Review Question Solutions

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8 Apr 2011
Review Questions Solutions
Chapter 1, An Introduction to Auditing
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A1 What is an audit? A financial statement audit? An audit of internal control over financial reporting (ICFR)? An integrated
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 company’s
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 company’s economic experiences and situation.
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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 management’s 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
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 auditor’s conclusions.
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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 management’s 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)
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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.
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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 company’s 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 management’s activities. Management is
accountable to the Board of Directors for the company’s performance. The audit committee of the board of Directors has a key
responsibility in fulfilling the Board’s 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.
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D3 What benefits can management derive from a company having an integrated audit?
A clean opinion enhances management’s 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 company’s 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
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..
Given that
-an individual shareholder may not understand all of the complexities of the financial statement presentation,
-even if the shareholder is diligent and has the knowledge to read and understand the financial statements,
he or she is not close enough to the business to be aware of all of the company’s day to day activities,
-even if he or she could, the owner would not likely want to spend the time to evaluate whether each
transaction was properly recorded and disclosed in the financial statements.
Auditors can provide assurance regarding the effectiveness of ICFR and the appropriateness of the financial statements and produce a
report that all shareholders can use.
D5 What do the complex transactions that occur in many businesses today have to do with the value of an audit?
The audit can provide reasonable assurance that the complex transactions are properly reflected in the financial
statements prepared by management.
D6 How can a company benefit from an audit in terms of its operations and performance?
During an audit the auditor examines and tests the functioning of numerous company controls and processes
and in so doing is able to recommend measures whereby the company can improve efficiency, either in financial and accounting
activities or operations.
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E1 Why is knowledge of auditing valuable to an accountant who is not working as an auditor?
Knowledge of the audit process is valuable to all accounting employees.
Understanding the audit process provides a perspective of what the auditors are doing and what they are trying
to accomplish.
It may promote efficiency and effectiveness in providing the audit team with information needed for them to
complete audit procedures.
An accountant in a management position who understands auditing can better communicate with the auditor, not
only during the audit engagement, but also when presented with any audit findings.
The requirement for an ICFR audit often forces accounting and non-accounting employees at all levels of a
public company into an awareness of audit activities; more knowledge in advance is better.
Because of ICFR audits, employees in non-accounting roles may have to deal with ICFR documentation and
reporting. An employee with knowledge of auditing is a valuable asset to the company in supporting company policies, procedures and
documentation that contribute to effective ICFR. The internal non-audit accountant may be the one who designs controls, and explains
their importance to other employees.
E2 In terms of their impact on auditing standards and audits, what is the relationship of the SEC and the PCAOB? The SEC
and the AICPA? The SEC and FASB? Congress and the SEC? State governments and the AICPA?
SEC and the PCAOB
The SEC, following the enactment of the Sarbanes Oxley Act (SOX) structured the PCAOB to be responsible for setting
auditing standards and oversight of audits of public companies, and the audit firms that perform the audits. The SEC approves the
PCAOB standards before they go into effect.
The SEC and the AICPA
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