Review Question Solutions

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University of Toronto Scarborough
Financial Accounting
Jackson/ Yien

Review Questions Solutions Chapter 1, An Introduction to Auditing Page 7 A1 What is an audit? A financial statement audit? An audit of internal control over financial reporting (ICFR)? An integrated audit? An audit is a process conducted to look for correspondence between a representation or statement and support for the representation or statement. A financial statement audit is a process through which an auditor examines and evaluates support for the proposition that what is shown in the financial statements of a company represents the underlying economic events that the company has experienced. An audit of internal control over financial reporting is a process that examines whether the companys internal controls are effective and as a result will enable it to produce fair and reliable financial statements. An integrated audit is a process whereby the auditor performs checks in order to state an opinion about whether internal control over financial reporting is effective and the financial statements are fair. A2 What is the purpose of an audit? The purpose of an audit is to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. A3 What types of companies must have an integrated audit? Public companies; entities that have to register with the SEC. A4 What is a clean or an unqualified opinion? A clean or unqualified audit opinion concludes that the internal controls over financial reporting are effective and the financial statements are a fair representation of the companys economic experiences and situation. Page 10 B1 Why is auditing described as a systematic process? Auditing is a systematic process because it involves a plan of action and specific steps to achieve an outcome. B2 What are assertions? For purposes of an audit, who makes assertions? In a general sense, an assertion is a statement that someone makes, presenting the statement as being correct or true. In auditing, assertions are representations that various economic events took place affecting the company and that the financial statements are a communication of those economic events and their results. Management makes financial statement assertions. Although not in the form of financial statement assertions, management also makes statements in its internal control report that indicate whether or not ICFR is effective. B3 What is audit evidence? Audit evidence is the support the auditor uses to examine the appropriateness of managements assertions. Audit evidence can be documents and records, but can also come in other forms. Audit evidence is anything the auditor uses to evaluate the correspondence between management assertions and the real state of affairs. B4 How are auditing and accounting different? Why do you have to be a good accountant to be a good auditor? Auditing involves the independent and objective verification or assessment of the output, reports or representations of others. Accounting involves the recording, accumulation and compilation of transactions in order to communicate the economic results of the activities of the business. To be a good accountant you must be able to determine what is important about the business activities and transactions, the appropriate accounting for the underlying events and the controls needed to capture the information and present it properly. An auditor also must be able to audit management assertions as presented in reports and financial statements. B5 Who is responsible for the report on internal control over financial reporting? Who is responsible for the financial statements? The audit report? How might these documents change as a result of the audit? Management is responsible for the report on ICFR and the financial statements. The auditor is responsible for the audit report. Management may choose to change its internal control report or the financial statements based on the auditors conclusions. 1 B6 What is the Sarbanes-Oxley Act? The Sarbanes-Oxley Act of 2002 (SOX) is federal legislation that requires, among other things, that an audit of ICFR accompanies the financial statement audit of public companies. B7 What is the COSO Internal Control Framework (COSO IC Framework), and why is it important? The COSO IC Framework is one of the accepted sets of criteria for design and function of internal control. It is important as it provides a benchmark for the assessment of the effectiveness of ICFR. The COSO IC Framework helps management to design ICFR and the auditor to audit it. B8 What is managements assertion that is assessed in a financial statement audit? In an audit of internal control over financial reporting (ICFR)? That the financial statements fairly represent the economic situation of the entity. That the ICFR is effective. B9 What entity issues the standards governing the integrated audit of a public company? The Public Companies Accounting Oversight Board (PCAOB) Page 13 C1 How does an audit benefit the capital markets? How does it benefit the company being audited? It provides the users of financial statements with assurance that the financial statements can be relied upon. It supports the orderly functioning of the capital markets by reducing the fear that loss will occur from reliance on information that may be inaccurate. This encourages public investment. This participation in the capital markets is an important driver of a successful United States and global economy. Because the risk of incorrect financial information is decreased, so is the cost of capital. C2 How might audits prevent as well as detect misstated financial statements? Why is this of value to the capital markets? Audits help prevent misstated financial statements because they motivate businesses to be sure that their financial statements are fair and in accordance with GAAP. If businesses know they will be audited, management will be motivated to make sure the financial statements are appropriate before they are ever released to users. This encourages investor confidence with the resulting benefits to the economy. C3 What is the difference between a financial statement error and financial statement fraud? A financial statement error is the unintentional presentation of improper financial statements. A lack of understanding of the accounting standards, or skill at applying them, can lead to errors in the financial statements. Even if they know what to do people sometimes just make mistakes. A financial statement fraud is the intentional presentation of misleading financial statements. Misappropriation of assets is also fraud if the thief covers it up in the financial statements. Page 15 D1 Why do shareholders value audited financial statements? Shareholders value audited financial statements because: (1) the audit provides assurance about what management has reported as the companys performance and financial position, (2) they use financial information to make investment decisions, (3) even though the financial statements are not the only source of information they are important and often confirm or validate that other information available to the sock markets is legitimate and credible, (4) it gives them more confidence that the information they are using for investment decisions is reliable. D2 Why do the Board of Directors and audit committee value an integrated audit? The Board of Directors is responsible for protecting shareholder interests and hires management to run the company. The Board of Directors must safeguard shareholder interests by overseeing managements activities. Management is accountable to the Board of Directors for the companys performance. The audit committee of the board of Directors has a key responsibility in fulfilling the Boards fiduciary duties through its involvement with the external auditor and the audit. The Board of Directors and audit committee need the audit to assist in discharging their fiduciary responsibilities to shareholders and regulators. 2 D3 What benefits can management derive from a company having an integrated audit? A clean opinion enhances managements credibility with shareholders and others and provides access to the stock exchanges. An audit is often required by creditors such as banks and lending institutions. An audit helps provide access to these sources of capital at the best costs. An audit enhances reliability of the companys performance indicators; one may be required before performance- based compensation and bonuses are awarded. Feedback from the auditor may help management improve operational and financial efficiencies. D4 What is a shareholder usually a remote owner? Why does the fact that shareholders are remote owners cause them to benefit from an audit? Shareholders of public companies are not usually involved in the day to day running of the business and are therefore considered remote from the business..
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