

Approved
shipping
order

Price
Inventory

Inventory
Open
orders

Open
orders
Ship
goods

Customer
order

Correct
error

Data validation
program

Input

Filed by
date

Error
report

Shipping
program

Order
acknowledgement

Approved
shipping
order

To
customer

To
customer

Filed
in numeric
order

Figure 8-5 Some Common Symbols Used in Flowchart


Symbol

Description

Document

Paper documents and reports of all kinds, e.g., customer orders, sales invoices, purchase orders, error
report, shipping documents, and paychecks.

Manual Input

Input entered manually at the time of processing, e.g., using keyboard.

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8 Audit Plan - Internal Control

Symbol

Description

Manual Operation or
Activity

Any manual operation or activity, e.g., preparation of a sales invoice, bank reconciliation, posting of
accounts receivable, and correcting errors.

Computer Process

Computer executed process, e.g., execution of data validation program or checking of customers
credit limit.

Data Inputted or
Outputted

Data inputted from or outputted to another part of the flowchart, e.g., cash received from customer is
inputted to cash receipts journal which in turn is outputted to accounts receivable ledger.

Off-page Connector

Off-page connector that indicates source or destination of items entering or exiting the flowchart, e.g.,
sending a copy of an invoice to an outside customer that exits the flowchart.

Computer off-page
Connecting Node

Computer connecting node that indicates source or destination of items entering or exiting the
flowchart, e.g., the connecting node from mail room indicates cash receipt entering the flowchart from
the mail room.

Paper Document or
Record File

Paper document or record storage, e.g., filing of bank deposit slips. An A indicates a file organized
in an alphabetic order, a N indicates a numeric order file, and a D indicates a file organized by
date.

Filed
by Annotation
Date
Flow-line

Annotation used for explanatory comments, e.g., filing of sales invoices by date, alphabetical, or
category of merchandises.
Lines indicating the directional flow of documents. Lines are typically downward or to the right unless
otherwise indicated by arrowheads.
Decision indicates alternative course of action resulting from a yes or no decision.

No
Yes

Computer Card

Computer input medium which is a punched card, e.g., payroll earning cards.

Computer Tape

Computer input medium which is a punched tape, e.g., inventory tapes.

Computer Data
Inputted or
outputted

Computer data inputted from or outputted to another part of the flowchart, e.g., payroll data is inputted
from payroll records which in turn is outputted to store in magnetic tape.

Computer Magnetic
Disk or Drum

Computer storage medium which is a magnetic disk or drum, e.g., customers names and addresses are
stored in a magnetic disk.

Computer Magnetic
Tape

Computer storage medium which is a magnetic tape, e.g., payroll data are stored in a master payroll
magnetic tape.

Computer Display

Computer input or output device in which the information is displayed at the time of process, e.g.,
display of customer accounts on a computer monitor.

Financial and Integrated Audits - Frederick Choo

Table 8-3 Two Ways in Assessing CR


(1) CR at the maximum of 100%
For assertions relating to some account-balances or classes of transactions, the auditor's initial understanding and documentation of the internal
controls may cause him/her to conclude that the internal controls are unlikely to be effective, or effort required to evaluate their effectiveness
would be inefficient. For these assertions, the auditor typically assesses CR at the maximum of 100% at the audit plan phase in the past.
However, under AU315, it is no longer acceptable to assess CR at the maximum of 100% based on the auditors initial understanding and
documentation of the internal controls. The auditor must now develop a greater understanding of the internal controls, which includes testing and
evaluating the design and operation of the internal controls in order to assess CR at the maximum of 100%. When assessed CR is at the
maximum (a) the auditor needs only to document the assessment but not the basis for the assessment, (b) the auditor would not plan to rely on the
internal controls, and (c) the auditor would not plan to perform TOC but to only perform TOB.

(2) CR below the maximum of 100%


For other assertions relating to some account-balances or classes of transactions, the auditor's understanding and documentation of the internal
controls may cause the auditor to assess CR at below the maximum of 100%. When assessed CR is below the maximum (a) the auditor should
document the assessment and the basis for the assessment, (b) the auditor would plan to rely on the internal controls, and (c) the audit would plan
to perform both the TOC and TOB.
When the auditor plan to rely on the internal controls, s/he must:

Identify the control activities (see Table 8-1) that are relevant to a financial statement assertion. The relevance of a control activity to an
assertion is judged in terms of:
(a) Its pervasive effect on an assertion.
A control activity can be relevant to an assertion either because it has a pervasive effect on many assertions or because it has a specific
effect on an individual assertion. A control activity that affects more than one assertion is usually more pervasive than one that affects only a
single assertion. For example, a credit managers follow-up on customers complaints in a monthly statement - a control activity of independent
checks that affects both the valuation and allocation, and completeness assertions - is a more pervasive control activity than the credit managers
approval of credit for customers a control activity of proper authorization that affects only the valuation and allocation assertion. In general,
the more pervasive is the effect, the more relevant is the control activity, the stronger is the overall internal controls, and the lower is the assessed
CR.
(b) Its direct relationship to an assertion.
The more directly related a control activity is to an assertion, the more effective it is in preventing or detecting material misstatements in
that assertion. For example, a sales managers tracing of shipping documents to billing documents - a control activity of adequate documentation
that affects the completeness of sales revenue - is more directly related to the completeness assertion than the sales managers reviews of sales
activities at various stores a control activity of independent checks that is less directly related to the completeness of sales revenue. In general,
the more direct is the relationship, the more relevant is the control activity, the stronger is the overall internal controls, and the lower is the
assessed CR.

Evaluate the effectiveness of the control activities in preventing and detecting material misstatements in an assertion.
After a control activity that is relevant to an assertion has been identified, the auditor evaluates its effectiveness in preventing and detecting
material misstatements in the assertion. To evaluate its effectiveness, the auditor obtains evidence (recall Chapter 7) about the design and
operation of the control activity by performing TOC. TOC directed at the effectiveness of the design of the control activity are concerned with
whether it is suitably designed to prevent or detect material misstatements. On the other hand, TOC directed at the operation effectiveness of the
control activity are concerned with how it is suitably applied to prevent or detect material misstatements. Recall some of the common TOC
procedures used by the auditor in Chapter 7. No one specific procedure is always necessary, applicable, or equally effective in every
circumstance. The auditor selects a variety of TOC procedures, for example, inquiry, observation, and inspection to evaluate the effectiveness of
the design and operation of a control activity.

Communicating Internal Control-Related Matters


Consistent with the PCAOBs AS 5 definition, the AICPAs AU 265 defines a material weakness as a material
weakness is a control deficiency, or a combination of significant deficiencies, in internal control over financial
reporting (ICFR), such that there is a reasonable possibility that a material misstatement of the companys annual or
interim financial statements will not be prevented or detected on a timely basis (emphasis added). AU 265 further
defines:
1. Control deficiency. A control deficiency exists if the design or operation of controls does not permit company
personnel to prevent or detect misstatements on a timely basis in the normal course of performing their assigned
functions. A design deficiency exists if a necessary control is missing or not properly designed. An operation
deficiency exists if a well-designed control does not operate as designed or if the person performing the control is
insufficiently qualified or authorized. Table 8-4 shows some examples of control deficiency in the design or
operation of controls in AU 265.
2. Significant deficiency. A significant deficiency exists if one or more control deficiencies exist that is less severe
than a material weakness (defined below), but important enough to merit attention by those responsible for oversight
of the companys financial reporting.

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3. Material weakness. A material weakness exists if a significant deficiency, by itself or in combination with other
significant deficiencies, results in a reasonable possibility that internal control will not prevent or detect material
financial statement misstatements on a timely basis.
4. Reasonable possibility and Materiality. To determine a material weakness, the auditor must consider two
dimensions: Reasonable possibility and Materiality. Reasonable possibility refers to reasonably possible or probable
that a misstatement resulting from a significant deficiency or a combination of significant deficiencies. Materiality
refers to the same concept of materiality that is used in determining financial statement materiality (discussed in
Chapter 9).
Table 8-5 shows the auditors consideration of reasonable possibility and materiality, and communication
of material weakness, significant deficiency, and insignificant deficiency. Note that if reasonable possibility is
remote, an identified control issue will not be reported. However, if reasonable possibility is reasonably possible or
probable, an identified control issue will be reported as a material weakness, a significant deficiency, or an
insignificant deficiency depending on the materiality of misstatement in the financial statements.
The auditor must communicate material weaknesses and significant deficiencies in writing (refer to as a
material weakness report) and such communication must be documented in the auditor's working papers. There is no
specific guideline for the format of the written report, for example, a memo is acceptable, but the content of the
written report should at least include: 1. An indication that the purpose of the audit is to report on the financial
statements and not to provide assurance on the internal controls. 2. A definition of material weakness. 3. A statement
that the report is intended solely for the information of the audit committee, management, and others within the
organization, and when applicable, specific regulatory agencies that have requested a copies of the report. 4. A
description of the material weakness and significant deficiency noted. The material weakness and significant
deficiency report should be addressed to those charged with governance (e.g., audit committee or its board of
directors) and the management. Figure 8-6 shows an example of a material weakness report.
AU 265 requires the auditor to communicate material weaknesses or significant deficiencies to those
charged with governance even if the management has addressed the material weaknesses or significant deficiencies
and has implemented new controls that improve the effectiveness of internal control. However, AU 265 does not
require the auditor to communicate material weaknesses and significant deficiencies if (1) the management has
already made them known to those charged with governance, and (2) those charged with governance has accepted
the management's conscious effort to trade off the cost against the risk associated with the material weaknesses and
significant deficiencies.
Ordinarily, a previously communicated material weakness or significant deficiency that has not been
corrected would not need to be communicated again by the auditor. However, the auditor should periodically
consider whether the passage of time or changes in the management, the board of directors, or the audit committee
would require the material weakness or deficiency to be communicated again. Finally, the auditor may choose to
communicate all material weaknesses and significant deficiencies either during the course of the audit or after the
audit is concluded.
In addition to communicating material weaknesses and significant deficiencies that is required under AU
265, the auditor may also send an optional clients advisory comments letter (also known as a management letter)
that: 1. Communicates insignificant control deficiencies. 2. Makes recommendations for improving the client's
business. 3. Promotes a better relationship between the CPA firm and the client. 4. Suggests additional tax and
management services available to the client. This clients advisory comments letter should be addressed to the
client's management (AU 265). However, many auditors combine the clients advisory comments letter and the
material weakness report into one report and report it to the audit committee. Figure 8-7 shows an example of a
clients advisory comment letter (management letter).
Note that an auditor should never issue a written report stating that no-material-weakne