CHAPTER 1 Introduction to Auditing

SOLUTIONS FOR REVIEW CHECKPOINTS 1-1 Auditors add credibility to financial information provided by the accountable party such as management (i.e. auditors make the financial or other information more likely to be true). Other common ways of characterizing this property of audited numbers is that the numbers are more accurate, have higher assurance, or are more reliable. hese relate to different dimension of truthfulness, as we discuss later in the te!t. Auditing is the verification of numbers provided by others. o attest means to lend credibility or to vouch for the truth or accuracy of the statements that one party makes to another. he attest function is a term often applied to the activities of independent $As when acting as auditors of financial statements. %ince financial statements are prepared by managers of an entity who have authority and responsibility for financial success or failure, an outsider may be skeptical that the statements are ob&ective, free from bias, fully informative, and free from material error" " intentional or inadvertent. he audit opinion of an independent" $A auditor helps resolve those doubts because the auditor's success depends upon his independent, ob&ective, and competent assessment of the conformity of the financial statements with (AA$. he auditor's role is to lend credibility to the statements, hence the outsider will likely seek his independent audit opinion. 1") *lient+ Auditee+ Auditors+ the company, board of directors, agency, or some other person or group who retains (hires) the auditor. ,sually the party who pays the fee. the entity (e.g., business firm, hospital, city government) whose financial information is under audit. report to the client on the auditee's financial or control information.

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hree party accountability consists of the auditor, the accountable party of the auditee such as management of the auditee, and the users. ,sers include the client as defined above. raditionally management hired the auditor so that there was some confusion as to who was the true client. -ew corporate governance concepts in part attempt to clarify this three party accountability. 1". Auditors performing auditing gather evidence related to the assertions management makes in financial statements and render a report. Accountants performing accounting record, classify, and summarize (report) a company's assets, liabilities, capital, revenue, and e!pense in financial statements. Accountants produce the financial statements, auditors audit them. he conditions of comple!ity, remoteness and conse0uences produce demands by outside users for financial reports. hey cannot produce the reports for themselves because of these conditions. *ompany managers and accountant produce them.

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%tudents can refer to the AAA and *;*A definitions in *hapter 1. %ome instructors may want to e!tend the consideration of definitions to include the internal and governmental definitions. ;n response to <what do auditors do,< students can refer to 4!hibit 1"# and respond in terms of+ (1) obtain and evaluate evidence about assertions management makes about economic actions and events, (#) ascertains the degree of correspondence between the assertions and (AA$, and ()) gives an audit report (opinion). %tudents can also respond more generally in terms of <lending credibility< to financial statements presented by management (attestation).

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he essence of the risk reduction theory is that audits of financial statements reduce the information risk (probability of materially misleading statements) to users to a socially acceptable level. %elf"regulation refers to the powers a professional group has in regulating its affairs without intervention by the government or government established e!ternal regulator. hese affairs include setting of standards, codes of conduct, education re0uirements, certification, and disciplining of members. ?inancial analysts and investors depend upon financial reports for making stock purchase and sale decisions. *reditors (suppliers, banks, etc.) use them to decide whether to give trade credit and bank loans. :abor organizations use them to help determine a company's ability to pay wages. (overnment agencies and $arliament use them in preparing analyses of the economy and in making laws concerning ta!es, subsidies, and the like. hese various users cannot take it upon themselves to determine whether financial reports are reliable, therefore low in the information risk scale. hey do not have the e!pertise, resources, or time to enter thousands of companies to satisfy themselves about the veracity of financial reports. hus they hire independent auditors to perform the attest function and reduce the information risk.

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he *anadian board (*$A2) is more self regulatory in that the profession has more influence through having a higher percentage of board membership, the monitoring process is less public and more designed to help firms improve their practices. he *;*A continues to set audit standards. he $*AO2, on the other hand, not only sets standards but also has a more confrontational an public approach in its monitoring process. ?orensic accounting is the broader term that includes fraud auditing. ?orensic accounting is the use of accounting for legal or investigative purposes. ?raud auditing is the use of forensic accounting in criminal investigations involving allegations of fraud. ?rauds that $As are most interested in are misappropriation of assets and fraudulent financial reporting (misreporting). ?raud is intentional deception resulting in in&ury to another. ?rauds that $As are most interested in are misappropriation of assets and fraudulent financial reporting (misreporting). Operational auditing is the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business ob&ectives, and compliance with company policies.

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he *;*A views operational auditing as a type of management advisory service offered by public accounting firms. 1"1) he elements of comprehensive auditing include+ (1) financial and compliance audits, (#) economy and efficiency audits, and ()) program results or effectiveness audits. $ublic sector is the part of the economy represented by all levels of government. $ublic companies are companies whose shares are traded on the stock markets. A compliance audit involves a study of an organization's policies, procedures, and performance in following laws, rules, and regulations. An e!ample is a companyAs compliance with environmental laws. Other kinds of auditors+ 9evenue *anada agentsBauditors, provincial and federal bank e!aminers, provincial insurance commissioner auditors. ?inancial statement audits are intended to provide assurance there are no significant intentional or unintentional misstatements. *AAs, *(AAs, and *;AAs 4!amples of attestation services+ Cote counts (Academy Awards) Amount of prizes claimed to have been given in sweepstakes advertisements ;nvestment performance statistics *haracteristics claimed for computer software programs 1"1@ Audits of financial statementsD Auditing %tandards Eork on unaudited financial statements of public companiesD 9eview 4ngagement %tandards Eork on unaudited financial statements of public companiesD *ompilation 4ngagement %tandards (%A%) he three ma&or areas of public accounting services+ Accounting and auditing a!ation 5anagement advisory services (consulting) 1"#7 1"#1 he %4* site is more comprehensive but covers only *anadian companies cross listed on ,.%. e!changes. he ;?A* site is at www.ifac.org and click on Fstandards and guidance.G

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SOLUTIONS FOR EXERCISES AND PRO LE!S 4$1"1 Ehen the $A is hired by 8ughes *orporation, he can no longer be considered independent with respect to the annual audit. he annual audit may then be unnecessary in a short" run view and unnecessary to the e!tent of services e!clusive of the attest opinion. ;t is true that the in" house *$A can perform all the procedural analyses that would be re0uired of an independent auditH however, it is e!tremely unlikely that he could inspire the confidence of users of financial statements outside the company. 8e cannot modify the perception of potential conflict of interest that creates demand for the independent audit. As a matter of ethics rules, this $A would be prohibited from signing the standard un0ualified attest opinion. 4$1"# Iou should point out that you will be unable to replace the independent audit with your own communication output as controller. 5ake the point that you can conduct an effect internal audit function and be of considerable service to management and can even assist the independent auditors with preparation of schedules and general cooperation (thus facilitating the independent audit). -evertheless, as a member of management, it would be impossible to be truly ob&ective and unbiased about the financial results of management's decisions, hence the directors could not satisfy their obligations to the shareholders' interests. -either could you issue an opinion to be used by outsiders. :acking an opinion on the financial statements, the company could find itself in noncompliance with audit re0uirements of a stock e!change, a $rovincial %ecurities *ommission, or the ,.%. %ecurities and 4!change *ommission. 4$1") a. b. c. d. e. risk of litigation needs offsetting lower information risk (for e!ample, litigation due to share practice decline or failure to meet a bond covenant). strength of internal controls (e.g., controls over financial instruments, controls over cash). financial health of client (industry factors, economic factors). management compensation system (management highly motivated to beat earnings targets, compensation tied to factors over which management has little control may motivate management to Fmanage earningsG). private vs. public company (publicly held company owners are more reliant on financial statements for information about their investment).

4$1". ?inancial statements are prepared on basis of (AA$. Jnowledge of (AA$ is thus indispensable for determining if the financial statements are in conformity with (AA$. ?or e!ample lease accounting consists of some very specific rules (bright line rules) that the auditor effectively tests compliance with. ,nfortunately such detailed rule based accounting leads to what some refer to as a checklist mentality where the form is more important than the substance. 4nronAs special purpose entity accounting also comes to mind. 4$1"/ Operational Auditing 2igdeal cannot hire the OA(. for private industry. his government agency does not perform operational audits

One possibility is the management advisory services department of a large $A firm. he ma&or advantage may be total ob&ectivity. he $A firm has no stake in making a report
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reflect favorably or unfavorably on %malltek (provided there are no prior relations of the $A firm with 2igdeal managers that may suggest a bias or with %malltek). he possible disadvantage is that the $A firm may not possess the re0uired e!pertise in %malltek' type of business. Another possibility is the 2igdeal internal audit department. he ma&or advantage may be a thorough appreciation of 2igdeal's managerial effectiveness and efficiency standards and a longstanding familiarity with 2igdeal's business. he possible disadvantage could be that the internal auditors may not be independent enough from internal management pressures for making or breaking the deal for reasons other than %malltek's efficiency and effectiveness. Another possibility is a non$A management consulting firm. he ma&or advantage of ob&ectivity would be similar to the $A firm, and such firms often have e!perts in manufacturing, sales, and research and development management. he ma&or disadvantage could be a lack of appreciation and familiarity with 2igdeal's management standards (as possessed by the 2igdeal internal auditors). 4$1"3 he neighbor appears to be uninformed on the following points+ 1" According to auditors' dogma, $rice Eaterhouse did not prepare the Kodge *orporation financial statements, and no auditor prepares a company's statements. An un0ualified opinion does not mean an investment is safe . ;nform your neighbor that Kodge management is primarily responsible for preparing the financial statements and deciding upon the appropriate accounting principles. ell your neighbor that the financial statements are history . he value of his investment depends on future events, including the many factors that affect market prices. ell him the opinion only means that the statements conform to (AA$ (and you can add that the auditor knows of no material fraud or error).

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4$1"= ;dentification of Audits and Auditors he responses to this matching type of 0uestion are ambiguous. he engagement e!amples are real e!amples of e!ternal, internal and governmental audit situations. Iou might point out to students that the distinctions among compliance, economy and efficiency and program results audits are not always clear. he <solution< is shown below in matri! form, showing some engagement numbers in two or three cells. he re0uired schedule follows. ype of Audit Jind of Auditor ;ndependent $A ;nternal Auditor ?inancial %tatement #, 17 3, > ., > *ompliance 4conomy, 4fficiency $rogram 9esults

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(overnmental (A(*) 9evenue *anada Auditor 2ank 4!aminer 1. #. ). .. /. 3. =. >. @. 17.

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1, ) L L (overnmental (A(*) ;ndependent *$As (overnmental (A(*) ;nternal auditors 9evenue *anada auditors ;nternal auditors 2ank e!aminers ;nternal auditors (overnmental (A(*) ;ndependent $As

?8A loan interest e0uity Advertising agency financial statements Kept. of ;nterior policies 5unicipal services a! shelters est pilot reporting 2ank solvency 5aterials inspection by manufacturer Krug enforcement vehicle seizures %ports comple! forecast

4conomy and 4fficiency or $rogram 9esults ?inancial statement *ompliance or 4conomy and 4fficiency or $rogram 9esults 4conomy and 4fficiency *ompliance *ompliance *ompliance *ompliance or 4conomy and 4fficiency 4conomy and 4fficiency ?inancial statement

4$1"> Analysis and Mudgment his problem is one of 9obert Ashton's cases on &udgment and decision making ( Accounting 9eview , Manuary, 1@>., pp. =>" @=.) Ashton gives credit to Moyce and 2iddle, <Anchoring and Ad&ustment in $robabilistic ;nference in Auditing.< Mournal of Accounting 9esearch , %pring, 1@>1, pp. 1 he case is set up to illustrate a person's tendency to anchor an estimate on some known information and ad&ust from that point in the course of performing analysis. his particular case set" up is intended to illustrate con&unctive and dis&unctive events. Ashton's <answer key< e!plains in this manner+ A"#ton$" An"%&r K&' ()*ridg& d + his e!ercise focuses on probability estimates for two types of comple! events called <con&unctive< and <dis&unctive.< he occurrence of a con&unctive event depends on the &oint occurrence of all of a number of sub" events, each with a given probability of occurrence . An e!ample is getting three )'s in a row when rolling a die. his is a con&unctive event with probability of 1B3 raised to the third power (1B3 ! 1B3 ! 1B3), or about 7.77/. An e!ample of a dis&unctive event is getting at least one of a number of sub" events, such as one ) in three rolls of the die. he probability of this dis&unctive event is about 7..# ;f you are asked to estimate the probabilities of the con&unctive and dis&unctive events of rolling the die, a natural starting place (anchor) would be to know that the probability of getting one three in one roll is 1B3, or 7.13=. hen to estimate the harder con&unctive event (three )'s in a row), a downward ad&ustment would be re0uired. *onversely, for the dis&unctive event (one ) in three rolls), an upward ad&ustment would be needed. 8owever,
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since ad&ustments from an anchor are usually insufficient, the estimated probability of the con&unctive event will likely be too large, and that of the dis&unctive event too small. For, A of the problem (the one in the te!tbook chapter) is a con&unctive statement of the problem, and it asks for an estimate of the probability of successful product introduction. Eith the five sub" events considered independent of each other, the best answer is 7.//. (.>7 ! .@7 ! .@/ ! .@7 ! .@7). %tudents may anchor on the probabilities of the elementary sub" events and fail to ad&ust sufficiently downward, and their probability estimates will be higher than 7.//.. For, of the problem (reproduced on the ne!t page, not in the te!tbook) is a dis&unctive statement of the same problem, and the best answer is still 7. //.. ?orm 2, however, is stated in terms of failure in the chain of events. (%tudent responses must be subtracted from 1.777 to make them comparable to ?orm A.) ;f students anchor on the probabilities of the elementary dis&unctive sub" events in ?orm 2, their probability estimates (subtracted from 1.777) will probably be too low . -O 4 O ;-% 9,* O9%+ Iou may want to reproduce ?orm 2 and give both the te!tbook problem (con&unctive) and the ?orm 2 alternative (dis&unctive) to different groups of students to illustrate the anchoring and ad&ustment behavioral phenomenon. Iou may also want to give students a response scale to make your classroom discussion easier. Ask them to circle one+ .77 .17 .#7 .)7 ..7 ./7 .37 .=7 .>7 .@7 1.77

4$1"@ 5anagement certification means that, in the words of %OL, F he *4O and *?O of each issuer shall prepare a statement to accompany the audit report to certify the <appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer.< A violation of this section must be knowing and intentional to give rise to liability. G 2efore %OL, managementAs responsibility was implicit, now it is made publicly e!plicit in writing. he primary effect on auditors is to reduce their legal liabilities by making it clearer that management takes on primary responsibility for financial reporting. Auditors are still needed because as the chapter discusses users may not trust management so any statements management makes does not really address this problem. 5anagement however is now held more accountable. ?or e!ample, management may no longer claim they didnAt understand technical aspects of accounting and deferred to the auditorAs &udgment.

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$rotecting investors is the most likely response. ;n public sector, protecting the ta! payer would be another possible response. ;n both cases, however, we are talking about capital providers as the ) rd parties and capital users as the # nd party in a ) party accountability relationship. here are other issues, however, such as how sophisticated are the ) rd parties. ?or e!ample, do they understand the limitations of (AA$D 8ow much about (AA$ should we e!pect them to understandD ?or e!ample, can we assume that they know about the accounting risks associated with (AA$D his 0uestion is very open ended.

4$1"11 1 st party N*9A auditor, # nd party N t a !payer, ) rd party N *anadian government

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4$1"1# 5ost non" auditors feel that an auditorAs prime responsibility is to detect fraud (part of the e!pectationAs gap). his was the ma&or focus of audits before the #7 th century. he switch to fairness of presentation seemed to take place with increased use of estimates in accounting in the #7 th century, especially after passage of the %4* Acts. he past decade has brought a renewed interest in fraud detection, especially in the post" 4nron environment.

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