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Case 1A

Last year you were assigned to minor parts of the audit of the sales and collections cycle for Bankrupt
Corporation. This year you have been assigned significant responsibility in the audit of the sales and
collections cycle. You recall that last year, the credit manager, Tim Ang, treated you as if you were one of
the clerks. In fact, you had to call him Mr. Tim” when you went to ask him several questions. This year, he
has become very friendly, Tim as he now wants you to call him, has just invited you to join him for dinner
at a very exclusive private club in town. You were called away before you could give Tim a reply, but he
did indicate to you that last year he took you predecessor to such a dinner. How do you respond to Tim?

Solution Manual

Independence means objectivity and freedom from bias. The auditor can favor neither the client nor the
third party in evaluating the fairness of the financial statements. The auditor must be independent in
fact and in appearance. Independence in fact means the auditor is unbiased and objective. An auditor
could be independent in fact if he or she owned a few shares of common stock in an audit client, but
might not appear independent to a third party. Independence in appearance means that a third party
with knowledge of the auditor’s relationship with the client would consider the auditor to be
independent. If users don’t perceive auditors to be independent then the value of the audit is lacking.

Case 1B

The fairness of financial statements and the adequacy of internal controls are judged only by reference
to pre-established criteria. What serves as the criteria to judge the fairness of financial statements and
the adequacy of internal controls? Explain why “reference to criteria” is important to the audit function
and the results communicated by the audit function.

Book

Assertions and Established Criteria

An assertion is a positive statement about an action, event, condition, or performance over a specified
period of time. To have unbiased and clear communication, criteria must exist whereby independent
observers can assess whether such assertions are appropriate. GAAP provide those criteria for financial
statement audits. COSO provides criteria for evaluating the design and operation of internal controls.
Internal auditors may refer to management’s policies and procedures in determining a department’s
compliance with company policies. An internal revenue agent will refer to the tax code to determine if
taxable income is correctly computed. When management prepares financial statements, they assert
that those statements are fairly presented in accordance with GAAP. Generally accepted accounting
principles become the criteria by which “fairness” of a financial statement presentation is judged.
However, accounting majors know that interpreting authoritative pronouncements is difficult. The
auditor’s task is to consider whether the application of a generally accepted accounting principle best
portrays economic activity of the company. The assertions embodied in the financial statements provide
directions for the design of the audit. For example, by showing inventory valued on the financial
statements at $25 million, management is asserting that the inventory exists, is complete, is owned, and
is properly valued at the lower of cost or market. The auditor thus needs to gather objective evidence to
test each of the assertions that are implied by showing inventory at $25 million. Similarly, management
may assert that it has implemented an internal control system such that the likelihood of material
misstatements occurring in the financial statements is remote. The auditor will examine the quality of
internal controls using the COSO framework to determine whether there is a sound basis for
management’s conclusions.

Solution Manual

Fairness is judged within a framework of GAAP. Some question whether GAAP results in the fairest
possible presentations when there are significant changes in market values of investments or assets. For
example, the SEC has encouraged financial institutions to move from using historical cost required by
GAAP to market values for all investments in securities because it believes that market value presents a
better picture of economic reality than does historical cost.

Case 1C

How does complexity affect (1) the demand for auditing services and (2) the performance of auditing
services?

Course Hero

Complexity affects the demand for auditing because of the vast amounts transactions, information, and
processing systems it requires a high demand of very skilled auditors because companies do not want to
face lawsuits if their financial reports are misinterpreted. It is difficult to determine their proper
presentation without a review by an independent expert. Third party users depend on managers and
auditors to deal with such complexities as financial instruments, derivatives, long-term contracts, and
other complex transactions to ensure that their performance of the auditing services are fairly presented
and fully disclosed in financial statements.

Book

1.

2. Accounting and Auditing Expertise

The complexity of today’s environment demands that the auditor be fully versed in the technical
accounting and auditing pronouncements. In addition to that technical understanding, the auditor must
have a sound conceptual understanding of the basic elements underlying financial reporting. This
conceptual understanding is necessary to address the ever-increasing infusion of new types of
transactions and contracts for which accounting pronouncements do not exist. As an example of these
new transactions, many financial instruments, such as derivatives, did not exist a few years ago. The
auditor is expected to discern the economic substance of these new transactions and use the financial
conceptual model to “reason” to the appropriate accounting treatment for these newer transactions
which the Financial Accounting Standards Board (FASB) may not have specifically addressed. Likewise,
the auditor must fully understand the fundamental concepts of auditing. Understanding the concepts, as
opposed to just the rules, will allow the auditor to adapt to changing economic situations or to plan
different kinds of audit or assurance engagements.

Case 1D

Who is the most important user of an auditor’s report on a company’s financial statements:

• Company management

• The company’s shareholders

• The company creditors

Briefly explain your rationale and indicate how auditors should resolve potential conflicts in the needs of
the three parties.

Course Hero

The most important user is the public, which are the company’s shareholder. These people are the most
important because they are the ones who make decisions based on the financial information about the
organization.

Book

The Need for Unbiased Reporting

The capital markets are built on transparent financial reporting; i.e., the statements reflect, within the
limits of the accounting model, a true and fair view of the organization’s financial results. The statements
do not favor one user over another. All users are considered important. In many cases, the interests of
the various users can conflict. Current shareholders might want management to use accounting
principles that result in higher levels of reported income, but lending institutions generally prefer a
conservative approach to valuation and income recognition. Exhibit 1.3 presents an overview of
potential financial statement users. The auditor must also consider whether a misstatement might be
material to a user. The need for unbiased reporting can easily be seen by examining a situation in which
a bank is considering a company’s loan request. In preparing its report, the management of the company
wishes to obtain the loan and prefers that its auditors agree with its own assessment of its financial
accomplishments. The bank relies on the financial statements of the company, among other information,
to assess the riskiness of the loan—i.e., the likelihood that the company will not be able to repay the
loan and its interest in a timely fashion. If the loan is made at a good rate, the bank will prosper and may
be able to offer higher savings rates to attract more depositors. The company receiving the loan will be
able to expand, hire new workers, and increase the community’s work force. All parties benefit from
accurate, unbiased information that portrays economic results. The more accurate the financial
information provided to the bank, the more positive the overall results of its decision will be, not merely
for the company and the bank, but also for society as a whole.

Case 1E

How does an audit enhance the quality of financial statements and management’s reports on internal
control? Does an audit ensure a fair presentation of a company’s financial statements or that internal
control systems are free of material deficiencies? Explain.

Course Hero

The auditor’s job is to obtain reasonable assurance about whether management’s statements are
materially accurate and to provide a publically available report based on the auditor’s findings. The
audited financial statements are provided to third-party users who have vested interest in the
organization. For the auditors to complete their job; management has responsibilities for (a) preparing
and presenting financial statements in accordance with the applicable financial reporting framework, (b)
designing, implementing, and maintaining internal control over financial reporting, and (c) providing that
auditors with information relevant to the financial statements. An audit is designed to give a reasonable
or positive assurance that the statements are materially accurate presentation of the company’s
performance and financial condition.

Book

Solution Manual

The audit enhances the quality of financial statements because the user has the assurance that an
independent, qualified professional has examined the financial statements and has rendered an opinion
on their fairness. The independence and expertise of the auditor serve as a quality control function to
overcome the potential bias of management in presenting the financial statements in a manner that
most flatters an assessment of their performance. The audit is designed to add credibility to the financial
statements.

An audit does not necessarily guarantee a fair presentation of a company's financial statements,
although it does dramatically increase the likelihood that there are no material misstatements in the
company's financial statements. The audit provides reasonable, not absolute, assurance about the
accuracy of the financial statements. The caveats about fairness exist for two reasons:

 Fairness is judged within a framework of GAAP. Some question whether GAAP results in the fairest
possible presentations when there are significant changes in market values of investments or assets. For
example, the SEC has encouraged financial institutions to move from using historical cost required by
GAAP to market values for all investments in securities because it believes that market value presents a
better picture of economic reality than does historical cost.

 Although designed to detect material fraud, it might be possible that a well-executed audit may still fail
to detect fraud.

Case 1F

In what ways does the practice of internal auditing differ from the practice of public accounting? To
whom is the internal auditing function responsible?

Book

The Internal Auditing Profession

Internal auditing is defined as: an independent, objective assurance and consulting activity designed to
add value and improve an organization’s operations. It helps an organization accomplish its objectives by
bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk
management, control, and governance processes.6 Internal auditing has emerged as an exciting
discipline and an excellent training ground for future management positions. The emphasis on adding
value and improving operations squarely aligns internal auditing with stockholders, the board of
directors, and management. The scope of internal auditing is broad and includes the evaluation of
processes to identify and manage risk, to develop and implement effective controls including those
designed to ensure efficient operations, and to ensure that the governance process is working
effectively. Internal auditing, whether it is performed in a company or in the practice of a public
accounting firm, is increasingly becoming a strong alternative entry point into the auditing profession.
The role of internal auditing is enhanced by requirements of both the NYSE and NASDAQ for listed
companies to retain an internal audit function. The existence of an effective internal audit function is
considered an important part of an organization’s internal controls. Internal auditing provides both
assurance and consulting services. Assurance comes in the form of assuring management and the board
of directors on the company’s compliance with policies or regulatory requirements, or the effectiveness
of processes and operations. Internal audit activities often identify significant problem areas and the
question has been: “Can the auditor assist the company in identifying potential solutions?” The
profession has answered that question with an unequivocal “yes.” Internal auditing has unique data
analysis skills and an independence from operations that can add value to task forces or other
approaches taken by management to deal with problems. The internal audit function can analyze and
identify potential solutions. However, management is responsible for making the choice of which
solution to implement and must take responsibility for implementing the solution. Internal auditing has
been very active in assisting organizations in documenting and evaluating the quality of internal control
as part of the organization’s Section 404 compliance with the Sarbanes-Oxley Act. An interesting task of
internal auditing is the analysis of company operations, often referred to as an operational audit.
Operational audits are designed to evaluate the effectiveness, economy, and efficiency with which
resources are employed. An operational audit can be applied to virtually every facet of an organization’s
operations. Operational audits are both challenging and interesting because the auditor must develop
objective criteria to evaluate the effectiveness of an operation. The auditor must become familiar with
best practices across companies as well as within the organization to develop such criteria. The auditor
then must develop methodology, including the analysis of market data as well as internal information, to
evaluate the effectiveness of operations. The auditor will have to thoroughly understand business
processes and how various processes fit together across the organization. The emphasis is on improving
operations and the profitability of the organization.

The Public Accounting Profession

The public accounting profession varies from sole-practitioner firms to large multinational professional
services firms such as the Big 4. Many of the regional and local CPA firms provide a variety of services to
both audit and non-audit clients. The large public accounting firms may provide many of the same
services—but not for audit clients. For example, all of the Big 4 firms provide significant internal audit
services tocompaniesthatobtaintheirfinancialstatementauditsfromotherpublicaccounting firms. Smaller
accounting firms that do not have public clients are still constrained by AICPA rules on services that they
may perform for an audit client, but for the most part, the smaller firms do provide information systems
consulting, financial planning, tax planning, and internal audit services to both audit clients and non-
audit clients.